Global Trends by Martin Khor

Monday 29 November 2004

Dollar’s fall cause for worry

Blurb:  As confidence in the greenback declines and interest rates rise, the US economy may eventually go into recession. The world may be in for more turbulent times unless action is taken soon.


US dollar has been going down, causing anxiety around the world. Much of the worry comes from expectation that the currency will plunge further and the situation will worsen before it starts to get better.

Although the dollar has been weakening for some time, significant downward movement came after the US presidential election. During the campaign, the John Kerry camp had publicised the damage caused by huge budget and trade deficits under President George W Bush’s administration.

When Bush won, he announced that he would change the tax laws to make permanent the tax cuts he had introduced. That signalled that the budget deficits would not go away but might even increase.

Bush also did not come up with a plan to reduce the ballooning trade deficit.

As these two deficits cannot continue indefinitely, confidence in the dollar has fallen, as its decline is seen as a corrective mechanism.

Asian countries have been holding the bulk of their large foreign reserves in dollars, especially Japan with over US$800 billion and China with over US$500 billion. They have been financing both the US budget and trade deficits, mainly by buying and keeping the US Treasury bonds.

If they decide to shift a little out of dollars, it would lead to a dollar decline. They do not even have to move out of their existing US dollar assets for the dollar to fall. All that is required is for China, Japan or others to diversify and put some of the new reserves that they earn into assets based on the euro or other currencies.

According to reports, this is what the big Asian countries have begun to do lately.

Pronouncements by top US officials recently have caused the dollar to plunge further.

On 19 November, chairman of the Federal Reserves, Alan Greenspan, gave a strong message. ‘Net claims against residents of the US cannot continue to increase forever in international portfolios at their current pace,’ he said.

International investors will ‘eventually adjust their accumulation of dollar assets or alternatively seek higher dollar returns to offset concentration risk, elevating the cost of financing of the US current account deficit and rendering it increasingly less tenable’.

In simple words, Greenspan was predicting that foreigners were now likely to move some of their assets out of dollars into other currencies, or slow down their investments in the US and that interest rates would be going up in the US to make dollar investments more attractive to prevent or reduce the outflows.

With such stark and unusual predictions coming from one of the most senior financial officials in the US, no wonder the dollar sank.

The US Treasury secretary John Snow and Bush himself said the US would have a ‘strong dollar policy’. But they rejected any coordinated action by developed countries to boost the dollar.

The Berlin meeting of the Group of 20 finance ministers and the APEC Summit went by recently without a decision to act on the dollar. Analysts and the markets have concluded that the US is not interested in saving the dollar. Thus, the stage is set for a probable deep plunge of the dollar.

The US government does not seem to be worried perhaps because the loans are in dollars and thus it can print money to pay back. That is the privilege of having the premier international currency.

Other countries that borrow in dollars cannot create new funds to pay their way out.

Perhaps too the US administration thinks that  a  slump in the dollar will make US exports cheaper and more competitive and thus have an advantage over its trade rivals.

Some analysts are however worried that there can be two negative developments for both the US and the world.

Firstly, as Greenspan predicted, US interest rates will go up to keep or attract foreign funds. Secondly, the US stock market may fall sharply as foreign funds exit. Both could contribute to a US recession and this will be transmitted to the rest of the world as lower US imports translate into lower exports in other countries.

In Asia, the Japanese and Korean currencies have appreciated significantly against the dollar and caused these two countries to worry about their export competitiveness.

However, other currencies such as the Thai baht, Singapore and Taiwan dollars have appreciated only modestly against the US dollar, while the Indonesian rupiah has weakened.

The currencies of China, Malaysia and Hong Kong are fixed against the dollar and have declined against other currencies together with it.

The gain to Malaysia from the pegging of the ringgit is that its exports have become cheaper and more competitive vis-à-vis the products of other countries whose currencies have appreciated against the dollar. Better export earnings have a positive effect on growth.

The disadvantage of the ringgit’s depreciation is that imports from Europe and Japan are more expensive and Malaysians have to pay more for overseas travel and education.

In any case, the world is in for a turbulent time as the major currencies gyrate against one another and a US-led world recession is becoming more of a prospect if the situation is not corrected in time.