international markets, all eyes are on the dollar,
since uncertainty prevails about the depths to which
it would decline. The currency, which appeared to
have stabilised relative to the euro in early 2003,
after declining from as far back as early 2002, has
been sliding sharply since early September. The Financial
Times reported on November 26 that the dollar had
been through its seventh straight week of losses,
falling to multi-year lows against the euro, yen and
Swiss franc. Currently close to 1.3 euro and 102 yen
to a dollar, the currency still seems heading downwards
in the trading days to come.
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The principal factor being quoted to explain the weakness
of the dollar is the $570 billion annual current account
deficit on the US balance of payments. This makes
the American appetite for international capital inflows
to finance its balance of payments insatiable. With
the US fiscal deficit running high and delivering
output growth even if not jobs, there is no corrective
in sight for the current deficit which is seen as
unsustainable. The difficulty with this argument is
that the deficit in the US balance of payments is
not new, nor is it a phenomenon specific to recent
years of rising fiscal deficits. Prior to that, consumer
spending, fuelled by debt, tax-cuts and the so-called
"wealth effect" of a booming stock market,
triggered growth. This too was accompanied by rising
trade and current account deficits. Thus, the fundamental
problem is that the US economy is not competitive
enough to prevent a substantial leakage of domestic
demand abroad and garner a significant share of world
markets. Growth is inevitably accompanied by external
deficits, making the stimulus required for any given
level of domestic growth that much larger.
long this was not seen as a problem. Initially, the
position of the dollar as a reserve currency and the
confidence generated by the military strength of the
US made it a safe haven for wealthholders across the
global. Dollar-denominated assets attracted the world's
capital and not just financed the US current account
deficit but also fuelled a stock market boom. Subsequently,
countries that had accumulated large foreign reserves
either because of they were successful exporters or
because their imports had been curtailed by deflation,
invested these reserves in dollar assets, especially
US Treasury bonds, and helped finance the external
deficit. The dollar remained strong despite the current
The difficulty is that underlying such confidence
of public and private investors is the view that the
trade and current account deficits in the US would
somehow take care of themselves, without damaging
US growth substantially. Unfortunately, while growth
has been better in the US than in the euro area and
Japan, the deficit has not disappeared but ballooned.
In the circumstance, the only way of curtailing the
US trade deficit seems to be to curtail growth - either
by depressing consumer spending or by slashing the
fiscal deficit or both. President Bush and his team
were unwilling to concede on either count prior to
his re-election. And the evidence seems to be that
he is not going to immediately wipe clean the glory
his victory has brought by declaring war on US buoyancy.
Bush is not the only one who is unwilling to spoil
the party. Alan Greenspan, who nears the finish of
what appeared to be an unending tenure, has warned
that the US current account deficit is unsustainable.
But he too has not shown any keenness to raise interest
rates to scorch consumption and investment spending.
What is more, countries which have gained from the
US predicament in the form of large exports to the
US market - such as China - are also not in favour
of a US slowdown.
The US has sought to use the last of these by virtually
declaring that its own deficit is not its, but the
world's, problem. Countries like China with a large
trade surplus with the US must revalue their currencies
upwards to redress that trade imbalance by exporting
less to and importing more from the US. Other countries,
such as those in Europe need to reflate their economies
so as to expand markets for the US. And, finally,
all countries must open doors to their markets by
reducing tariffs, so that the US can ship in more
of its commodities. All this, in the US government
view, would help reduce its current account deficit
and stabilise the dollar, without affecting US and,
therefore, global growth.
None of these countries are willing to toe that line.
China, under pressure to permit an appreciation of
the yuan, has come out quite strongly. In an interview
with the Financial Times, Li Ruogu, the deputy governor
of the People's Bank of China, warned the US not to
blame other countries for its economic difficulties.
"China's custom is that we never blame others
for our own problem," he reportedly said. "For
the past 26 years, we never put pressure or problems
on to the world. The US has the reverse attitude,
whenever they have a problem, they blame others."
At the recent G20 meeting, finance ministers and central
bank governors called for a global effort to reduce
trade imbalances, and in particular, the US current
account deficit. The rhetoric seemed to be that everybody
should share the costs of that adjustment. John Snow,
the US treasury secretary, chipped in by promising
to work towards halving the US budget deficit and
increasing US national saving. But no concrete measures
were on offer.
In sum, there is a degree of global paralysis on the
issue of the US deficit and its impact on global growth.
This implies that the only way in which the external
deficit may stop rising and possibly decline is through
a downward adjustment of the dollar, which renders
imports into the US expensive and cheapens US exports.
However, an adjustment of the dollar has been underway
not so much because of any automatic responsiveness
to US trade trends, but because of a growing fear
among wealth holders that excess exposure to dollar
denominated assets threatens erosion of the value
of that wealth. The gradual adjustment of private
portfolios explains the dollar's decline in the past.
More recently, however, pressure from the dollar has
come from a different, and more powerful, source:
the growing unwillingness of central banks to hold
a disproportionate quantity of dollar reserves and
risk substantial losses.
Russian central bank officials have recently declared
that they are likely to adjust the structure of its
reserves, estimated at around $105 billion, by substantially
reducing the share of the dollar. Even a small country
like Indonesia with just $35 billion dollars of reserves
has threatened to cut its dollar holding. But the
real threat comes from China with $515 billion in
its chest and Japan, which together account for the
bulk of Asia $2.3 billion of reserves. A recent statement
by a Chinese academic, which was quickly retracted,
that the rate of increase of China's holdings of US
bonds had fallen and the total was now around $180
billion, was enough to trigger a slump in the dollar
in jittery markets.
If this trend for policy makers in the US and elsewhere
to wait-and-watch and for wealthholders and central
banks to turn cautious on the dollar persists, the
downward slide of the currency is likely to accelerate.
Unfortunately, this would help no one. The appreciation
of the euro and the yen would affect their exports.
The slowing of growth in the US that an enforced cutback
in government and private spending and inflation induced
by a falling dollar would result in, would hurt most
exporters, including those from China. And a possible
meltdown in US markets is bound to wipe out a huge
quantity of paper wealth that sustains even the current
level of business confidence. Above all, the fragility
in financial markets that the process generates can
trigger a liquidity crunch that would spell deflation.
The fundamental problem is that countries desperate
to accelerate or protect the growth of their own markets
and exports, are unwilling to come together to deal
with what is not just a US problem. And their failure
to do so hurts not just the US but the world economy
as a whole.
These contradictions in the current global conjuncture
reflect the peculiar nature of US leadership. That
leadership is no more attributable to the relative
strength of the US economy, but rather is explained
by the military might of the US and its self-assumed
role of global policeman. However, despite the lack
of US economic supremacy, there is a bias to bilateralism
in the global system. The US remains an important
market for most countries, especially the successful
exporters like China in goods and India in services.
The US has also been the most favoured destination
for financial investment for private wealthholders
If countries want this cosy but undeclared relationship
with the US to continue they are bound to be asked
to pay a price for the militarism that makes the US
a buoyant economy, a sponge for global exports and
a safe haven for investment. If they are unwilling,
they must seek out strategies that break this undeclared
bias to bilateralism that is reminiscent of colonial
times. That would spell an end to US supremacy and
the emergence of a truly multipolar world. However,
the transition is not guaranteed. The costs are likely
to be substantial and the outcomes are uncertain.
But perhaps the dollar conundrum signals that there
are no mutually acceptable choices left.