Manufacturers have spent the better part of the last two decades moving their operations out of the high-cost environment of the United States and into relatively low-cost countries such as Mexico, South Korea and China.Companies moved because costs, particularly wages, were substantially lower in developing countries, and when coupled with a strong U.S. dollar, greater profits could be achieved. However, over the last few years a seismic shift has occurred which alters the entire global manufacturing sourcing network – a low-valued U.S. dollar. The value of the currency of choice in the world financial community has fallen substantially, to historic lows against some currencies, and it is expected to fall further. As a result, the cost/benefit decisions on manufacturing outside the U.S. must now be re-evaluated.

Exchange rates greatly influence the cost of doing business between countries and will have a direct impact on manufacturers’ profitability. The value and costs of goods produced in one country and sold in another will fluctuate based on the exchange rate between the countries’ currencies. A country with a strong or strengthening currency will find their exports to another country relatively more expensive and imported goods less expensive.However, a weakening currency reverses this outcome as a country will find imports relatively more expensive than exports. This reversal is what is occurring today in the global financing and trading system, and policy changes by the Federal Reserve are the primary cause.

Strong dollar drives ’90s growth

American economic policy regarding exchange rates has changed dramatically during the last 12 years. Between 1995 and 2002, the United States followed a “strong dollar� policy regarding exchange rates: monetary and trading policy was based on keeping the value of the dollar strong relative to foreign currencies. The policy was carried out, in part, by keeping interest rates in the United States high relative to key trading partners’ rates, and this attracted global investors to American treasuries because they could receive a comparatively strong, low-risk return on their money.

The United States consistently imports more goods than it exports each year, and the strong dollar policy minimized the value of dollar assets leaving the U.S. economy and allowed low-cost imports to flood the American marketplace. Much of the economic growth of the late 1990s and early 2000s can be attributed to the low costs and low prices that cheap imports provided.During this same time period (1995 to 2002), the dollar appreciated dramatically against other currencies; up 39% against the Euro, up 33% against the Yen and up 14% against the Canadian dollar. The Major Currencies Dollar Index (see chart) is an exchange-rate index measuring the value of the dollar relative to other major currencies, and it clearly shows the increase created by the strong dollar policy. The impact of the policy on American trade was to create a huge increase in imports to the United States, and while exports from the U.S. also increased, they did so at a much slower pace. As a result, the current account balance, an accounting measure of the import/export relationship, ballooned to $500 billion by 2002 – a 300% increase from 1995.

9/11 brought a change

However, monetary policy made a dramatic change in 2001 and set in motion the precipitous decline of the value of the dollar. In response to a mild economic slowdown and the terrorist attacks of September 11, the Federal Reserve reversed the strong dollar policy and began aggressively cutting rates. Between January 2001 and June 2003, the Federal Reserve lowered the Federal Funds rate – the key overnight borrowing rate for banks – from 6.5% to 1.0%, a 40-year low. As a result, the dollar became less attractive to global investors, and investment alternatives such as foreign currencies were sought. The impact on the dollar was to decrease its value significantly. Although exchange rates were shifting, American demand for foreign goods did not change and, in fact, continued to grow. Between 2002 and 2004, the overall value of the dollar fell 20%, but exports to the U.S. continued to grow at a much faster pace than imports. As a result, the trade deficit increased another 21% to $650 billion.

In the summer of 2004, the Federal Reserve reversed its policy again and began aggressively increasing interest rates in an effort to alleviate possible inflation from an overheating economy. The key Federal Funds rate increased from 1% to 5.25% by June 2006, but the rate changes did not have the same impact on the dollar as before.Generally, increasing interest rates would strengthen a country’s currency, but the economic situation of the United States had changed since the last aggressive interest hikes of the late 1990s. Global investors now believed American currency had become a riskier asset.

Investor perceptions of the risk associated with the dollar changed in part because of the huge trade debt the United States incurred during and after the strong dollar policy period. Although exchange rates were fluctuating, the United States’ demand for foreign goods remained consistently strong, and the trade deficit continued to expand. Between 1995 and 2007, the current account debt – the sum of each year’s trade deficit – equaled $6 trillion or $20,000 for every American citizen. The U.S. continues to import more than it exports, and the annual trade deficit now exceeds $800 billion. At this pace, the current account debt will exceed $10 trillion by 2013.The huge and growing current account balance, coupled with the acceptance of alternative currencies, has led investors to seek other quality investments. In times of uncertainty, investors move resources into low-risk, high-quality assets, and the world currency markets are revealing the dollar as no longer the preferred choice.

Real dangers, and a silver lining

There are real dangers for the U.S. economy caused by the large fall in the dollar, one of the biggest being the possible rise of inflation. Billions of dollars of imports have become relatively more expensive, and with few short-term alternatives, importers will possibly need to raise their prices to offset the currency decline. This could create an inflationary environment in the U.S. economy. In addition, if demand for imports by Americans remains strong, the low dollar will increase the trade deficit at an even faster rate since fewer dollars can purchase the same amount of goods as before.However, there is a silver lining in this dark dollar cloud. For U.S. exporters, the change in the value of the dollar creates a new price and profitability situation, and puts them in a stronger position than their off-shore competitors. The full amount of the cost implications from currency fluctuations cannot be passed along entirely to the consumer, thus profitability for exporters to the U.S. will decline.The low-valued dollar also makes U.S. goods relatively cheaper, and demand for U.S.-based exports will increase. Recent trade data suggests this change is occurring. Led by a resurgence in U.S. exports, in 2007 the U.S. trade deficit will be less than 2006, the first annual decline in years.The lower dollar is also making manufacturing in the U.S. relatively cheaper. Since 2002, the dollar has fallen 31% against the Euro, 31% against the Canadian dollar, and 6% against the Japanese Yen. This means that goods manufactured in these countries for sale in the U.S. have gotten much more expensive, and goods manufactured in the U.S. for sale there are relatively cheaper. Compared with developing countries, the exchange rate implications are just as pronounced. Between 2002 and 2007, the dollar has also fallen against many low-cost manufacturing sourcing countries: Brazil – down 36%, China – down 8%, India – down 18%, Malaysia – down 10%, South Korea – down 26%, and Thailand – down 20%.

These changes in exchange rates are having an impact on sourcing decisions for manufacturers. Airbus, the European airplane builder, announced in December they are considering locating a plant in Alabama to offset the effects of the soaring Euro. Volkswagen is also considering significant manufacturing investments in the United States to take advantage of the currency situation. Investment in the U.S. is starting to increase as companies in other countries realize the new economic advantages; direct foreign investment into the United States reached $73 billion in Q2/2007, the highest quarter in seven years.The exchange-rate situation is not expected to change in the short-term as the dollar is expected to remain low for a number of years. Recent rate cuts by the Federal Reserve and investor concerns regarding housing, credit and the overall health of the U.S. economy have only increased the pace of the dollar’s decline. The huge American debt, which has increased even further due to the Iraq and Afghanistan wars, continues to worry global currency investors. The CSM/FERI exchange-rate forecast expects only a minor rebound of the dollar through 2013.

Conclusion

The dollar has reached a new low that, when coupled with existing institutional advantages, may make manufacturers re-evaluate where profitable sourcing should occur. Recent concessions to domestic automobile manufacturers by organized labor create a new era for wage structures and benefits and reveal a new understanding of the global competition faced by U.S. companies.

Product quality concerns, particularly from China (i.e., pet food contamination, lead paint in toys) have some consumers demanding more government oversight and more domestically produced goods. Higher air and shipping costs, caused by huge increases in oil prices and transportation supply constraints, are negatively impacting the profitability of off-shore production. In addition, legal systems, especially piracy laws, are not effectively enforced in some low-cost countries. When these factors are reviewed and coupled with the 10%-40% pricing advantage exchange rates currently provide, manufacturers may find the United States is at the top of their low-cost sourcing list.