Even in quiet times, predicting the paths of exchange rates is a fool’s errand. Economists can come up with the most reasonable of arguments for why this currency will rise and that will fall, only to have their forecasts overturned by small shifts in the financial weather. In 2008, working out where foreign-exchange markets might be in a week’s time, never mind a year’s, has been about as easy (and as sensible) as holding a finger to the wind in a tornado.
To make matters trickier still, past financial crises have been national or regional—meaning that analysts have had only a few currencies to focus on. This time the turmoil is much broader, and America and western Europe are in the thick of it. And whereas economies as a whole can suffer or stockmarkets around the globe can fall, in foreign-exchange markets it is relative prices that count: whether the world economy is doing badly or well, some currencies must go up and others down.
Even so, some trends are discernible. And those trends do not look at all bad for—of all currencies—the dollar, even though the financial crisis began in the United States and America’s economy is in hard times. Indeed, as the crisis intensified during 2008, the dollar’s six-year decline against the euro and some other leading currencies went into reverse. There are good reasons to think that the dollar will hold up in 2009.
Everything is relative
The demand for a currency depends on the return that investors expect from holding it. That in turn depends largely on the interest rates on offer and on underlying rates of economic growth. At first sight, little of this favours the dollar. American official short-term interest rates are far more likely to go down than up. The rates on Treasury notes have at times fallen to almost zero: at almost any price, the safety of government paper trumps risky-looking banks. And America’s growth prospects for 2009 are poor. Some economists have even argued that the financial crisis could spell the end of the dollar’s long reign as the world’s premier reserve currency—doing for the greenback what the Depression did for the gold standard.
Look around the world and there are, to be sure, better bets on offer than the dollar: the yen is one, even though Japan’s economy is faltering. For Japanese investors, prospects are no better abroad than at home; and the carry trade—borrowing cheap yen and buying assets denominated in high-yielding currencies—has become a much harder game to play. The Chinese yuan is not about to reverse its climb either, even if exports and the economy slow down. But European currencies are a different story.
In both Frankfurt and London, central banks have more room to cut rates than in America, and are likely to use it. That would narrow transatlantic differentials. The outlook for growth in Europe is no better—and is perhaps even worse—than in America. Housing markets in Britain, Ireland and Spain were every bit as bubbly as in America.
Moreover, the backing of Uncle Sam still counts for something. That will help the dollar if a slowing world economy gives investors in emerging markets a lasting bout of the collywobbles. (It seems a fair bet that it will.) Treasury notes are still regarded as a safe haven—and they will continue to be trusted, even if America has to issue many more billions of dollars’ worth to finance the bail-out of its banks. Stephen Jen, an economist at Morgan Stanley, points out that in past years there have been huge flows out of dollars and yen into European and emerging-market currencies, which will have to return. He has a long list of currencies that could come under severe pressure, which includes the Indian rupee, the South Korean won and the Brazilian real, as well as “most” east European currencies.
A faltering world economy will also weigh down commodity producers’ currencies: the Australian and New Zealand dollars, which lost ground in 2008, may lose more in 2009. The most vulnerable currencies when financial storms break, however, belong to countries whose banks, companies and households owe large amounts of short-term debt denominated in foreign money. In the Asian crisis of 1997-98, that meant a collapse of the Thai baht, the Indonesian rupiah and others. This time the most conspicuous victim has been the Icelandic krona. Even if they are not in for such a rough ride, other countries may be exposed too.
All in all, if 2009 brings a currency crash, the dollar is unlikely to be the victim.