How weak is a too weak dollar?

By SHIHOKO GOTO, UPI Senior Business Correspondent  |  Dec. 30, 2004 at 12:53 PM
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WASHINGTON, Dec. 30 (UPI) -- The dollar's value is falling, and dropping fast, much to the angst of the Europeans and Japanese. But for many Americans, the greenback's decline has actually been more of a blessing than a problem, and U.S. officials are likely to continue welcoming a further fall, at least up to a point.

The question then is just how far can the dollar fall next year before everyone gets cold feet?

Since October, the dollar has continued to post record lows against the European currency at around $1.33 to the euro, while it has fallen nearly 10 percent against the Japanese unit at 103 yen. Yet most currency analysts expect the greenback to devalue even more, citing on the one hand a fundamental weakness in the U.S. economy, and the need to have a weaker dollar in order to shrink the ever-growing U.S. trade deficit with the rest of the world.

There is no doubt among investors that there is a growing risk in putting money into the United States, especially in Treasuries and the greenback. For in addition to the burgeoning trade deficit, the country is also suffering from a budget deficit, with the federal deficit posting an all-time high of $412 billion in the latest fiscal year ended Sept. 30. That number is expected to grow further as military and security spending continues to rise, while the Bush administration pushes to keep cutting taxes.

Yet, a currency's value not only reflects economic fundamentals, but it also affects the value of trade. So while it may make sense from a macroeconomic perspective for the dollar to continue falling, the Europeans and Japanese remain deeply concerned about the weakening U.S. dollar precisely as it would hurt their own trade relations. The less valuable the greenback, the stronger their own currencies become, and a strong yen or euro makes Japanese and European exports that more costly and thus less competitive in international markets. That's a problem when they both remain highly dependent on exports boosting their internal growth.

For the United States, in turn, a weaker dollar will give it an edge in export markets, and lead to a reduction in the trade deficit. Moreover, U.S. businesses including the National Association of Manufacturers have been actively lobbying the White House and Congress to get the Chinese in particular to stop keeping their currency deliberately low, and swamp U.S. markets with goods cheaply made in China.

In order to put the U.S. current account deficit, which currently stands close to $500 billion, or about 5 percent of GDP, into a sustainable position, the dollar needs to fall another 20 percent from current levels, argued Fred Bergsten, head of the Institute for International Economics. "Much of the correction (in currency values) must come from China and the rest of Asia," Bergsten added, making it clear that politics would be the driving force in determining the dollar's value, as other industrialized countries step up efforts to get China to float the yuan, which has been pegged to the dollar at around 8.3 since 1995. And therein lies the problem of trying to get the dollar lower.

"The issue is not where (the dollar) should go, but whether central banks will allow it," said Joel Naroff, chief economist at Naroff Economic Advisors. He added that while the dollar was likely to fall 10 percent against major currencies next year, and be accepted by the central banks of most industrialized countries, a 20 percent drop would likely to trigger an intervention.

To be sure, the effectiveness of any central bank going into the foreign exchange market and buying up dollars in order to prop up the greenback is limited, given the sheer size of the global market.

"But they can slow down the direction (of a currency's move) that the bottom is not as low, and the top is not as high," Naroff said.

In order to make an intervention as effective as possible, however, the U.S. Treasury "has to keep its mouth shut," he added. "If you want to stop the fall, you want to move in so that the shock is the greatest, and it causes extreme pain to those shorting" the dollar, Naroff said.

Being too confident about the dollar's direction, therefore, can still be a more dangerous game for speculators than stocks or bonds. Caveat Emptor continues in 2005.

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