Weakness of dollar must stay 'orderly'

Ground Floor: So George W has settled back in to the White House and propped his feet up on the desk for four more years, the inevitable result of which is that the dollar will put its feet up too.

It is chalking up daily lows against both the yen and the euro and most people reckon that the Bush Administration really doesn't care all that much.

According to a Treasury official last week, the markets were operating in an "orderly" way - which is another means of saying that the authorities are quite happy to see the dollar continue to decline; and that's despite the fact that Treasury spokesman Rob Nichols re-iterated his view that the administration hasn't changed its "strong dollar" policy and that they have a plan to cut the budget deficit in half.

Right Rob. The Fed's Trade Weighted Major Currency Dollar index is currently at a nine-year low and there's been a 21 per cent depreciation in the value of the currency since George W first put the key in the White House front door back in 2001, but there's no change in the strong dollar policy.

The administration might think that way but others aren't so impressed.

Japan's Vice-Finance Minister, Hiroshi Watanabe, commented that the dollar's "slump" deviates from economic fundamentals and the European Central Bank's vice-president, Lucas Papademos, rowed in by saying that "excess volatility is not desirable".

Actually, the dollar is not volatile, it's just going down. As a result the Japanese say they are considering taking "aggressive action".

Not the kind of talk you want to be using around the newly re-elected president!

The fact is, of course, that the administration is happy to see the dollar fall because it desperately wants to narrow the gaping trade deficit which the US has run up over the past four years.

It was a record $166.2 billion (€128 billion) at the end of the second quarter, which is the equivalent of nearly 6 per cent of US gross domestic product.

This means that the Americans have to attract even more foreign capital to sustain it (currently $1.8 billion a day, according to Bloomberg).

At the moment, and despite the continued dollar slippage, they're still getting those inward flows.

Most investors are simply hedging their currency exposure - which has worked so far and has meant that, from the point of view of the US, the decline has been relatively orderly. Therefore, as long as the hedging mechanisms operate successfully, the investors will continue to purchase dollar assets.

But what everyone is afraid of is that the dollar could suddenly begin to free fall and hedging the currency no longer becomes a viable option.

One of the major fears is that the Chinese will stop being the major buyers of Treasury paper. Part of the reason that they've invested so much in US dollars is to keep their own currency low so that they can continue to remain competitive in the export markets.

If they suddenly row back on their dollar purchases, the greenback could fall much more quickly than it has previously and, the next thing you know, the orderliness of the past few years could become a rout.

There have been increasing murmurings in foreign exchange circles that this is starting to happen and that, in fact, China has begun to offload some dollars in recent weeks.

The authorities love to say that exchange rates should be left to market forces until those markets begin to exert those forces in a way that the authorities themselves don't like very much.

Former US Treasury Secretary Robert Rubin, who is now an executive at Citigroup, is someone who thinks that the decline could begin to accelerate. In a recent speech, he said that he was an advocate of the strong dollar policy and (in a somewhat critical assessment of the current administration's efforts) said that the US had "a lot of work to do in a very difficult political environment".

Federal Reserve governor Edward Gramlich is also concerned about US policy, although he's targeting the budget deficit. According to Mr Gramlich, the United States has to cut the deficit to finance the investment it needs to provide for the baby-boomer generation as it retires.

He thinks that low savings and high spending has led to an "unstable" situation for Americans and highlights the financing of both the budget and trade deficits by those overseas investors.

Mr Gramlich is concerned that policy is too short term and that they are devoting a "very low share of our output to building up the future". He doesn't think that the United States can depend forever on overseas investors to support the American propensity not to save.

The bottom line is that both the trade and budget deficits have the capacity to drag the dollar and US economy into the mire. The problem of the "twin deficits" has been around for a long time but no one is sure which is the more worrying - or maybe even where to lay the blame.

Should it be on American consumers who don't save enough? Or should it be placed squarely with Europe, whose consumers don't spend enough?

Economists (naturally) have a foot in both camps, suggesting that deficits are a global problem of which the US is only one part - and they're right, of course, because a deficit in one country is a surplus somewhere else.

Neither a rampantly weak nor a rampantly strong dollar is a major problem. The issue is how it reaches its highs or lows.

So far, and happily for everyone concerned in the US, the decline has been of the orderly nature beloved by the financial authorities. As long as they can manage to keep it that way, the effects on the global economy should be easily managed.

However, if traders get tired of acquiescing to the deep-seated desires of the authorities and decide to flex their own muscles, then the whole thing could get a good deal uglier. And when market forces get ugly, they get really ugly.