US dollar: Prepare for a prolonged devaluation

Those nagging whispers warning that the United States is heading for an Argentina-like currency crisis are getting louder. The prospect of a prolonged devaluation of the US dollar is just one more challenge in what has already been a difficult period for savers and investors. Have we really reached the point where the greenback is in danger of becoming an “also ran” currency?

The likelihood that the dollar will suddenly lose most of its value is remote. The economy would have to deteriorate to unimaginable levels for the dollar to fall to the depths of the Argentinean peso in 1999. However, this does not mean that the dollar is a risk-free investment. Quite the opposite, really, as there is a strong possibility that the dollar is mired in what could be a prolonged devaluation extending well into next year.

The credit crisis that triggered the Great Recession exposed several flaws in the US economy. The list of shortcomings includes economic growth too dependent on asset bubbles of one form or another, a workforce struggling in the face of greater international competition, and a long-held tradition of relying on deficit financing to keep the party going. The result? An economy – and a currency – in dire need of a correction.

This correction has already started as millions of unemployed Americans can attest. The Federal Reserve has conceded that unemployment will remain elevated through 2011. When employment does pick up, it is expected to do so at a much slower pace than experienced following recessions of the past.

Next week, the Fed is expected to intervene directly. Its Federal Open Market Committee can’t adjust interest rates downward because they’re already zero-bound. This leaves the Fed with only one option; additional stimulus spending in an attempt to inject more cash into the system.

Alas, just as in physics, every economic action has an equal and opposite reaction. While carpet-bombing the economy with excess capital increases liquidity, there is also the unintended side effect of further devaluing the dollar. And it may not be unintended.

In January’s State of the Union address, President Obama stressed the need to reduce the trade deficit. The last time the US recorded a trade surplus was 1975 and the president set a target of doubling exports in five years “because the more products we make and sell to other countries, the more jobs we support right here in America.”

What was not included in the speech was the fact that the only way in the short term to sell more products to other countries is to actively pursue a low-dollar policy that makes American exports less costly to these markets. A weaker dollar also makes imported goods more costly for American consumers, thereby further reducing the trade deficit. Simply put, in order to meet the administration’s aggressive goal of reducing the trade deficit through a doubling of exports, a weaker US dollar is the new reality.

Naturally, the prospect of a devalued US dollar has China concerned. In 2009, the US Census Bureau placed the yearly value of China’s exports to the United States at $296.4 billion or 17.7 percent of China’s total exports. Of course, China is no stranger to currency controversy itself and both sides have routinely accused each other of unfair trade practices. But the rhetoric reached a new level when a trade bill was recently approved by the House of Representatives. If the bill is passed into law, US officials will be free to introduce tariffs on Chinese imports that will decrease the price advantage typically enjoyed by Chinese manufacturers.

While the US market remains an important export destination, China is hard at work cultivating new customers and many of these are to be found within her own borders. The increase in demand for consumer products within China is advancing at an unprecedented rate, and the domestic Chinese market – together with other emerging Asian nations – is universally recognized as the largest untapped pool of consumers on the planet.

China will not replace the American market overnight; indeed, it will likely never withdraw from the US entirely. Still, it is clear that a move is on to decouple China’s future from the US by reducing its dependence on the American consumer.

So what does this mean for America and more specifically, the US dollar? In the short-term, there is little doubt that the Federal Reserve will enter into a new round of quantitative easing to inject more cash into the economy. This action alone will devalue the dollar, and the continuation of record-low interest rates will further reduce demand for the buck.

This leaves holders of US assets in a bit of a quandary. If the falling dollar appears to be a short-term phenomenon, then it may be feasible to ride out the downturn and hope for a quick turnaround. If however, a weaker US dollar is destined to be with us for awhile, investors and savers may need to look beyond dollar-denominated assets in order to protect investments over the long term.

–Scott Boyd is a currency analyst and writer for Oanda, a Forex trading company with offices in New York, Toronto, Singapore, and Dubai. Neither Mr. Boyd nor Oanda take positions in any currencies.