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BW Businessworld

Is Dollar Decline More Dangerous Than It Seems?

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Neither Washington nor Wall Street is losing much sleep yet over the dollar as it slips close to all-time lows. But perhaps they should be.

The dollar has shed some 8 per cent against major currencies this year, and if the decline quickens, it could provoke protectionism from America's trade partners, worsen inflation at home and spark a general loss of confidence in US assets.

That would all make it much more difficult to finance the country's huge deficits, and could threaten to send the US economy into another recession.

In fact the burgeoning national debt is where all the negatives for the dollar converge, with America's prized AAA credit rating under threat and large corporations like Caterpillar urging Washington to get its act together.

"There's no sign of panic yet. But the situation can change on a dime," said Brown Brothers Harriman strategist Lena Komileva. If the US economy weakens and US lawmakers fail to find a way to slash a yawning budget deficit, "that could create a run on the dollar."

US policymakers, including Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke, insist they want a strong dollar, but investors say their actions suggest otherwise.

The Fed has held interest rates at zero since late 2008, in contrast to other central banks that have begun raising rates to fend off inflation.

That's been an invitation for investors to borrow dollars at virtually no cost and swap them for higher-yielding currencies and assets such as oil and equities. Gold and silver have hit record highs and the euro is hovering near $1.50, about 10 cents from its all-time peak hit in 2008.

Standard & Poor's put another chink in the dollar's armor this month when it warned it could cut the United States' credit rating if lawmakers don't find a way to slash a massive federal budget deficit within two years.

Corporate America is voicing its concerns as well. The chief executive of Caterpillar Inc on Friday called for a resolution to the long-running budget battle, saying that finding a way to strengthen the economy would help control the nation's rising deficit and improve long-term competitiveness.

'Remarkably Nonchalant'

Bernanke argues that the US economy remains too fragile for tighter policy and suggested the Fed's pro-growth measures will help the dollar down the road.

"If we do what's needed to pursue our dual mandate for price stability (and) maximum employment, that will also generate fundamentals that will help the dollar in the medium term," he said at a press briefing this week.

Adnan Akant, who helps manage about $20 billion in currency assets for Fischer Francis Trees & Watts, a New York unit of BNP Paribas, put it this way: "You don't get a strong dollar by raising rates. You get it by having low inflation and a stronger economy that requires you to raise rates."

But that's cold comfort for emerging market countries who claim Fed policy encourages investors to pour money into their economies in pursuit of higher returns, pushing up inflation.

"The cheap dollar is exporting inflation to the rest of the world and that creates problems," Komileva said. "What worries me is the prospect of more protectionism, which could create a lot of volatility in markets."

So far, efforts by countries such as Brazil to limit capital inflows have had little effect. Instead, the real has soared to two-year highs against the greenback, which could undermine Brazil's exports and damage the broader economy.

Europe would be just as unhappy to see the euro set a new high above $1.60, which would complicate indebted euro zone countries' ability to grow their way back to health. It would also increase the chances of a Greek debt restructuring, which would hurt European bank balance sheets.

The euro is currently at $1.4825, after weakening from $1.3345 at the beginning of the year, and would probably be higher but for Europe's own debt crisis.

"This administration and this Fed are remarkably nonchalant about the dollar's place in the world," said James Grant, editor of Grant's Interest Rate Observer. "I think it's quite worrying."

Watching Treasury Yields

There's no doubt a weaker dollar will boost US exports -- which is good news for corporate balance sheets and stocks. The White House has set a goal of doubling exports by 2015 as a key way to create jobs.

It also forces developing countries that rely too much on exports to become more comsumption-oriented, helping reduce inflation, said Eswar Prasad, senior fellow at the Brookings Institution in Washington.

But a weak dollar makes imports, including oil, more expensive for US consumers, and it could also lead to higher borrowing costs for consumers and businesses. All of this could hurt demand and economic growth.

So far, the dollar decline has been orderly, with the 10-year Treasury yield at a manageable 3.30 per cent -- hardly what one would expect in a currency crisis.

But many investors fear those low yields were largely engineered by the Fed, which has been buying about $75 billion worth of Treasuries a month since November.

When it ends those purchases in June, other buyers may require higher yields to step in.

"When it comes to the US economy, it's not that obvious that the benefits of a weaker dollar outweigh the costs," said David Woo, currency strategist at BofA-Merrill Lynch.

Dealing With The Deficit

In the late 1970s, the last time the US found itself facing rising inflation and a loss of confidence in its assets, the Fed was forced to push interest rates through the roof, thrusting the economy into recession.

"You don't have to be that old to recall those years, when Roman hotel clerks would look down their noses at dollar travelers checks because of the dollar inflationary crisis," Grant said.

The situation is certainly not as parlous today, though there are signs that some investors are starting to slap a higher risk premium on dollar assets.

U.S. Treasury data shows China and other large foreign creditors' demand for U.S. government debt has cooled since the Fed began its $600 billion bond-buying program last year.

Private buyers have their doubts as well. PIMCO, the world's largest bond fund, announced in February it had sold all US Treasuries in its $236 billion Total Return Fund, and chief investment officer Bill Gross said he expected interest rates to climb, the dollar to fall and the United States to eventually lose its AAA credit rating.

The quickest way to reverse the dollar decline, Woo said, would be for Congress and the White House to reach a deal on slashing the deficit. That would increase demand for dollars and push the euro back to $1.30 in coming months.

But if politics get in the way and the fiscal situation is left to fester, things could get ugly fast, particularly if higher bond yields force the Fed to restart its bond-buying program later this year, said Douglas Borthwick, managing director of currency execution firm Faros Trading.

"That's when you'll see a tipping point," he said. "Then S&P and the Chinese central bank and others will step up their rhetoric and the dollar will be on a very rough road."