Dollar's decline masks danger to new friends

The China-US relationship is crucial... next year it will be these two that drive the world economy
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The dollar fall may or may not be mostly over but it has already moved far enough to have an impact on the world economy. Trouble is, it is not a very helpful impact in the sense that it is unlikely to lead to more balanced growth.

The dollar fall may or may not be mostly over but it has already moved far enough to have an impact on the world economy. Trouble is, it is not a very helpful impact in the sense that it is unlikely to lead to more balanced growth.

There may be plenty of practical reasons why the dollar has fallen, including of course the widening US current account deficit, the difficulties of financing that deficit and hopes of a better economic performance in the eurozone. But a fall of the dollar is only helpful to the world economy if it helps narrow the current account deficit. The danger is the decline will not do much to correct the deficit and will damage the eurozone's recovery.

To see these concerns, start by having a look at the graphs. The dollar has come down sharply this year on its weighted measure (first graph) but it is not at bargain basement levels by historic standards. It did not rise by as much as it did during the mid-1980s surge but it is only just heading towards its long-term fair value.

That fair value level has been calculated by the ABN Amro economics team at 95 on the dollar index - with 100 in 1973. Allow a few points on either side as a trading band and the dollar is within it but not yet at the mid-point. And of course past experience suggests that currencies often overshoot so it would be perfectly plausible for the dollar to fall further.

The sad thing is that this would not help much because the dollar is falling against the wrong currencies. The second graph shows the quite modest fall when measured against a broad trade-weighted index (red line) and the much sharper one against major currencies, mostly the euro (blue line). But against minor currencies the dollar has actually strengthened and some of these, such as the currencies of Latin American countries, are quite important to US trade.

We focus on the dollar-euro rate but the fall against the euro is exceptional. If you look at the dollar from Frankfurt or Paris it has become very weak. If you look at it from Buenos Aires it still seems pretty strong. This rise against these so-called minor currencies includes the stable rate against the Chinese renminbi, for the renminbi is pegged to the dollar. It follows that a fall in the dollar does nothing to cut the US trade deficit with China, now running at more than $12bn a month. Indeed it is worse than that, for the fall of the dollar also pulls down the renminbi, making China more competitive in other markets in South-east Asia and Europe.

The China-US relationship is particularly crucial. At the moment the US has been the principal supplier of additional demand in the world, with China number two. Together they have supplied nearly half the additional total demand that the world has enjoyed over the past seven or eight years. Next year it will again be these two who drive the world economy, as you can see from the final graph, which looks at where the additional demand will come from next year. The rest of Asia comes in behind that, and I'm afraid the European nations are even further back, with the UK leading Germany, France and Italy.

The importance of this is to show that the really crucial relationship is the triangular one between the US, China and the rest of Asia. The US runs this huge deficit with China but China runs a deficit with the rest of Asia. But the decline of the dollar and the renminbi does nothing to help narrow the US-China gap. If China keeps growing at the present rate it will continue to suck in imports from the Asian region and that imbalance may grow too. Most of the South-east Asian currencies have also fallen along with the dollar so again this fall of the dollar does not help narrow trade imbalances.

On the other hand it is likely to hit the European recovery. Most of the additional demand in the eurozone this year has come from exports. As the euro rises it has the effect of tightening monetary policy: a rise in the euro is equivalent to a rise in interest rates.

As you can see from that final graph, the eurozone is simply not important as a source of demand next year but the higher the euro goes against the dollar the less relevant it becomes.

Ideally the world would fly on four engines - the US, China, Europe and Japan - with South-east Asia and Latin America chipping in a bit to help things along. But the more the dollar falls against the euro the greater the extent to which the world continues to fly on two engines rather than four - the US and China. The forecasts for growth next year for the eurozone are better than this one but are unexciting. Until domestic consumers pick up confidence they are not likely to get much better and if the dollar were to fall sharply they may get worse.

So what happens next? It would be silly not to dismiss the possibility of a sudden downward lurch in the dollar. But since this would not be in anyone's interest that this should happen, there will be strong efforts to prevent it. I would expect three things to occur.

First, the US will make it clear that it does not want a super-competitive dollar - it wants the currency to remain reasonably strong. Second, there will be concern about currency instability as voiced by Jean-Claude Trichet, the new head of the European Central Bank. He will not say that he is worried about the euro getting too high, for he is too canny for that. But it will be phrased neutrally. And third, if all this fails, we may move to a new concerted effort by central bankers to stop the dollar's fall. To be credible this would have to include intervention, ideally concerted, on the exchanges. December is a good time for intervention, for the markets are thin and a little money has a disproportionate impact.

I don't know whether things will come to this but I think we have to be aware that in extreme situations central bankers and finance ministers have to act to steady the markets. This has happened before and it will happen again. There are however two differences between now and in the 1980s when they last co-operated in this way.

One is that level of co-operation is lower now than then. The relationship between the US authorities and the eurozone ones is worse than it was between the members of the Group of Five who met at the Plaza Hotel in New York in 1985 to steady the rise of the dollar.

The second is that there is another player, China, which has never joined in such discussions and which has been needled by the US seeking to bring in trade quotas. Part of the dollar support deal would have to include some flexibility in the rate of the renminbi. So it will all be much more difficult. But the alternative would be worse.

Let's hope it does not come to this. The attractiveness of the US as an investment haven ought to rise as the recovery deepens and US profits carry on rising. Growth will eventually enable the US to get its figures back into better shape. Meanwhile it is in the self-interest of both Japan and China to carry on financing the US twin deficits. But I think it should be on people's radar that things may slither out of control. If that were to happen, expect the US to find that international financial co-operation is not such a bad idea after all.