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Thursday, December 11, 2003

The trouble with a weakening US dollar

You know there are lots of nervous people around when the grapevine is filled with talk of capital controls.

The capital controls in this case would be unusual - stopping the euro from appreciating, presumably by preventing the purchase of European assets such as euro deposits.

The European Commission (EC), of course, has denied allegations that they are examining the legal basis for imposing such controls. Analysts also scoffed at the idea. Mr Jonathan Hoffman, chief European economist at the Royal Bank of Scotland told AFP: 'Exchange controls in Europe are even less likely than a re-incarnation of Elvis.'

But the currency market went into a tizzy following the rumours, and the euro remains at the all-time high of US$1.216 (about S$2.10) against the United States dollar, hit last Thursday.

How the tables have turned. The euro was launched at a rate of US$1.17 in 1999, but it slumped to 83 US cents the following year. In the past two years, however, it has gained more than 40 per cent against the dollar.

There is no fundamental basis for this spectacular rise. Yes, the Eurozone economy has improved in the past few months, but it doesn't come anywhere close to matching US economic growth, which surged 8.2 per cent in the third quarter, compared to the Eurozone's 0.3 per cent.

Most observers believe the US economy will continue to outperform. The Organisation for Economic Cooperation and Development (OECD), for example, expects the US economy will grow a robust 4.2 per cent next year. In contrast, the Eurozone economy is expected to expand by just 1.9 per cent.

But the euro continues to gather strength. And that's despite a mounting political crisis over the collapse of the European Union's (EU) pact on fiscal stability and growth.

According to Economic and Monetary Affairs Commissioner Pedro Solbes, the EC is preparing a more stringent discipline mechanism to deal with countries that repeatedly exceed budget deficits. His announcement followed remarks from Mr Juergen Stark, Bundesbank vice-president, who said the decision by EU finance ministers to suspend the rules would create a 'real institutional crisis', lowering the European Central Bank's authority. Germany, which engineered the suspension of the pact two weeks ago, insists that strict adherence to the pact is hurting its economy.

The euro, however, grows stronger only because the dollar is expected to weaken. There is a vicious circle at work in the currency markets when analysts claim that while there is no chance of capital controls being imposed, such talk 'actually (makes) the news more positive for the euro' because it reveals how concerned EU officials are over a weak dollar.

In fact, the only reason the dollar hasn't fallen even faster than it has is due to frantic support by Asian central banks, concerned about a weak dollar undermining their nascent economic recoveries. Japan, for example, has spent a record US$164.5 billion this year to keep the yen from appreciating. As a result, Japan's foreign reserves hit a record US$644.57 billion at the end of last month.

The Bank of Japan (BoJ) and other Asian central banks that have been accumulating dollars mostly invest their greenbacks in US assets. They have been doing so to such an extent that holdings of US bonds by foreign central banks have now passed the US$1 trillion mark. That's more than the US Federal Reserve's own bond portfolio, which is worth less than US$660 billion. Reuters reported that foreign central banks took up as much as a third of US Treasuries auctioned last month.

The dollar's unique role as the world's reserve currency means there is no risk of a default. The Federal Reserve can always print more dollars to pay the country's debt. But by doing so, and in the massive amounts required, a sharp devaluation of the greenback's worth is inevitable. Hence the growing concerns over a weak dollar.

If the dollar's fall is inevitable, some have argued that perhaps Asia should simply stop trying to prevent it. Currency manipulation, after all, only distracts Asia from fixing real problems, like reinventing their economies.

In fact, a somewhat similar situation unfolded in the latter half of the 1980s, and the world managed to survive that episode of financial turmoil. Fear of a weak dollar led the BoJ to sell US Treasuries, resulting in a sharp rise in US interest rates. It was an important factor triggering the 1987 stock market crash.

The global economy, nonetheless, bounced back swiftly as the Federal Reserve acted decisively to lower interest rates. East Asia eventually benefited from the surge in the yen as it sparked an inflow of Japanese investments.

But don't bet on a similar fortuitous outcome this time. The Japanese economy is far weaker than it was in the 1980s. When the yen last strengthened below 100 yen against the dollar in 1995, and as it nearly did again in 1999, both periods failed to spark any surge in investments into East Asia (apart from China), and they left the Japanese economy in a vulnerable position.

So East Asia continues to intervene in the forex market, accepting more dollar assets in the process. The talk of capital controls, however, shows the accumulation of such a large amount of dollar assets has the currency market on the edge. The pressure for a large devaluation of the dollar could come sooner rather than later.

But which of the world's major currencies is capable of rising to the challenge?

Eddie Lee is senior economics writer on the Straits Times

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