Jeremy Warner: Dollar weakness could undermine Obama's plans

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The Independent Online

Outlook The outlook for the USdollar might seem a subject too trite for analysis on a day of such historic significance, yet it may shape the Obama presidency rather more than he would like. Despite the hope and expectation which is being vested in the new president, not just in the US but internationally too, a strong dollar is by no means guaranteed, and without the backing of the dollar, Barack Obama may struggle to meet his ambitious, fiscally liberal spending plans.

Perhaps oddly, the dollar has been strengthening in recent months as the credit crisis reached its crescendo, certainly against the euro and sterling if not the yen and some other Far Eastern currencies. Yet the biggest reason for this phenomenon is not – as widely assumed – an international flight to safety in recognition of the US's supposed resilience and innate attractions as an economic powerhouse. Far from it. The attractions of US assets to international capital are far from obvious, particularly to the two biggest providers of surplus liquidity, China and the oil-rich states of the Middle East. They have both been burnt by the horrors of the last year and a half and they are not exactly dashing to get back in the water again. Nor would you want to invest in the US for its ultra-low interest rates.

Rather, the main cause is a technical shortage of dollars prompted by the credit crunch. During the age of leverage, money was widely borrowed in dollars around the world to buy both foreign and dollar assets. As these assets are liquidated, even more dollars have to be bought to make up for the losses that have been sustained so that the borrowings can be repaid. That's created a shortage of dollars in other G7 nations and in emerging markets. Plainly, this is not going to be a permanent phenomenon, and it may already be drawing to a close. Two related factors have been contributing to this temporary period of relative dollar strength. One is that on the safety-first principle there has been a lot of repatriation by Americans of money held abroad. High volatility also causes money to chase the most liquid outlets available, and there are few assets more liquid than US Treasury bills. If we are now over the worst of the banking crisis, these factors will begin to ease in coming months.

By implication, the current period of relative dollar strength may also prove shortlived. I'm not going to get into the argument over whether the dollar's hegemony as the world's major reserve currency is essentially over. It will be many years before we know the answer to that question. But certainly a prolonged period of weakness is all too possible, and that's going to give the new president a major headache. America is already heavily borrowed by international standards. As Gordon Brown never ceases to remind us, US national debt as a proportion of GDP is about double what it is in the UK. The federal budget deficit is also surging to record levels. Assuming the majority of Hank Paulson's $700bn Troubled Assets Relief Programme (Tarp) is spent next year, the budget deficit will swell to well over $1 trillion, or around 7.5 per cent of GDP, taking the total size of the national debt to more than $11 trillion.

Most of Mr Obama's spending plans were proferred as fiscally neutral, a case of simply taking from the rich and giving to the poor, yet with now sharply falling tax revenues all round, that can no longer be the case. Big business is already lobbying against the enhanced levels of taxation proposed by the Obama team, arguing with some justification that they are inappropriate in a recession. They may well succeed. To deliver the reflationary package promised, Mr Obama will have to borrow a lot more. The willingness of markets to lend it to him must be open to question. Mr Obama's sometimes overtly protectionist rhetoric doubles up the nature of the challenge.

America's need for foreign capital is now greater than ever, yet it may struggle to attract funding without significantly higher interest rates. That in turn will limit the new president's ability to deliver on his promises. Everyone starts with exceptionally high hopes of Mr Obama, yet he has been left an appalling economic legacy, and it may not be long before he is disappointing his supporters.

In any case, it seems unlikely the dollar will give him the following wind he needs. It may be no bad thing if America is forced to become less dependent on constant infusions of foreign capital, yet it might also reinforce Mr Obama's protectionist instincts, and that would unambiguously be a negative development.