Stores 2008 Global Powers of Retailing - (Page 42) 2008 global powers of retailing It was to be expected that, with a large US current account deficit, the dollar would fall. When financial market participants believed that, at a given exchange rate, the deficit was unsustainable, they removed support for the dollar. As the dollar falls, it causes import prices to rise and export prices to decline, thereby leading to an improvement in the current account deficit. This process should continue until financial market participants are convinced that the dollar is low enough to bring the deficit to a sustainable level. So far, the decline in the value of the dollar appears to have had a positive impact. Real imports have declined and real export growth has accelerated. Moreover, the current account deficit has begun to improve. Yet the dollar will probably fall further. A decline in the value of the dollar acts with a lag. Financial market participants, however, tend to push the dollar down until they are convinced that the dollar level is sustainable — and they probably don’t think it is at this point in time. Other factors are pressing down on the dollar, such as US interest rates, which are lower than in Europe. The fact that many central banks are known to be rebalancing their foreign currency portfolios away from dollars is also having a negative effect on the dollar. The biggest concern about a falling dollar is that it could be inflationary in the US if it causes a sizable increase in import prices. This hasn’t happened yet, but could as the dollar falls further. Until now, many importers have absorbed the exchange rate movement by allowing for lower profit margins. Yet this cannot go on forever, and ultimately import prices will have to rise. When that happens, it could inhibit the flexibility of the Federal Reserve to lower interest rates — an important consideration given the continuing problems in credit markets. On the other hand, a declining dollar means a rising euro, pound, and yen. For Europe, Britain, and Japan, this means deflationary pressure and, therefore, more flexibility for these countries’ central banks to lower interest rates without sparking inflation. Finally, a rapid decline in the value of the dollar remains a possibility. Financial markets have been known to become volatile when investors panic. Given the uncertainty in credit markets, currency market volatility could become a problem. A rapid drop in the dollar could destabilize financial markets and might require currency intervention by major central banks in order to restore stability. economy in this decade has grown faster than at any other time in recorded history. A significant portion of this growth was attributable to the rise of China and India. Notably, both countries subsidize the cost of energy, thereby encouraging highly inefficient use of energy. Thus, it should be no surprise that so much of the world’s increased demand for oil came from these two countries. This is quite different from oil price spikes of the past, many of which were due to a drop in supply rather than an increase in demand. The price of oil has also risen because the capacity to produce oil has not kept pace with rising demand. Why not? After all, a rising price should encourage producers to explore for more oil and develop new productive capacity. Yet it takes time for new investments to bear fruit. Moreover, when the price of oil started to rise earlier this decade, many producers were not convinced that the increased price would be sustained. Consequently, they were reluctant to take on new investments that might not be profitable should the price reverse. Finally, much potential new capacity exists in countries where governments, rather than private investors, decide whether to undertake new investments. In many countries, the high price has enabled governments to accumulate cash, pay off debts, and flex their political muscle. New investments, which would have siphoned off much of that cash, were not considered a high priority – especially when the payoff was likely to be so far in the future. The result has been very slow development of new capacity. There are other factors influencing the price of oil. Political risk surely plays a role. An increased threat of war in an oil producing country always leads to a higher price. Political or social turmoil in an oil producing country often reduces both investment and current output — consider Iraq or Nigeria. Finally, the declining value of the US dollar tends to have a positive impact on the dollar price of oil. Where do we go from here? There is no easy answer to this question. The good news is that the world has collectively managed to absorb a huge price increase without much economic cost. That is partly because of the massive investment in improved energy efficiency following the oil shocks of the 1970s. Today, the world can better absorb higher energy prices than in the past. Still, there are limits. It is probably safe to say that further substantial increases beyond the current price ($97 as of early November 2007) could be onerous, both for economic growth and inflation. The price of oil in the future will be the result of several factors. First, consider demand. If the US economy slows down in 2008, the price of oil would probably fall. Second, exchange rates matter. If the US dollar continues to fall in value (which is likely), there will be pressure on the price of oil. Finally, much will depend on the political situation in several oil rich countries or their neighbors. The price of oil Why has the price of oil jumped five-fold in the past five years? And why has the global economy done so well despite this rise? The answers to both questions are related. The price of oil rose, in large part, due to the strength of the global economy and its impact on the demand for oil. In fact, the global G42 STORES / January 2008 www.deloitte.com/consumerbusiness http://www.deloitte.com/consumerbusiness
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