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As the United States heads into the November presidential election, the implications for the markets remain a concern. Will the economy benefit or falter with the new administration? Will the stock market rise or fall? And for foreign exchange traders, what will be the effect on the U.S. dollar?

When the decision is made, there will be a reaction by the markets. The U.S. dollar’s strength or weakness will most likely depend on how each candidate addresses the trade balance.

Determining the value of a currency in the short term involves a number of variables. Over the long term, the health or weakness of a currency is a direct result of the flow of funds into and out of a country. The trade balance is representative of that flow.

If a country runs a large trade deficit, the value of the currency will decline over time. The impact from the next president is dependent on policies that are initiated over his term(s) that will affect the direction of the trade balance.

What Determines a Trade Balance?
The U.S. ran an increasing trade deficit for a number of years (see chart). From January 2002 to July 2006, the trade deficit moved sharply from $30 billion to $67 billion (blue line). Over that time, the dollar responded accordingly with the U.S. Dollar Index, falling from around 115 to 85. Since July 2006, the trade deficit has moved sideways, while the dollar has continued to move lower to 77 at the end of August 2008. The continued decline in the dollar over this period is a function of many factors.

Generally speaking, the U.S. tends to save less than the rest of the world while consuming more. U.S. businesses, consumers, and government have also tended to utilize more debt, which leverages spending to an even higher level. Over the last few years, there have been a few key imbalances that have driven the U.S. trade deficit toward record levels. The reaction to these issues by the next administration will determine the relative strength of the U.S. dollar.

The China Trade Imbalance
It’s no secret to any U.S. consumer that imports from China are abundant. The catalyst for the disequilibrium of trade is China’s ability to supply Americans goods at a cheaper price than domestic producers.

While the cost of labor is cheaper in China, the Chinese government keeps the value of its currency artificially low. This makes the cost of Chinese imports even cheaper for U.S. importers and U.S. exports more expensive to Chinese importers.

By allowing this to continue, the U.S. effectively subsidizes the cost of imports from China into the U.S. This gives an unfair competitive advantage for Chinese exporters. In addition, China has not had an open-door policy with regard to U.S. goods and services. The combination has led to an outflow of dollars and a larger trade deficit.

Some progress is being made with Treasury Secretary Henry Paulson conducting biannual meetings with the country since 2006. Since that began, the value of the Chinese yuan has risen against the dollar from 8.100 yuan to 6.84 yuan (as of the end of August). Also, new doors have been opened for U.S. manufacturers to sell goods in China.

But the trade deficit has not improved much. According to the U.S. Commerce Department, the cumulative deficit for the year in June 2007 totaled $267.8 billion (not seasonally adjusted), while the deficit for the year ending June 2008 was higher at $277.4 billion. The mix of imports to exports showed that the U.S. imported $27.8 billion of Chinese goods in June, while exports totaled only $6.4 billion. In comparison, the deficit with the United States’ largest trading partner Canada is only $6 billion on average over the last year.

The imbalances cause uncertainty and disequilibrium. They lead to job losses in the U.S. and pressure the dollar. The next administration will need to continue to promote reform in China. Doing so will lower the deficit and in turn strengthen the U.S. economy, the dollar, and bring a better balance to the world’s economy.

U.S. Dependency on Foreign Oil
The second area of major influence is energy dependency. Over the last year, the U.S. has had a harsh wake-up call from our dependency on foreign petroleum products. The surge in oil prices not only imposed a harsh burden on U.S. consumers and businesses but also contributed to the sharp fall of the dollar.

Because oil is denominated in U.S. dollars, oil producers had no incentive to raise production to lower the price while the dollar remained weak. It was thought that the higher price for oil offset the dollar’s decline. The misconception in this argument is that the rise of oil prices more than offset the dollar’s decline. From February 2007 to June 2008, when oil prices peaked, the value of the dollar fell by around 20%. Over the same period, the change in the front crude oil contract rose by a larger 128%.

The dollar also suffered from the lack of alternative energy sources in the U.S. Because energy prices rose so dramatically, the dollar value of those imports likewise rose by a huge amount. In a normal market, if a price of a good becomes too expensive from abroad, a substitute is found domestically. With energy, however, the U.S. dependency on foreign oil had only one relief valve. That was a decrease in U.S. demand for oil.

According to the Commerce Department, the total barrels of petroleum products imported by the U.S. did in fact decline 7.6% from June 2007 to June 2008. Over that time, the price of a barrel of spot crude oil rose 92%. The result was a ballooning of petroleum imports from $26.7 billion in June 2006 to $45.2 billion in June 2008.

The impact to the total trade deficit after accounting for U.S. petroleum exports was an increase in petroleum imports of $15.3 billion. Putting it another way, stripping out petroleum, the U.S. trade deficit in June 2008 would have been $20.32 billion, a 41% improvement from June 2007. The gain is mainly a result of the competitive advantage finally realized by the weaker dollar that made U.S. goods and services more affordable abroad.

However, because of the sharp increase in the price of oil, the total deficit including petroleum only grew from $59.13 billion in June 2007 to $56.77 billion in 2008. In addition, the distribution of dollars flowing out of the U.S. went from a more balanced sample of countries in 2007 to a more concentrated distribution to the oil-producing countries.

The oil producers received dollars they could use to invest in cheap American assets that are potentially more valuable from an economic and investment standpoint. By being dependent on foreign oil and raising the trade deficit in the process, America is selling its country abroad. Developing alternative sources of energy, tapping domestic sources of U.S. energy, changing U.S. consumers’ inefficient energy consumption are all options the next president must explore.

The Challenge for the Next President
The next president must realize the implications of these two major imbalances. The solution will involve time and the cooperation between countries that may have differing objectives. It will require rallying Americans to change consumer behavior and perhaps even more pain for the economy during the transition. However, in the long run, the benefits will improve the trade deficit, the U.S. dollar, and stabilize the global economy. It’s time to wake up and face the problems.

Greg Michalowski is chief foreign exchange and economic analyst for FXDD, an online foreign exchange liquidity provider for retail traders and investment managers. For daily market commentary on the foreign exchange market, visit http://forex.fxdd.com or contact Michalowski at greg@fxdd.com.