Saturday, December 02, 2006

There May be Trouble Ahead

The frontpage of the Indie, today, focuses on the weakening dollar. It's now worth about $1.9848 against Sterling and $1.3180 against the Euro. The signs are, apparently, that the dollar is set to tumble even further. Larry Elliott suggests that there are 3 major reasons for this pressure on the US currency.

Firstly, the US is running a colossal current account deficit, [$869bn (£450bn, €664bn)] which it funds by borrowing money from the rest of the world. Secondly, the economy is clearly slowing following the steady increase in interest rates from 1% to 5.25% since 2004. The boom in the housing market that artificially inflated growth a year ago has turned, predictably to bust. Thirdly, the differential between US interest rates and those in the rest of the world is narrowing. Despite all its tough anti-inflationary rhetoric, the Federal Reserve will not raise rates again.

Clearly (?), it's the second factor here which has been the catalyst for this anxious selling of dollars (perhaps someone can put me right, here, if I'm wildly off). The visible slowing of growth in the US economy has made the underlying weakness of the US economy (the first factor Elliott mentions) much more pressing, while the Federal Reserve's reluctance/inability to raise interest rates even more (because to do so would further damage US manufacturing competitiveness I suppose) means that they cannot offer further inducements to traders to buy dollars to plug the growing trade deficit gap. So, what we have might here, then, is the start of a vicious spiral downwards for the US economy. As Elliott concludes, the "dollar's weakness is no flash in the pan; it is the start of something big."

The FT provides further reasons to suspect that the US economy might soon be in for a little tumble. There is, apparently:

growing talk of global central banks diversifying their foreign exchange reserves away from the US currency. One factor supporting the dollar has been huge purchases by foreign central banks. Since 2001, global currency reserves have soared from $2,000bn to $4,700bn according to the IMF, with two-thirds of the world’s stockpiles held by six countries: China, Japan, Taiwan, South Korea, Russia and Singapore.

Anxieties over reserve diversification have been around for at least six months, with central banks in Russia, Switzerland, Italy and the United Arab Emirates announcing plans to cut the proportion of dollars held in their reserves. A shift by central banks away from dollars would remove a key source of financing for the US deficit.

... speculation is increasing that China, which is thought to hold 70 per cent of its foreign currency stockpile in dollars, is considering a fundamental change in its reserve allocation. Mitul Kotecha, head of foreign exchange research at Calyon, the French bank, [said] “The Chinese authorities are becoming increasingly nervous about holding too many dollars,” ...

If the Chinese and others sell their dollar holdings - ie refuse to prop up the US's deficit - then (in my understanding) that's it for the US economy. It's had it. I suppose it's not in the interests of the Chinese and others, however, to pull the rug out from under the feet of the US economy very rapidly - a US crash, means a world crash. They'll want to manage the decline of the US as an economic superpower (and that's what this amounts to) as carefully as possible. The thing about capitalism, though, is that it's notoriously difficult to manage in such a way - the anarchy of the market and all that.

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