One of the interesting elements in the US dollar’s recent decline is that few, if any, are suggesting that it is being driven by its perennial nemesis, the large trade deficit. Most seem to recognize that the divergence of monetary policy and the anticipated trajectory of interest rate differentials are the significant force driving the greenback lower. However, many expect the fall in the dollar to fuel improvement in the US trade deficit. Such hopes are likely misplaced.
In some ways, the NY Federal Reserve’s June Current Issues publication has anticipated this debate. In “Why a Dollar Depreciation May not Close the US Trade Deficit, Fed economists Linda Goldberg and Eleanor Wiske Dillion persuasively argue that there are three mitigating factors that may limit the impact of a dollar’s decline on the US trade imbalance.
First, the economists argue that because nearly all of US imports and exports are invoiced in dollars, the impact on import prices of a weaker dollar is less than would otherwise (and for other countries) be the case. Ninety-three percent of US imports are invoiced in dollars as are 99% of US exports. By way of comparison, 54% of the euro-zone imports and 59% of their exports are invoiced in euros. In the case of Japan 26% of their imports and 38% of their exports are invoiced in yen.
The literature suggests that since the advent of the euro, the euro-area and the EU accession countries have reduced the use of the dollar as an invoicing currency for intra-European trade, but in trade with the US, the dollar is still used predominantly in trade with the US. Studies suggest a high percentage of traded goods in Asia, Latin America and Australia are invoiced in dollars. And the share of exports invoiced in dollars exceeds and often widely the share of exports accounted for by the US, unequivocally pointing to the dollar’s role as a vehicle currency (i.e., using the dollar to invoice trade when the US is not one of the trade partners).
Second, the Fed economists note that the long-term competitive strategy of foreign exporters to the US are aimed at preserving market share and may except narrower profit-margins by not passing through to the US the costs of a weaker dollar. They suggest that this is largely a function of the higher competitiveness of the large US economy.
There is another possible explanation as well. Consider that business in the US and Anglo-American economies in general rely more on the markets for capital than banks. The key to maintaining low costs of capital is quarterly earnings. This makes them keen to protect profit-margins and therefore they are more likely to pass along adverse currency movements.
In Continental Europe and Japan the process of disintermediation has not gone as far. Companies are more reliant on banks than markets for capital. Banks tend to be more patient than the markets. The corporate expansion strategy that follows from the way capital is distributed provides incentives to protect market share. In the short-run that may mean accepting a squeeze on profits to maintain the longer-term strategic position.
The third factor the Fed economists examine is the value-added to imports after the goods have entered US ports. Specifically they look at storage, transportation and marketing costs. It turns out that these costs account for 30-50% of the final price of a wide range of goods that US households purchase. Moreover, this appears to be a greater percentage than in other countries.
The storage, transportation and marketing costs are of course denominated in dollars. This reduces the share of the final price of a good that is impacted, even in the best of conditions, by the vagaries of the foreign exchange market, even if the other mitigating factors were not in play.
What this amounts to is that the US experiences the least pass through to import prices of currency movement than other countries. A study the Fed economists cite covers the 1975-2003 period and looks at the impact on import prices with a year lag. The average pass through for OECD countries was estimated at 0.64%, which means that a 1% change in currency prices generates an average of 0.64% change in import prices, with admittedly wide variance around the mean.
In the euro-zone the pass-through is estimated at a little more than 0.8%. For Japan, estimates vary between 0.57% to 1.0%, with the rate usually found to be high and nearly complete. By contrast the pass through to import prices in the US is estimated at 0.42%. Since 1990, the degree of pass through has dropped to 0.32% in the US, which is well below the OECD average of 0.48%.
These arguments suggest that the improvement that has been seen in the US trade balance, which contributed 1.4 percentage points to Q2’s 4.0% growth is likely more a function of growth differentials than the decline in the dollar. The dollar’s decline has been largely concentrated against a handful of major currencies. The Federal Reserve’s major currency trade weighted index has fallen by a little more than 11% since the beginning of last year. Its broader trade weighted index has fallen by a more modest 8.5%.