Su Zhixin
Senior Economist

Since March this year, the US dollar has staged a new round of substantial depreciation, becoming once again the focal point of attention in the world economic and financial arena. The trend of the dollar exchange rate not only affects financial markets as a whole, but also exerts some impacts on the recovery of the real economies. To a certain extent, China and Hong Kong are far more sensitive to the issue than any other economies, thus deserving an even closer attention and careful study.

Reasons Behind

From March to mid October this year, the US dollar composite index dropped by around 15%, reaching the lowest point of the past 14 months. In less than a half-year, the US dollar plunged 13% against Euro, 30% to Australian dollar, and 20% to Canada's. At the same period, gold prices climbed about 20%, oil racketed over 80%, and the CRB index for a basket of commodities also assented more than 30%, besides the stock markets all over the world have staged a comeback from lows reached earlier this year. While the surge of financial and commodity markets can be attributed, at a certain degree, to the recovery of the world economy, they have also reflected the dollar's weakening trend and the market expectation of its continuous depreciation.

The depreciation of the dollar stems from the long term and deep seated problems in the United States, i.e. a decade long problem of “twin deficits”, the diversification trend of the international monetary system, the steady decline of the dollar's role as an international reserve currency. However, the reasons behind the recent round of depreciation can be examined from the following two angles.

On the one hand, the dollar depreciation reflects the “normalization” process. During the second half of 2008 to March this year, the dollar once appreciated amid the worst time of financial crisis with the overall loss of investors' confidence and the meltdown of global financial system. The US dollar composite index went up to the two-year high of 89. It sounds reasonable. Since the United State has the strongest composite strength in the world; the dollar is justified to act as an “asylum” for the global capitals when world crisis emerges. Recently, the dollar has softened again since March when the world economies and financial markets gradually stabilized staged. Therefore, the recent dollar depreciation can be deemed as a natural adjustment to the dollar's previous rise. As the world economic and financial environment is increasingly normalizing, the dollar would restore its real value. In this regard, the dollar's recent depreciation does not provide any hint to its long term trend.

On the other hand, the policies American authority adopted during the crisis enhanced greatly the negative factors of the dollar's long term trend. The United States took much more radical “bailout” scheme than any other countries during the financial crisis. As a result, a large scale of fiscal deficit has been accumulated, and the Fed's balance sheet has also been inflated by a wide margin. By the end of 2008, the Fed's balance sheet was enlarged by 1.4 times compared with the same period of 2007. According to the government budget, this fiscal year's deficit will amount to US$1.4 trillion, three times last fiscal year, accounting for almost 10% of its GDP. It is quite safe to say that the Fed's quantitative easing policy has dearly undermined the market confidence in the dollar.

Long Term Determinants

Based on the above analysis, it appears that whether or not the weakening of the dollar continues, or the long term trend of the dollar, will largely hinge on the following three factors.

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