November 21, 2004
By Mike Dolan, Economics Correspondent
WASHINGTON (Reuters) - The United States is set to turn a blind eye to the sliding dollar and a deaf ear to protests about its fall, but experts smell trouble for all in what looks like an effective devaluation of the world's reserve currency.
While a messy, uncontrolled slide in the dollar may help cut record U.S. trade and budget deficits, it transfers the pain to its creditors and could rebound on the United States by inflicting a longer-term dent on the dollar's prized reserve currency role.
The risk that central banks around the world look to diversify their holdings away from dollars was highlighted by Federal Reserve Chairman Alan Greenspan on Friday.
In a speech seen to accept the inevitability of a dollar decline to help ease U.S. deficits, Greenspan warned foreigners face an "unacceptable amount of concentration risk."
With too many of their eggs already in one basket, he said, foreigners will be increasingly reluctant to bankroll rising U.S. trade and budget deficits with ever more purchases of its bonds, equity and other assets without much higher returns.
In the absence of more concrete efforts to rein in the budget, economists said that Greenspan was explaining the logic that the dollar will take the heat.
Many economists agree and say this should be a big concern for both U.S. policy-makers as well as U.S. creditors.
"Further substantial increases in the U.S. net debtor position would raise the prospect of a substantial U.S. dollar depreciation, with the associated capital losses inflicted on its creditors," said Philip Lane, professor of international macroeconomics at Trinity College, Dublin.
"In turn, this may threaten the special status of the dollar, also in light of the emergence of the euro as an alternative reserve currency, and raise the rate of return required by foreign investors on dollar instruments."
SLIPPING HALO
Despite the emergence of the euro five years ago, more than two-thirds of foreign reserves -- well in excess of $2 trillion -- are still banked in dollars and U.S. bonds.
The decades-old reputation the dollar has as a liquid, long-term store of value means the United States has to date received cheap and risk-free foreign funding in its own currency from foreign governments seeking to bank their reserves safely.
Foreign central banks, for example, are set to finance some 60 percent of the U.S. budget deficit for 2004.
But this cheap financing has, in part, allowed the U.S. budget and trade deficits to blow out to unprecedented levels without any penalty on the U.S. government and has heaped pressure on the dollar to weaken to keep attracting investment.
Resisting this dollar fall to keep exports competitive in the United States, many central banks in Asia and elsewhere have amassed even more dollars -- with just Japan and China now holding more than a trillion dollars in reserves to date.
But this arrangement may be reaching a breaking point.
"The concentration risk that Greenspan highlights is the real problem for foreign central banks," said Phil Suttle, international economist at JP Morgan in Washington. "Greenspan is lecturing them on the risks they face from preventing a market-led dollar decline."
STOP DIGGING?
For the central banks that have been financing the U.S. deficits and propping up the dollar, the issue is whether to stop now and take any dollar foreign exchange loss on the chin or wait longer and sustain even bigger losses down the road.
Economists say there is no really elegant way out, but if you are in a hole, it may be advisable to stop digging.
A further decline in the dollar, already more than 25 percent (^DXY - News) weaker since President Bush came to power, looks likely either way. Neither the U.S. Treasury nor the U.S. Federal Reserve looks willing to stand in its way.
Nouriel Roubini, associate professor of economics at New York University's Stern Business School, said he felt the "game" of foreign reserve accumulation was very fragile and could be undermined sooner than many think.
Roubini, who was a White House and Treasury economic adviser between 1998 and 2001, said it takes only one or two smaller central banks -- like in India or Russia -- to start diversifying reserves to undermine the whole process.
"The central bank accumulation is a game but it is a game that can be played only if there is no free riding," said Roubini, saying that the fear of a dollar slide would now be worrying for many developing countries.
For example, he said, if China allowed the yuan to float freely and the dollar dropped 20 percent, it would incur a capital loss on its half trillion of reserves equivalent to about 8 percent of its annual gross domestic product.
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