The dollar fell 12% against sterling in 2006, but why did this happen, and how does it affect you?
The dollar fell 12% against sterling in 2006, but why did this happen, and how does it affect you?
What drives exchange rates
A variety of inter-related factors affect the value of a currency, including:
- Trade imbalances: When countries import more than they export, they effectively sell their own currency to buy the foreign currency they need. In 2006, Americans did this to the tune of nearly $3,000 for every man, woman, and child -- that's almost 7% of GDP. This drives down the value of the dollar.
- Inflation: Normally, currencies with higher inflation will depreciate relative to those with low inflation -- as a currency buys less, it becomes less valuable. This does not seem to be a problem in the case of the dollar, as US inflation is below UK levels. In fact, the low levels on inflation in both countries result partly from the trade imbalances mentioned above; cheap imports from developing countries help to hold average prices down.
- Interest rates: In general, money is attracted to currencies with higher interest rates, driving up their value. At 5.25%, US interest rates are now slightly above sterling's 5%. Some attribute the strong rise in the dollar in 2005 to the tightening of dollar interest rates over that period, and its subsequent weakness to the interruption of that trend.
- Speculative cash flows: This is the big one, often dwarfing the flow of funds related to trade. Over the very long term, fundamental economic factors would be expected to dominate, but in the short term 'hot money' calls the shots, partly driven by interest rates.
What does this mean for British companies?
Many companies buy and/or sell in dollars. Some, like Wolseley
(LSE: WOS)
, derive most of their business from North America; others, like BP
(LSE: BP)
operate in industries where worldwide prices are denominated in dollars. A fall in the dollar reduces the sterling value of dollar revenues and profits, and the sterling cost of dollar purchases. For British exporters trying to sell into the US, this is clearly a problem as a weak dollar makes them less competitive.
Also, a weak dollar means our imports, including oil, are cheaper, so inflation is lower. This in turn means less pressure to increase interest rates, so individuals and businesses have cheaper credit and more cash to spend.
What can dollar-generating companies do?
- Hedging: Companies can arrange dollar transactions in advance at fixed rates. This improves predictability of earnings, but ultimately is a cost to the business. Arranging purchases in the same currency as revenues acts as a natural hedge, but is not always feasible.
- Reporting in dollars: Many companies simply remove the need to translate revenues and profits into pounds, reducing the effect of currency fluctuations on earnings. But for a sterling-based investor this doesn't solve the problem -- you're investing sterling to buy dollar-based profits, so if the dollar falls you still lose.
Where does this leave investors?
Firstly, I don't think we can predict the direction of exchange rates with any accuracy, so I won't try. Consequently, I don't make investments based on expected exchange rates, but it can be useful to understand the extent to which one's investments depend on foreign currency earnings; we know the exchange rates in real time, so this can help in forecasting profits for the current or last period.
