Waning Days Of The Dollar

The U.S. dollar took another big hit last week, not only because of more news around subprime mortgage losses, but also thanks to comments from a Chinese official that the country has a "very clear plan" to diversify its currency reserves. Most economists believe that further weakness lies ahead, and one of the big questions is how this will affect consumers and investors around the world.

The dollar's decline is part of a much larger and more consequential rebalancing in the global economy, the impact of which will differ significantly from country to country. With the United States continuing to run a large trade deficit, the depreciation of the dollar is largely unavoidable over the medium term. Moreover, investment flows into dollar-denominated bonds are likely to slow as the Federal Reserve continues to cut interest rates and, more generally, the U.S. financial system works through the damage from the subprime debacle.

So far, the dollar has fallen by about 40 percent since its peak around five years ago. This is warranted not only by the payment imbalances, but also because the dollar has started from such a position of overwhelming dominance in the portfolio allocation of large institutional investors around the globe, including many central banks (most notably Japan, China and oil producers in the Middle East). This makes it vulnerable to a process of portfolio diversification that will accelerate as these investors seek to mitigate their concentrated currency risk.

The impact of the fall will vary widely. At the moment, it is most acutely felt in Europe, where the euro has surged to record levels against the dollar. No wonder European exporters complain of competitive pressures while European tourists are flooding the United States.

The phenomenon is less pronounced in Asia. There, the basket of 10 Asian emerging currencies has appreciated just 16 percent against the dollar in the last five years. The resulting depreciation of Asian currencies versus the euro has bolstered already-robust Asian exports.

How will a weaker dollar affect Americans? The most immediate impact of the dollar's fall is being felt through the related surge in oil prices and other raw materials. As these higher costs make their way through the production chain, they will result in declining profit margins, price inflation and greater pressure on wages. This will further complicate the job of the Federal Reserve, accentuating the trade-off between containing inflation and avoiding a sharp economic slowdown.

What explains these striking divergences among currencies and countries? I'd like to emphasize an important and often overlooked factor: currency moves do not simply represent what ought to happen, but what governments allow to happen. For the last few years, Europe has allowed its currency to move freely in response to market forces. In contrast, certain Asian countries, led by China, have been reluctant to allow such flexibility, lest it disrupt the dynamics of a truly historic breakout phase in growth. This combination has meant that the euro has done the bulk of the work in accommodating the dollar weakness warranted by economic and financial conditions in the United States.

Asia's reluctance to allow the currencies to move will likely dissipate gradually in the months and years ahead. Indeed, with several Asian economies reaching a new level of economic and institutional robustness and maturity, it will increasingly be in their national interest to allow their currencies to appreciate, and do so in a manner that is guided by market forces.

This medium-term shift in currency policy will be part of a more general transformation for the region and for the world. Look for Asian growth to shift gradually away from exports to a formula in which domestic consumption plays a greater role. Specifically, policymakers in the region will move from strongly favoring the producer to attaching more importance to the consumer. In the process, Asian consumers will gradually step up to the plate and offset the declining global impact of U.S. consumers pressured by falling house prices and large indebtedness.

While this phenomenon will be far from smooth, it will allow for a much needed global economic and financial rebalancing over time. Indeed, the world economy is evolving from reliance on a single and increasingly overwrought U.S. engine to one that is powered by several emerging economies. The result will be a more sustainable account-balance picture, but also a new and more important role for currencies like the yuan, yen and won.

Those currencies will move against the euro and each other in new and surprising ways in the years ahead. Indeed, the headlines will no longer be simply about dollar weakness; they will also capture the gradual emergence of the Asian currencies as a force in international finance. What Chinese officials think about the dollar will be only one of many factors moving currencies in a changing and more complex global investment landscape.