Will you hold Euro currency and travel to US? Will you still hold US Dollar and travel to other asian countries? How would you know the value of dollar is still maintained? Two theory one is FEER and traditional one on value of Dollar, mentioned in this article. Just want to share this article!
Jun 19th 2008
From The Economist print edition
America still has a big current-account deficit. So is the dollar too dear?
ANYONE in France dispirited by the loss of purchasing power stemming from high oil and food prices should be revived by a trip across the Atlantic. The exchange rate that would equalise prices in America and the euro area—the purchasing-power parity, or PPP—is $1.16, according to the OECD. Yet a euro buys as much as $1.55. With such a discrepancy, a European visitor cannot help but feel flush. On arriving in America, his spending power is instantly boosted by a third.
The wallets of American travellers are correspondingly thinner. Measured against the currencies of America’s trading partners, the dollar has fallen by a quarter from its peak in 2002. Some economists have long argued that such a big drop was necessary. By curbing imports and boosting exports, a cheaper dollar helps shrink America’s current-account deficit and wean the economy off its reliance on consumer spending.
Thanks in part to a weaker dollar, exports have helped prop up the ailing American economy. But the current-account deficit has not narrowed by as much as hoped. Figures released on June 17th revealed that it grew to $176.4 billion (5% of GDP) in the first quarter. Though down from a peak of 6.6% of GDP in late 2005, this is still a big shortfall. Strip out the surplus on investment income, and the underlying trade deficit is close to 6% of GDP.
The competitiveness of American businesses has improved. The deficit on goods and services other than petroleum has narrowed sharply as a share of GDP (see chart). The trouble is, much of the improvement has been offset by a ballooning deficit on oil, reflecting the rising cost of America’s energy dependence.
Despite this enduring imbalance, some think the dollar may now have reached bottom after its long fall. David Woo, head of currency strategy at Barclays Capital, senses a shift in investor sentiment. “Dollar bears are clearly outnumbered now,” he says ruefully. The conviction that the next move in American interest rates is up has helped stabilise the greenback, as have comments by Ben Bernanke, the Federal Reserve chairman, that he is mindful of the inflation threat posed by a weak currency. And as French and German holidaymakers are discovering, the dollar is cheap against a PPP benchmark.
Against other gauges, however, the greenback may still be overvalued. One is the fundamental-equilibrium exchange rate (FEER), which is the rate consistent with a steady economy at full employment and a sustainable current-account balance. The FEER approach was pioneered by John Williamson at the Peterson Institute for International Economics in Washington, DC, who, with his colleague William Cline, is about to publish a paper with new estimates for 30 countries. Mr Williamson reckons the dollar has “not greatly overshot” its fair value against the euro, though it could more usefully gain ground against Asian currencies.
A recent IMF paper sets out its approaches to valuing currencies. As it uses FEER-type analyses in two out of three of its main models, the fund’s judgment on the dollar is likely to be similar to Mr Williamson’s own. As he himself notes, the FEER estimates depend heavily on assumptions about what counts as a current-account balance that can be sustained in the long run. The Williamson-Cline model imposes a symmetrical 3% rule: that no country’s surplus or deficit should exceed 3% of its GDP.
That may be too restrictive for some tastes. In a forthcoming paper, Richard Cooper of Harvard University points out that America’s relatively fast-growing population, secure property rights and liquid financial markets make it a magnet for global savings. The share of assets owned by foreigners is still lower than in some other rich countries, so large trade deficits could plausibly continue, if not indefinitely, then for many years.
Such judgments matter. A rule-of-thumb for FEER models is that a 1% of GDP increase in the “permitted” trade deficit lifts a currency’s fair value by 10%. Investors who are relaxed about the current account point to the PPP gauge as evidence that now could be a good time to buy the dollar. Those who fret about “imbalances” favour the FEER approach and believe the greenback should stay near today’s level to keep America on the right path. For them, the increasingly familiar sound of French and German accents on New York streets is a symptom of a necessary adjustment.
Source:http://www.economist.com/finance/displaystory.cfm?story_id=11599161, an article from the Economist.com
