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Wed Mar 16 11:17:45 PST 2005

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Mar 16th 2005
>From The Economist Global Agenda

The dollar may get another short-lived respite but it is heading inexorably
down. The question is how much it takes with it

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ALL you need to get into Harvard Law School these days, it seems, is a pair
of fuchsia-pink high-heeled shoes. Or so say Buttonwood¹s daughters,
reliably informed by an early-teen cult film, ³Legally Blonde². On the basis
that they can probably manage the shoes, if not the grades, Buttonwood is
paying close attention these days to exchange rates. Her hope is that in
seven years¹ time, if the dollar continues to slide against other currencies
(and British universities continue to raise their fees), it might cost
little more to send the thuglets to study in Cambridge, Massachusetts than
it would to pay their way in Cambridge, England.

What gives with the greenback? In two of the past three weeks, the dollar
took a pasting on reports that various Asian central banks, whose purchases
of America¹s debt help it to go on borrowing and consuming, were planning to
diversify their foreign-exchange reserves away from dollars. Bond yields
spiked up (ie, prices fell) and shares looked glum too.

Then, on Tuesday March 15th, keenly-awaited figures from America¹s Treasury
showed a big increase in net purchases by foreigners of American long-term
securities. The net flow in January ($91.5 billion) was 50% up on December¹s
figure ($60.7 billion), way over January¹s trade deficit of $58.3 billion.
Hidden in the figures were some interesting trends: purchases of American
shares picked up, for example‹which suggests a genuine fondness for the
dollar unlikely to be unwound soon. But so too did purchases from the
Caribbean‹home to even more hedge funds than The Economist¹s own St James¹s
Street‹which could be liquidated tomorrow. Mark Austin, chief of
foreign-exchange research at HSBC, a British bank, points out that central
banks bought about the same amount as before, while private-sector purchases
increased sharply. Is that positive for the dollar or negative? The currency
rallied, though questions persisted.

The Treasury data tend to be volatile and in any event show only a portion
of real flows. And one month does not a summer make. But taken together with
other figures from the Federal Reserve showing an increase in February and
early March in the securities it holds in custody for foreign owners, they
do suggest two things. The first is that the full shock-horror scenario, in
which Asian central banks dump the dollar and America promptly collapses, is
way overdone. The second is that although Bretton Woods II is still in
business, it is likely to change fundamentally.

The fact is that the markets are hyper-sensitive to these figures, and
analysts pore over them like Kremlinologists. The fear that central banks
are contemplating industrial action against the dollar‹and the collective
sigh of relief when it seems they are not‹is part of a broader unease about
the nature and solidity of America¹s economic growth. Based, as it is, on
mammoth consumption by both the private and public sectors‹ie, on big trade
and fiscal deficits‹it needs foreigners willing to suspend disbelief and buy
shiploads of securities denominated in a currency that has steadily lost
value for about 40 years.

So far, the foreigners‹mainly Asians plus a few outliers, including Russia
and Brazil‹have obliged, permitting America to scoop up 75% of the world's
surplus savings. Together, Asian central banks have accumulated about $2.5
trillion in foreign-exchange reserves, up almost a quarter in little more
than a year, most of it in dollars; Japan and China alone have reserves of
nearly $1.5 trillion between them.

Central banks have more reason to purchase dollar assets than to dump them.
Buying American securities keeps their own currencies low, their exports
competitive and their workers free to move from fields to factories.
America¹s economy is still growing strongly, despite higher oil prices: this
week¹s retail-sales figures confirmed that. There is money to be made there:
like investors everywhere, foreign buyers are chasing yield by moving up the
risk-reward curve these days into bigger purchases of agency debt (the stuff
put out by Fannie Mae and other government-sponsored agencies) and corporate
bonds. And the biggest dollar holders‹especially China and Japan‹cannot
really afford to start talking down the currency for they would see the
value of their own holdings diminished at a stroke.

But the Faustian deal into which Bretton Woods II has turned‹whereby America
gets to spend beyond its means and Asia gets to invest in export-led growth,
at the cost of recycling much of its earnings in America¹s securities
markets‹turns out to have a shorter horizon than most people reckoned. It
could turn sour at any time now. And confirmation of that came from another
set of economic data, released on Wednesday: America¹s fourth-quarter
current-account deficit widened to $187.9 billion, a record.

The dollar¹s role as the reserve currency of discriminating central bankers
everywhere has already lost ground. On figures from the Bank for
International Settlements (BIS), the world held 76% of its reserves in
dollars in 2000; by 2003, the proportion had slipped to 68%. Part of that
reflects the dollar¹s slide in value. But part reflects growing
diversification, which is as it should be. Asian countries are trading more
with each other these days, as well as with Europe. The euro now offers a
liquid alternative to the dollar, and Europe shows no signs of wanting to
flood the world with its paper.

Russia, Indonesia, South Korea, India and Japan have all murmured
significantly, if guardedly, about diversifying of late. Though figures are
elusive, the best guess is that most are doing so already. At the end of
February, officials and academics from all around Asia met in Bangkok to
discuss the sliding dollar and concluded that they should move more
definitively to their own advantage. There are repeated suggestions that
regional payments systems should be set up, such as the gold dinar standard
proposed for the Islamic world in 2002 by Malaysia¹s prime minister.

It is possible that, this time around, OPEC and other oil exporters will
channel their windfall profits through the Treasury¹s books. But what will
happen if a significant portion of countries decided not to add to their
dollar holdings? More than the dollar would weaken. Big foreign buyers of
bonds have been keeping interest rates down, perhaps by one percentage
point, as Alan Greenspan suggests. That would change, for a start. Without
this support, the yield on the ten-year benchmark Treasury bond could rise
to more than 5%, pushing up interest rates on mortgages. That, in turn,
could prick America¹s house-price bubble and prompt a general deleveraging,
with implications for economic growth both in America and elsewhere.
Standard & Poor¹s, a rating agency, warned on Monday that a weak dollar
would substantially increase concerns about credit quality.

This is perhaps not the week to air such apocalyptic concerns, though they
are much on Buttonwood¹s mind. In the end, what foreign central bankers have
it in their power to do is to reveal before all the world that the mighty
American economic empire has no clothes‹not even a pair of little
fuchsia-coloured shoes.

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