Why the Dollar's Fall is Bad for Everyone

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Thu, 18 Nov 2004 12:05:00 -0500

Subject:Why the Dollar's Fall is Bad for Everyone

 

SPIEGEL ONLINE - November 18, 2004, 11:54 AM

URL: http://www.spiegel.de/international/spiegel/0,1518,328487,00.html

 

Global Economy

 

Why the Dollar's Fall is Bad for Everyone

 

As the United States pushes further and further into debt, the country

is financing its budget with infusions of a billion dollars a day from

Asia. But if China and Japan started trading in euros instead, the

dollar could collapse. That would be bad for the US and Germany, where

economic recovery is dependent on exports.

 

The logo on one of the classic T-shirts on display in the souvenir

shop at the Chicago Futures Exchange reads: " Pigs are trendier than

you thought. " For generations, the Exchange's building on Wacker Drive

has been famous for trading in pork bellies.

 

These days, of course, a different commodity has become the focus of

speculation: On the floor of the exchange, currency traders, in their

brightly colored jackets, are betting billions on the future of the US

dollar. And if the traders' predictions hold true, it's not exactly rosy.

 

The futures traders, in any event, seem to agree: They're betting that

the greenback will continue to decline. To show that they mean

business, they've covered themselves with at least 200,000 so-called

short contracts, which entitle them to sell currency at a set exchange

rate on a fixed date in the future.

 

The volume of selling positions has quadrupled since spring. Recently,

in early November, trading volume jumped by 17 percent in one week

alone. Into the euro and out of the dollar -- that's the traders'

current mantra.

 

The US currency has dropped into a downright tailspin, rapidly losing

its value, and not just in recent weeks. Since February 2002, the

dollar has declined by 30 percent, while the value of the euro has

increased proportionately. Back then, investors were getting $0.86 for

one euro. This week, the euro jumped over the $1.30 mark, an all-time

high. " We are experiencing a weak dollar across the board, " says

Stephan Beilke, a currency trader with Bremer Landesbank. He is firmly

convinced that this trend will continue.

 

The economists are outdoing each other with bleak forecasts. Thomas

Mayer, chief European economist at Deutsche Bank, believes $1.40 is

realistic, while his counterpart at investment bank Goldman Sachs, Jim

O'Neill, expects an exchange rate of $1.50. Finally, US economist Fred

Bergsten is boldly talking about rates of $1.80 and $2.20. Everything

seems possible.

 

Bush II: four more years of debt?

 

It seems odd: A US president is re-elected by a larger margin than

expected, normally a sign of confidence and strength, but then the

currency begins taking a nosedive. Some people are just now realizing

that the election slogan " Four More Years " could also mean four more

years of more debt, more unemployment and more uncertainty.

 

People are beginning to worry that the consequences of the dollar's

weakness could be more serious than anticipated. In the United States,

a strong currency is the basis for relatively low interest rates and

healthy consumption rates. In Asia and Europe, it's an important

condition for a flourishing export economy.

 

Germany's economic recovery, in particular, is completely dependent on

exports. The German economy was almost stagnant in the third quarter,

because exports haven't been as strong as they used to be. Carmakers

and chemical conglomerates are worried that they could be selling

fewer and fewer products in US dollar markets in the future. Customers

in those markets are seeing these products become more expensive as

the euro strengthens.

 

Of course, most German companies have learned their lesson and are now

hedging their dollar revenues against exchange rate risks. But this

also has its price. " The longer the hedge transactions continue and

the more the dollar fluctuates, the more expensive the whole thing

becomes, " says Diether Klingelnberg, senior manager at a mechanical

engineering firm in Germany's Rhineland region. " If the euro reaches

1.50 or even 1.80, it'll become unaffordable. "

 

Growing wary of the dollar

 

The anti-dollar mood is also being stoked by speculators. Hedge fund

managers, who are some of the most aggressive investors, periodically

pump billions into the market for a few days, just to push exchange

rates in the desired direction. So what happens if they permanently

turn against the dollar?

 

Hardly anyone expects George W. Bush to spend his second term

enthusiastically addressing the country's economic problems: the US

budget and current account deficits. Caio Koch-Weser, an

undersecretary in the German Ministry of Finance, warns that this

double deficit is " alarming the markets. " As long as it exists, the

dollar will not regain its strength.

 

The US budget deficit for the last fiscal year will reach a record

$422 billion. The war in Iraq is consuming enormous sums of money, and

tax cuts are also taking their toll.

 

At the same time, the current account deficit is growing: Americans

are buying more than they produce, and they're using credit to pay for

their affluence. The deficit had already reached $531 billion in 2003

and is expected to grown by another $120 billion this year. The

government can't borrow from its citizens, who are saving at a rate of

only 0.2 percent. As a result, it's forced to borrow overseas, mainly

in Japan and China.

 

 

Of last year's $531 billion current account deficit, $441 billion was

financed with foreign capital, with the majority -- about $377 billion

-- coming from Asia. To put it differently, financiers from the Far

East are pumping an average of a billion dollars a day into the US

economy. " The Asians are acting as America's bank, " says Scott Mather,

a fund manager at Pimco, a subsidiary of German insurance giant Allianz.

 

The Asian central banks can only afford to do this because the export

trade has enabled them accumulate enormous currency reserves; Japan

has more than $800 billion and China almost $500 billion. They're

investing most of their money in short-term US government bonds,

thereby preventing the US dollar from sliding even further.

 

This practice conceals a tacit agreement among the major powers. China

saturates America's virtually inexhaustible need for credit and fills

the holes in the US's double deficit. In return, the Americans buy

Chinese imports and accept that the People's Republic has tied the

yuan to the dollar since 1995, even through the currency is overvalued

by at least 20 percent. This enables China to easily supply the world

market with cheap goods.

 

Dietmar Hornung, a currency specialist with DekaBank, calls this

giving and taking " a symbiotic relationship of sorts. " Of course, one

could also say that America's affluence depends on Asia's good will.

 

This mechanism has been effective until now. However, politicians and

central banks worry that the situation is gradually becoming too

precarious for Asia's financiers. People in Washington are nervously

asking themselves how long the Asians will continue to cover the US's

double deficit. What happens if they slow down, halt or even reverse

the flow of capital, switching from the dollar to the euro?

 

The currency specialists at ING BHF Bank are already sounding the

alarm, warning that, " ultimately, the Asian currency authorities will

not be willing to continue building up their dollar receivables

indefinitely, especially when the value of these receivables becomes

increasingly questionable. "

 

If Asia moves out of the US currency, this could trigger a fatal

sequence: The dollar would rapidly lose value, the weak currency would

drive up the cost of imports, inflation would grow, and the Federal

Reserve would be forced to raise interest rates more quickly than

manageable. Borrowing would become more costly, consumption would

decline, and highly indebted households would be unable to service

their mortgages. In the end, the dollar bubble would burst and the

real estate bubble would follow suit.

 

The United Nations already warned against such a scenario in its world

economic outlook for 2004. According to the document, the global

recovery would " probably end " if the " adjustments in the United States

following a decline in the dollar were linked, in particular, to a

sharp decline in consumer expenditures, investments and demand for

imports. "

 

The euro as the world's currency?

 

The markets are already rife with rumors that Asia and the Middle East

are exchanging their currency reserves for euros on a large scale in

an effort to spread their risk. British financial historian Niall

Ferguson even believes that the dollar regime has already come to an

end. His gloomy prediction is that " no monetary system lasts forever, "

noting the fate of the pound sterling. The euro, in Ferguson's view,

is certainly capable of " giving the dollar a run for its money as the

international reserve currency. "

 

The euro as the leading global currency? That seems to be a long way

off. Nevertheless, the US government is unlikely to make much of an

effort in the near future to drive the dollar back up to its former

strength. In fact, it wouldn't find a minor devaluation altogether

inconvenient. After all, a weaker dollar makes US goods cheaper and

more attractive overseas.

 

Another element of this logic is that Washington wants China to

abandon tying its currency to the dollar, which would make its goods

more expensive -- symbiosis notwithstanding. Cheap imports are a thorn

in the side of many US companies, making it almost impossible for them

to compete.

 

A loosening of exchange rates would even be in China's interest,

allowing it to apply the brakes to its overheated economy. The Chinese

economy is growing too fast, with growth rates routinely exceeding its

seven percent target.

 

It's highly unlikely that China will deregulate its currency entirely,

and revaluation of the yuan will probably be a controlled process.

There are two possible scenarios. In one scenario, the Chinese could

introduce a price corridor of perhaps five or ten percent within which

the currency would fluctuate, amounting to a de facto revaluation. Or

they could tie the yuan to a basket of currencies instead of just the

dollar. This, however, would meant that a portion of China's reserves

would have to be exchanged for euros, flooding the market with dollars.

 

In either case, the US currency would face further pressure and the

euro would continue to soar.

 

BEAT BALZLI, ALEXANDER JUNG, JANKO TIETZ

 

Translated from the German by Christopher Sultan