Dollar fall raises concern over impact on global economy

The dramatic slide is merely a continuation of a trend begun five years ago, writes Marie Finneganin an outlook for the dollar.

The dollar's continuing decline against all major world currencies culminated this week with a record low of €1.48 against the euro.

Dramatic as these moves have been, the US currency's slide is merely the continuation of a trend begun five years ago. The concern centres on the sudden acceleration and its impact on the global economy.

Three key economic fundamentals are at play here. Firstly, expected interest rate differentials. Higher expected interest rates support a currency because investors diversify into higher yielding assets denominated in that currency.

In Europe interest rate expectations are flat, tinged with a slight upside risk. Correspondingly, interest rate expectations in the US are flat with a downside risk. The markets now attach a strong probability to a cut on December 11th.

Secondly, the US trade deficit. When demand for imports outstrips demand for exports, consumers need more foreign currency to buy those imports, so demand for the domestic currency goes down.

The US has been sporting a massive trade deficit in recent years; the surprise was that this deficit was not undermining the currency - until now. Although the trade deficit has been declining of late, its sheer size - $56.6 billion (€38.15 billion) in September - will add to the dollar's slide.

The third impediment to dollar strength has to do with economic growth. There are concerns that the recent sub-prime crisis, combined with higher oil and commodity prices will retard US growth. Recent data deepens these concerns.

Moreover, the recent financial crisis which unfolded in the summer has not gone away. Markets are still nervous and any more bad news in the banking sector would further undermine the demand for US assets and, consequently, the dollar.

A further factor which may blindside the dollar in the coming months relates to its status as a reserve currency. Over 20 countries have fixed exchange rates with the dollar, a fact which, historically, has tended to support the greenback.

The trouble is, some countries are thinking about divorce. In particular, six Arab nations, including Saudi Arabia, are to consider changing their link to the dollar at the Gulf Co-operation Council summit in Doha next month.

Can anything stop the dollar's decline? One possibility is intervention co-ordinated by the Federal Reserve. Concerted dollar buying would prompt a market rethink and suggest that the US currency was no longer a one-way bet.

Something similar happened in October 2000, when the euro hit an all time low and the threat of a global financial crisis prompted co-ordinated intervention by central banks.

The real question, however, is whether anything should be done to halt the dollar's decline in the first place.

On this question, the difference between US economic rhetoric and reality is stark. US treasury secretary Henry Paulson and the Federal Reserve chairman Ben Bernanke, continue to insist that a strong dollar is in US interests.

However, the reality is that a weak dollar suits the American economy, making goods and services cheaper for foreigners and boosting US exports.

The risk of course, is that the dollar could freefall, sending demand for US stocks and bonds through the floor and plunging the global economy into recession. Thankfully, this is not considered likely.

Marie Finnegan is lecturer in economics in GMIT