INBU 4200 Spring 2004 Addendum to Lecture 4, Part 1 A Review of Exchange Rates, Interest Rates and U.S. Trade with China February 2004 Information

Fundamentals of the Dollar's Fall The rise of the yen and euro against the U.S. dollar Source: WSJ THE DOWNWARD DOLLAR INVESTORS WORLD-WIDE are watching the value of the U.S. dollar fall, and no U.S. intervention has taken place to counteract its steady depreciation. Plagued by the swelling budget and trade deficits, low interest rates and waning foreign investment flows, the dollar has lost 26% of its value against the world's major currencies since early It has fallen 14% against an index of all U.S. trading partners' currencies, including Asian countries. The euro continues to steam ahead, reaching a record intraday high of $ in February. The European Central Bank recently expressed concern about excessive exchange-rate moves and said the common currency has climbed too high. The yen, meanwhile, is trading at about 105 to the dollar. The dollar has lost about 11% against the yen since year-end The decline may have been steeper hadn't Japan stepped in, spending nearly $200 billion in 2003 to restrain the yen's rise.

A MAIN CONTRIBUTOR to downward pressure on the dollar is the current-account deficit -- the shortfall in goods, services and the flow of investments between the U.S. and the world. The deficit hovers at half a trillion dollars annually. As the widest measure of U.S. international trade, it's running at about 5% of U.S. gross domestic product, a high and historically unsustainable level. The trade deficit is the largest component of the U.S. current-account deficit. The trade deficit grows when a country imports more goods and services than it exports. Currently, the U.S. is now importing at greater than 1.5 times the rate of its exports, meaning the U.S. has been buying about $500 billion a year more from foreign countries than those countries buy from the U.S. Analysts expect imports to keep increasing as companies replenish inventories and U.S. manufacturing operations move overseas. By country, the shortfall with China is the largest at a record $ billion for The U.S., in large part, finances its trade deficit by selling assets, including Treasury bonds, Treasury bills, corporate bonds, stocks, real estate and companies to foreign investors, much as you might take out a home-equity loan or sell some of your mutual funds if your wages weren't enough to cover your spending habits. Traditionally, foreigners have financed the debt by buying U.S. securities, but because U.S. interest rates are so low, the returns on their investments have become less attractive. While that reduces many private investors' appetites for U.S. investments, foreign governments, especially China and Japan, remain aggressive buyers. Chart: U.S. Current Account as a % of GDP

Key interest rates in the U.S. and the EU DIFFERENCES IN the level of interest rates from country to country have a powerful influence on the relative value of currencies. Money tends to flow to countries where interest rates are higher as investors seek out higher returns. Investors' purchases lift the value of the currency in which the investments are denominated. The low level of rates in the U.S. relative to those in Europe has helped to depress the value of the dollar. Amid recession and a sluggish recovery, U.S. interest rates fell steadily from 2001 through last year, leaving the key federal-funds target rate at a 45-year low of 1%. European interest rates have been higher on average; the European Central Bank has held the 12-nation euro zone steady at a 2% minimum bid rate since its last cut in June. There are signs that the disparity between rates in the U.S. and Europe may change in the coming months. In the U.S., economic growth has accelerated. Continued strength could convince the Federal Reserve to lift interest rates to head off inflation. Although inflation has remained subdued for some time, a rise in the price of imported goods -- including crude oil -- could put upward pressure on prices. At the same time, the ECB feels pressure to reduce rates. The surging euro tends to increase the cost of goods exported from Europe, which reduces demand. European companies are being pinched. Many are reluctant to see the cost of their goods rise in America and elsewhere, fearful that they will lose market share to competitors.

U.S. trade balance with China WHILE GROWTH is picking up across Asia, almost all of it comes from exports, mainly to the U.S. and China. China's economy grew at a ferocious pace last year, with GDP up 9.1% compared with 8% in Ordinarily, this lopsided U.S. demand for Chinese goods should force China's currency, the yuan, higher against the dollar. As China's exports to the U.S. increase more than China's imports from the U.S., for example, the demand for yuan rises because China's exporters either want to be paid in yuan or have to be paid in yuan due to government regulation. If more dollars flow to China, and the supply of the dollar in China became greater than the demand for the dollar, the yuan would appreciate and the dollar depreciate. However, China fixes the exchange value of its yuan against the dollar, fearing that should the yuan rise, Chinese exports would fall, costing jobs. China's currency has been pegged at about 8.28 yuan to the dollar since U.S. officials are concerned that the yuan is undervalued, keeping Chinese imports into the U.S. cheap and creating an unfair trade advantage. There are signs, however, that China may no longer be able to hold the yuan down. Chinese monetary authorities must continually issue new yuan in exchange for the dollars earned from exports, the quantity of yuan in circulation is climbing faster than the economy's ability to produce goods and services, fueling inflation. A higher yuan would likely raise the price of many Chinese-made goods in the U.S. and eventually reduce the U.S. trade deficit with China, which U.S. manufacturing industries believe has cost the U.S. jobs. Chart: U.S. Trade Balance with China