The Financial Crisis; How Far Could the US Dollar Fall?

Financial crisis became an important issue in the last semester of 2008 until today because the impact was so wide toward the entire world, especially for a country that caused the reason why the financial crisis was emerged, USA. In USA, there are many impacts because of this problem that is caused from the policy of supreme mortgage, such as so many banking and financial institutions faced collapse and bankruptcy, then the value of dollar decreased fall. Already between summer 2007 and spring 2008 the value of the US dollar declined. Then in the wake of the collapse of Bear Stearns it dropped to 1 Euro = 1.60 USD. Since then the dollar recovered fairly, up to 1.39 for the Euro on the eve of the “crazy week” (September 15-19 of 2008), and nowadays, the morning after Congress’s rejection of Paulson’s plan, it stands at 1.46. The reasons explaining the limited dollar flow are easily stated;

a. Embattled US financial institutions were selling assets in other currencies to repatriate funds they desperately needed, so pushing up the value of the dollar.

b. Second quarter figures for the US economy were less bad than expected (and to some extent surprisingly good) making the US economy look a better place for profits than the Euro zone, where bad news was becoming more common.

c. Also the earlier major dollar devaluation temporarily increased US exports (+13%); giving the US economy a small breathing space as the repatriation of sales revenues induced capital flows into the US dollar zone.

However, not all of this reasons that make the dollar’s reserved run look likely to continue. The asset selling process has already gone quite far. The US economy’s results for the third and fourth quarters of this year are likely to be worse than those for Europe. The export flow has nearly exhausted its potential, and even if the US dollar were to go down sharply again, export flexibility looks like being much smaller than during the second quarter.

Nowadays, the demands on USD have developed. The “crazy week” ended with an extraordinary US dollar injection through central banks and various bailouts commitments, which will push the US budget deficit to previously unseen levels. Even before the recent crisis, the budget for the fiscal year 2009 anticipated a deficit of 439 billion. Now significant amounts must be added to that figure.

a. The cost of the Fannie Mae and Freddie Mac bailout has probably been underestimated by 100 billion dollars.

b. Even if the FED has funded the largest part of the AIG bailout, the Treasury had to lend money to the FED and from that we can expect another drain of probably 50 billion dollars.

c. The cost of Paulson’s plan, estimated at 700 billion dollars, or a similar one will have a great effect on the US public debt. There are good reasons to think that nobody knows or could know how far it will go. One can probably estimate the amount of bad assets held by banks and insurance companies today, but if the economic situation degrades in coming months, household and enterprise solvency will decline. Debts assessed as “good” today could become “bad” by December or early 2009. For example, consider the consequences of a possible General Motors bankruptcy next spring. This huge and deeply embattled company has issued large amounts of debt and Credit-default Swaps (CDS). If General Motors or a similarly sized industrial company were to go under Chapter 11 protection, it would have a tremendous overall effect on debt quality. The point is that debt quality assessment can’t be done without some forecasts of US economic activity in the months to come. The 700 billion dollar price tag on Paulson’s plan was no more than a political rabbit he pulled out of his hat to get his plan moving. Some people, like former IMF chief economist K. Rogoff, have estimated that the plan would turn out to cost between 1,000 and 2,000 billion dollars. The truth is nobody really knows.

d. So far no one has raised the issue of diminishing US budget incomes. But if economic activity slows seriously in this year’s 4th quarter and remains at a lower level in the first quarter of next year, one can expect federal and local tax income to be significantly lower than planned. Assuming a GDP depression of around -1.5% to 2.0% during the forthcoming winter, the total loss of budget incomes could be in the 80 to 100 billion dollar range.

As we know that the expected of deficit in 2009 is 439 billion dollars, if we want to add the estimation budget for deficit at least we need 930-950 billion dollars more. The total US deficit for the fiscal year 2009 could easily be pushed up to 1,370-1,400 billion dollars or close to 11% of GDP. In here, it means that we need more bailout from government of USA to cover the loss that caused by the impact of financial crisis.

Such estimates, of course, are highly dependent on the impact that the US economy’s performance has on debt (and CDS) quality. If the government introduced a new economic activity-boosting package, the bailout cost could be reduced. However such a package would come at a cost, so I don’t expect the deficit to go much under 1,250 billion dollars in the best-case scenario. But if economic activity decreases faster than expected and with a higher bankruptcy level than planned, then in the worst-case scenario the budget deficit could well reach 1,700 billion US dollars. In any country but USA, such a budget deficit would push down the value of the national currency considerably. However, because of the US economy’s central role in international flows of trade and finance, numbers do not tell the whole story.

Analysis

Based on introduction above, the problem that is faced by US is how to maintain the value of US dollars to be not falling or reducing, it is about how to take care the it value to be more stable after financial crisis has hit its country. US dollar is primary capital assets for sovereign and private funds in Asia, the Middle-East and Russia. These funds currently hold large quantities of US Treasuries and Agencies (the GSE issued bonds also known as A-bonds). Some of these countries are also important exporters to US internal markets. The financial and real economic relations are interlinked in a complex way that makes it impossible to estimate the outcome the current crisis on the basis of numbers alone.

There are several ways to maintain the currency of US dollar not having too much falling and to preserve its value to be stable; first, focusing in Asia countries trade interest. If the currency value of US dollar decreasing sharply compare to the value of Yen and other Asia’s currency, it will give impact to their international trade especially for competitive boundary of these countries will be reduced significantly. However, to repair its condition does not need just weekly or monthly, it needs more time to process. Therefore, to keep US dollars not too falling, countries with large trade surpluses must buy large quantities of US T-bonds and A-bonds.

The second strategy is they have to raise the issue of the dollar’s role as a capital asset. Private and sovereign funds holding large quantities of US Treasuries and Agencies would suffer a significant capital loss if the USD faces fallen significantly. One could argue that to prevent further losses fund managers will increase their portfolio diversification and reduce their exposure to the USD risk.

Then for third strategies are involving in political thing. As we know that people are confident in US bonds because of the USA’s political leverage. There is no country could directly challenge US power. However, US power has been globally eroded from the 1998 crisis up to the present one to such a level that US leadership looks weak and very unstable. By that reason, US should manage well the confidence in the US debt because actually US faced condition of lack confidence in US debt. The spread on CDS for Treasuries in the wake of the “crazy week” suggest that this lack is on the increase among financial actors.

In here, when financial crisis came, US also features crisis in internal leadership: the very bad crisis management so far, the high uncertainty level about the bank bailout cost, and now when, how and if a bailout will take place. As explained in a previous article, fluctuation in the US administration, and now in its legislature, about a bank bailout has eroded confidence in the nation’s ability to manage a major crisis. Nor did the way the FED chairman presented the case about Lehman Brothers at the September 23rd US Senate Hearings foster confidence. The forthcoming Presidential election is also adding to the uncertainties, be they real or not.

By implementing those three kinds of strategies to prevent the currency value of US dollar not to fall very low after impact of financial crisis, it still bring uncertainty about the financial condition for US in the future. Financial community expectations could be so strictly upset that we could see a massive process of expectation difference. If so, the possibility of a run against the USD can’t be released. The USD could then fall very low definitely and even a huge interest rate rise by the FED would be hard pushed to stop the process without completely destroying what is left of the US financial system.

Conclusion

Considering the explanation that is stated in the introduction and problem analysis, we know that the biggest issues that already hit surround the world is financial crisis that comes from the effect of supreme mortgage. Its impact is very largely toward the financial of US as a pioneer of the publishing of it’s caused, especially the impact for the currency value of US dollar (USD). Time to time, we faced the fact that the currency US dollar fallen down. This condition is not good for financial activities in particular for International trade because actually the biggest activities in US is export import so that the currency value of USD has strongly influence toward economic condition in there.

There will so many predictions about how falls the value of USD falling. It is very hard for answering this question. There is no hesitation that the USD will go down relative to the Euro and the Yen. It is highly probable we will see a 5% to 10% fall in the value of the USD in forthcoming weeks (somewhere like US 1.55 to 1.62 for 1 Euro), coupled to an inversely correlated rise in the price of oil. The USD fall could be greater against the Yen and Asian currencies than against the Euro (maybe 1 JPY = 0.0115/0.0120 USD).

It condition is common situation. In here, US government should take many actions to overcome and at least to stabilize the stable currency for value of USD. They hope can do this effort with stabilizing at this new level for some months before beginning to slowly move up probably by spring or early summer 2009, or will a catastrophic chain of events take place creating the psychological context for an uncontrolled decline in the value to the US dollar.

There are so many uncertainties in particular of the US economy condition will be determined by next spring and when the Euro Zone economy is expected to be at its worst. The USD value could then begin to increase slightly. However, as interest rates will still be low, and the budget deficit a major issue, the USD will not in 2009 regain its average 2007 value, let us say stabilization at USD 1.40 for 1 Euro by the end of 2009. Its condition will be tragedy a large share of the European industry.

The strategies that are should be taken by US government are focusing in Asia countries trade interest, then they also have to raise the issue of the dollar’s role as a capital asset because of private and sovereign funds holding large quantities of US Treasuries and Agencies would suffer a significant capital loss if the USD faces fallen significantly, and for the last is US should manage well the confidence in the US debt because actually US faced condition of lack confidence in US debt because the spread on CDS for Treasuries in the wake of the “crazy week” suggest that this lack is on the increase among financial actors. US should handle the feeling of uncertainty about US leadership and its ability to manage the current crisis comes to out-weigh its feeling of confidence, leading them to arrange of their USD assets, then sovereign funds would have to follow quickly to prevent huge capital losses.

With doing these three strategies, hopefully it can take care and maintain the currency value of dollars not to fall down because the impact of financial crisis. In the early semester of 2009, US should increase the international trade to keep its currency, not just depend on the bailout from their government to stable its economic condition.

Reference

· Sapir, Jacques, (2008). “The financial crisis; how far could the US dollar fall?” Real World Economics Review. issue no. 47, 3 October 2008, pp. 232-236