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Does a Declining Dollar Spell Doom?

Some things are so bad, they're simply hard to imagine. For those of us too young to remember the Great Depression, the mere thought of 25% unemployment or disappearing bank deposits is terrifying. So are the financial situations in many developing countries, where governments routinely devalue money in response to rampant inflation. Just imagine if the federal government here forced everyone to turn in their "old" dollars for "new" 50-cent coins.

The odds of an outright devaluation of the U.S. dollar at the hands of the federal government are fairly low. However, in today's global economy, investors can suffer from many of the consequences of devaluation, even without any formal governmental action. Because the relative values of foreign currencies fluctuate from day to day, long-term trends in one direction can have dramatic macroeconomic effects on a nation's economy. In turn, these trends can favor investments in one country over another.

Effects of a falling dollar
Those who travel abroad know firsthand the impact of a declining dollar. When the dollar is low, you have to spend more dollars to buy a certain amount of foreign currency. Because prices in foreign countries tend to stay in line with their local currencies, a falling dollar generally makes buying things abroad more expensive.

Back home in the United States, the effects are a little more subtle. For domestic businesses that don't have to import supplies or materials for production, the impact of currency fluctuations is relatively small. On the other hand, for businesses that rely on international trade, changes in the values of foreign currency can have a huge effect on their profitability. Foreign-based businesses find that the prices they charge in dollars translate to a smaller amount of foreign currency. In response, they can either accept lower profits, potentially hurting their stock prices, or increase their dollar prices to compensate for the adverse currency move, which can potentially hurt their sales.

The other side of the coin is that for U.S. exports, a falling currency helps bolster sales abroad. As the value of the dollar falls, exporters can accept smaller amounts of foreign currency in exchange for their goods, increasing potential sales. Alternatively, exporters can keep prices constant in foreign currency terms and increase their profits. Given that imports have greatly exceeded exports for a long time, the burden on businesses that rely on imports may outweigh these beneficial effects on exporters.

Volatile currency markets
Foreign currencies have shown a great deal of volatility over the past several years. Since 2001, the dollar has lost nearly 50% of its value against the euro, 30% against the British pound, and about 15% of its value against the Japanese yen. Although some countries choose to peg the value of their currencies to those of other countries, most commonly the U.S. dollar, these pegs have come under attack in some cases, especially with China.

So far, international-trade figures have demonstrated a decided lack of demand elasticity in response to these changing conditions. While economic theory would predict that a falling dollar would cause imports and the trade deficit to fall, U.S. current account data shows that trade imbalances have continued to widen over the past several years. In combination with high levels of inflation, this suggests that foreign companies that export goods to the United States have been willing to forgo price increases and suffer the brunt of adverse currency shifts against their profit margins. How long these companies might choose to continue doing so is difficult to predict.

How you can profit
Although a falling dollar threatens to damage the purchasing power of Americans in the global economy, you can take certain actions with your investments to profit from currency changes. Buying stock in foreign companies, either directly from foreign stock exchanges or through the use of American depositary receipts (ADRs) that trade here in the United States, can help you diversify your currency risk away from assets denominated solely in dollars. International stocks have done extremely well over the past several years, and the drop in the dollar's value explains a large part of their rise.

For example, if you bought shares of BT Group (NYSE: BT  ) on the London exchange five years ago, your stock would have returned just 3.69% in British pounds in that time frame. However, for American investors, the ADRs trading on the NYSE have risen over 25% in those same five years. With many developing economies, such as those in Russia, China, Brazil, and India, performing extremely well even in local-currency terms, changes in the value of the dollar were often just icing on the cake for investors who were already happy with their returns.

To a lesser extent, American companies with global scope also benefit from a falling dollar. Large blue-chip companies, such as Coca-Cola (NYSE: KO  ) , General Electric (NYSE: GE  ) , and McDonald's (NYSE: MCD  ) receive revenue from locations around the world, generating profits that come in a diverse set of currencies, helping to broaden their currency exposure and soften the impact of fluctuations in value among currencies. However, if you believe the dollar will continue to fall, the way to maximize your return may be to lean toward international companies -- like Turkish telecom provider Turkcell (NYSE: TKC  ) or Brazil electricity generator CPFL Energia (NYSE: CPL  ) -- that perform operations in their own currencies and rely very little or not at all on the dollar.

As a word of warning, international investing can give you a very bumpy ride. Double-digit percentage gains and losses in foreign markets are commonplace, and you can't always count on the quality of regulation that exists in the United States. Using mutual funds or exchange-traded funds can buy you advice from money managers who specialize in international stocks. If you prefer individual stocks, you may want to take a look at The Motley Fool's international stock service, Global Gains. International expert and fellow Fool Bill Mann leads a team of analysts who scour the globe looking for the best investment opportunities for global investors.

Despite the risks, international investing can be both a profitable way to increase returns, and a good method of diversifying your portfolio to reflect the increasingly interrelated world economy.

Travel around the world with:

This article was originally published Nov. 28, 2006. It  has been updated.

You can take a look at Global Gains risk-free via our 30-day free trial. Coca-Cola is a Motley Fool Inside Value pick, and Turkcell has been recommended by Global Gains.

Fool contributor Kristin Graham updated this article, originally written by Dan Caplinger. Kristin owns shares of Turkcell; neither she nor Dan own shares of any of the other companies mentioned. The Fool's disclosure policy covers you around the world.

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