If the dollar is so weak, or about to be given up by the BRICS+ nations for some alternative backed by gold, as Russia has confirmed ahead of next month’s BRICS Summit in Durban, South Africa, imagine what a strong dollar would look like?
The ‘weak dollar’ is so strong it is estimated to be 15.2% overvalued against a basket of 34 currencies, according to economists at the Coalition for a Prosperous America and Blue Collar Dollar Institute. The two produce a monthly index on dollar valuation called the Currency Misalignment Monitor (CMM). The index is designed to provide a rough approximation of the degree of movement of exchange rates that would be required to bring the U.S. into a better trade balance with partner countries over a five-year stretch.
Why the Dollar is So Strong
Why is the dollar always overvalued against most currencies, including the second most used currency in world trade – the euro? Basically, it’s because of the securities market. Stocks and bonds (and real estate) are America’s most important product.
Money from around the world – be it from Japanese bond traders, Chinese exporters, or European life insurance companies – all buy U.S. stocks and bonds. That constant flow of foreign capital into dollar-denominated U.S. securities is one of the main reasons why the dollar is so strong and almost always overvalued.
How overvalued is it?
When compared to 14 of the biggest currencies in the world, the dollar is only undervalued against the Mexican peso (3.6% heading into August) and the Brazilian real (9.5%). It is overvalued against the Japanese yen by 50%.
In the model, each nation’s exchange rate versus the dollar affects the trade balances between the two partners. The weaker the opposing currency, the more the U.S. buys from them and the less the U.S. sells.
Based on the CMM model, if the dollar rate fell 15.2% and remained there, the U.S. trade deficit would shrink over five years because the dollar would lose some of its purchasing power.
An overvalued dollar makes it more attractive for American businesses to buy from abroad, especially in countries with the weakest currencies.
The rise of Vietnam as a contributor to the U.S. trade deficit is an example of both U.S. and Chinese companies leaving mainland China due to tariffs and geopolitics, and the fact that the Vietnamese currency is worth about $0.000042 cents.
Vietnam buys next to nothing from the U.S. because they cannot afford it. But the U.S. imports multiple billion dollars worth of goods from there, leading to a record $116.12 billion deficit with Vietnam in 2022, based on Census trade data.
Japan: Rich Country. Poor Yen.
One yen is worth just $0.007 cents. The dollar has long clobbered the yen. Japan cannot afford American imports. But Americans get bargain basement prices for Japanese imports. This might be good for Japanese exporters, but it is not so good for the Americans that compete with them. (Sony stocks are up 70% in five years, while the MSCI Japan is up 8%.)
The foreign exchange rate between the U.S. and Japan is largely driven by interest rate differentials, with Japanese institutions being known for the “carry trade” – borrowing locally to use that capital to buy foreign debt.
The U.S.- Japan interest rate differential on 10-year government bonds is at 3.41, the highest since 2004. That difference between the interest rate set by the central banks drives yen borrowing to buy dollar debt or stocks. This serves to weaken the yen.
Japanese investors have done this for generations with the Brazilian real, where interest rates are often double-digits. The problem with the Brazilian market is that it is not as large. There are only so many bonds to be had.
For Japanese institutional investors, their outlook is that U.S. interest rates will edge up in the second half of this year, while the Bank of Japan is dovish on interest rates. In fact, some rates were negative in Japan this year, which means investors there are only trading on hopes that yields become even more negative in order to gain from the bond price. At that point, the bond is no longer a yield-producing instrument and becomes like a stock, which defeats the purpose of owning a bond in the first place.
For 25 years, Japan has operated a low-interest-rate, loose-money policy in an effort to kick-start economic growth and a rather “meh” economy. One result of that policy has been a very low value for the yen. At 142 to the dollar, the yen is at similar levels to 1998, despite the fact that Japan’s current account surplus has averaged over $100 billion a year since.
Japanese investors, like the Europeans who also had negative yield for some time, prefer to buy U.S. securities instead. That trend continues apace.
China’s Currency Wipes Out Tariff Costs
In 2018, the Trump Administration imposed an average 25% tariff on some $300 billion worth of manufactured goods from China. Over time, some of those tariffs fell to 15% and even as low as 7%.
But with the RMB some 28% undervalued, based on the CMM model, all of those higher prices on imports have been erased. China is still cheap, even with tariffs. The RMB started 2019 at 6.86 to the dollar and is now 7.14.
The effect of the tariffs is wiped out.
“The Chinese yuan has fallen by about 12% against the dollar since tariffs were imposed,” says Jeff Ferry, chief economist for the Coalition for a Prosperous America in Washington. “Thinking of the bigger picture, the Misalignment Monitor tells us that the dollar is overvalued by 28% against the yuan due to China managing its currency to maintain a huge trade surplus. The undervalued yuan creates a huge competitive advantage for Chinese exporters.”
Earlier this month, Treasury Secretary Janet Yellen said it was too soon to remove tariffs on China. Those tariffs, known as the Section 301 tariffs imposed under Trump, are under review this fall.
Many importers have argued that tariffs led to rising inflation, but that storyline was dispelled this summer.
Global supply chain disruptions following the onset of the COVID-19 pandemic contributed to the rapid rise in U.S. inflation over the past two years, a June report by economists at the Federal Reserve Bank of San Francisco wrote. Evidence suggests that supply chain pressures pushed up the cost of inputs for goods production and the public’s expectations of higher future prices. The authors said these factors accounted for about 60% of the surge in U.S. inflation beginning in early 2021.
Global shipping companies – most of them Asian and European – took advantage of the supply chain snafus caused by China’s Covid-19 lockdowns by hiking prices of containers. The companies were accused of price gouging. The fiasco led to empty containers and port bottlenecks in China for months.
Since supply chain disruptions directly constrain supplies of traded goods, with only indirect effects on services, one would expect a supply chain shock to boost goods price inflation, the Fed economists said in June.
Moreover, the weaker currencies versus the dollar put deflationary pressure on tariffs, meaning even though U.S. importers were often asked to pay the tariff difference, their stronger dollar went further for them.
The Economic Policy Institute said that talk of tariffs leading to rising inflation was “deeply dishonest”.
“The pre-Trump status quo in trade policy for decades was deeply damaging to working families and domestic business,” said Robert Scott, a research associate with EPI. “Many of those who inflicted this damaging status quo on U.S. workers have tried to leverage the current inflationary episode to roll back all tariffs introduced under the Trump administration in the name of containing inflation. This is a deeply dishonest linkage. Tariffs introduced over the past five years were not large enough, and the timing of them is completely inconsistent with them being a cause—or plausible significant solution—for inflation.”
For Ferry, a strong dollar is okay. An overvalued dollar is not OK for the health of the U.S. economy. “The pattern of interest rate increases we’ve seen around the world over the last year is making it worse because the U.S. has raised rates more aggressively than most other nations,” Ferry says, adding to the global money manager’s interest in buying U.S. yield.
The CMM is based on pioneering work done by William Cline at the Peterson Institute for International Economics. The Cline model, also known as SMIM for Symmetric Matrix Inversion Method, uses IMF forecasts for current account balances for 34 nations to derive a simultaneous solution for all exchange rates that will minimize national current account balances, including surpluses and deficits.
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