Greenback Rocks the World Market

The impact of weaker U.S. dollar is felt around the globe

By XIAO LIAN

BIG DIFFERENCE: A streetside sign in London shows the contrast of exchange rates between the euro and the U.S. dollar

In the last month of 2004, the U.S. dollar has continued sliding, falling more than 5 percent over the euro and drawing near to a record low against Japanese yen. Some experts in international finance believe the downtrend is only temporary while others say the dollar’s decline could grow out of control and lead to a collapse.

Two factors have caused the devaluation. One is deficit in the U.S. current account, the broadest measure of U.S. transactions with the rest of the world, which has made the international financial market skittish. The other is the laissez-faire attitude the Bush administration has taken with the weak dollar situation. Because of the two factors, the early prediction of dollar devaluation became a reality, which, in turn, has further aggravated the dollar’s depreciation in the financial markets.

Since the 1990s, the U.S. current account deficit keeps rising, from $48 billion in 1992 to $530.7 billion in 2003, according to the U.S. Department of Commerce, with its percentage of the country’s GDP rising from 0.8 to 4.8.

Meanwhile, whether the U.S. foreign and national debts can continue to increase is another concern for foreign investors since the current account deficit exacerbates the country’s debt. U.S. present foreign debts exceed $2.7 trillion, accounting for 23 percent of its GDP. Dollar devaluation can ease the pressure and offset part of its foreign debt. The Bush administration has approved an increase of the national debt to $8.18 trillion. If the country’s deficit spending continues, the national debt will reach $14.5 trillion in 10 years.

A large financial deficit has led to the dollar’s plummet after George W. Bush won reelection. During his first term, the U.S. budget shifted from a financial surplus of more than $200 billion to a deficit of $427 billion at the end of 2004, with total debt exceeding $2.5 trillion, according to the Congressional budget plan. Furthermore, Bush’s tax cuts may further reduce government revenues and enlarge budget deficits of the federal government.

Though the U.S. Congress expressed a willingness to cut deficit spending by adopting an annual budget of $388 billion for 2005, cutting nearly $12 billion expenditures, foreign investors are wary of Bush’s capacity to reduce financial deficits. Social security and medical insurance account for a large part of U.S. spending. The government is hesitant to cut spending in these programs because of the growing number of aged people. In 2007, those born during the first wave of the baby boom will reach retirement age, putting more fiscal pressure on government in pension spending.

With a sliding dollar, international investors might regard a clear U.S. government policy on the matter as an indicator of dollar’s future performance. However, the Bush administration has not given enough incentive to strengthen the dollar on the international financial market. The lax U.S. attitudes toward dollar depreciation and Bush’s weak dollar policy have made investors vigilant about a further drop in the future.

To improve its current account, the United States should fundamentally adjust its imbalanced structure of domestic deposit savings and investment. The improvement cannot be completed overnight and cannot be solved simply with the further devaluation of the dollar. It is not easy for the United States to cut its deficits under the backdrop of large-scale tax cuts and increased fiscal spending. Currency devaluation is unlikely to help improve the U.S. trade deficit. On the contrary, the current deficit does not show any indications of declining, but continues to rise.

For the Bush administration, a devalued dollar can bring benefits. First, it can increase the competitiveness of the U.S. products, since price for goods will be lower. Starting in July, the country’s exports rose for three successive months with export values hitting a record of $97.5 billion in September. Washington believes the gains were the result of a weak dollar.

Second, dollar devaluation can improve its current account deficit. Export increases can raise employment in related industries. In return, increased employment can ease the trade protections in the manufacturing industry and the pressures from organizations such as labor union.

Taking these things into consideration, the Bush administration has chosen a weak dollar policy over the past four years, and will likely be the policy of choice some time to come. The current account deficit and financial deficits, as well as the U.S. Government’s weak dollar policy, all lead to speculation of further dollar devaluation.

Theoretically, when the dollar is devaluated to a critical point and foreign investors’ confidence is stricken, it could lead to great financial pressure, such as a breakdown of the current dollar-dominated international currency system.

Actually, dollar devaluation is not expected to threaten the international currency system. Fluctuations in a country’s foreign exchange rate are a reflection of its domestic economic contradictions, and cannot reflect a country’s total economic strength. A country’s economic strength determines the strength of its currency in the international market. A strong U.S. economy is the true impetus that ensures the dollar’s dominant role in the global financial market.

Compared with the EU and Japan, the United States still has obvious economic advantages. After a short period of recession, the U.S. economy has entered a recovery phase with GDP growing rapidly over the past seven successive quarters. The U.S. economy is much stronger than those of the EU and Japan in terms of vigor, self-adjustment and growth potential. Meanwhile, the United States still leads the world in labor productivity, R&D capacity, economic aggregate, trade volume and capital market efficiency. Because of these factors, the United States controls the global capital and trade flow. Its economic strength is like an anchor, which should prevent the dollar from devaluating too much.

At the same time, the United States benefits greatly from the dollar’s status as a world leading currency. It can impose “mint taxes” on all countries in the world by exporting dollars globally. It can collect “inflation taxes” through dollar devaluation and can take advantage of the fact that the dollar serves as the major currency in international payment. The dollar functions as an international reserve method, which increases the capital supply capacity of the U.S. market. The advantage decreases the borrowing cost of U.S. corporations and raises their competitiveness with foreign investment. Washington is unlikely to give up these benefits. The U.S. Government will take measures to fix the weak dollar only when it harms the financial interests of the country and undermines the leading roles of dollar in the international currency system.

After a period of economic depression, the U.S. economy has entered a new period of growth. Washington’s policy focus has shifted to counter inflation. Since June 2004, the Federal Reserve has increased interest rates five times. The federal fund interest rates have reached 2.25 percent, after holding the rate for one year at 1 percent-the lowest it’s been since 1958. The interest rate increases can restrain dollar devaluation. The adjustment of the exchange rate is an important instrument for managing the recovery.

Global Impact

Dollar devaluation gave a heavy hit to the euro. The euro has posed a challenge to the dollar’s dominance. One of the best ways to strike at the euro is to restrain the EU economy and weaken the European currency through dollar devaluation.

Viewed from the history of the euro’s creation and development, people see that the euro’s value is often inconsistent with the strength of the European economy. Similarly, the fluctuation of dollar does not match U.S. economic trends. The U.S. economy is expected to be stronger in 2004. The U.S. economic growth rate is several times of those of major countries under the euro, yet dollar value keeps going down.

The yen has felt pressure from both the dollar and the euro. It cannot dominate the world financial market, but can balance the contradictions between the dollar and euro. Dollar devaluation gives revaluations to the euro and the yen, giving a massive threat to economic growth in Europe, which is already in recession. This phenomenon gives the EU and Japan reasons to intervene in their foreign exchanges.

Dollar devaluation hurts the economic interests of countries with a surplus of international trade. Experts predict that the net foreign debts of the U.S. will increase to more than 60 percent of its GDP by 2020. This amount will digest 75 percent of the current account surpluses of countries such as Japan, China and Germany, which have surplus trade with the United States.

Weak dollar also has influenced the interests from developing countries. The situation will not be improved for some time since that status quo is in the strategic interests of Washington. It needs the deficits and is capable of maintaining them. The United States purchases large quantities of cheap products from other countries to reduce its own inflation rate. The suppliers, especially developing ones, make money from the trade surpluses and make deposits into U.S. banks or buy U.S. debts. Thus, the U.S. restrains developing countries in both commodities trade and capital flow. They cannot compete. Developing countries suffer from the pressures of both importing U.S. goods and the appreciation of their domestic currency against the falling dollar.

Dollar devaluation also impacts the current international currency system and rigs the international foreign exchange market. But it does not indicate any change in the world economic structure. The strength of the euro will not exceed the dollar, nor will the euro take the place of the dollar as the dominant international currency.

However, the U.S. exchange rate policy that allows profits to be made at the expenses of others may force some countries to change their foreign exchange reserves. More countries may choose to increase the percentage of euro holdings in their foreign exchange reserves, and decrease their dollar assets. The euro’s percentage in foreign exchange reserves worldwide rose from 12.5 in 1999 to 19.7 in 2003, while that of dollar dropped from 68.3 in 2001 to 63.8 in 2003.

Still, the percentage of dollar in international foreign exchange reserves is larger than the combined percentage of the euro and the yen. Dollars flowing outside the United States exceed 70 percent of the total value of current dollar cash. The strength of the dollar directly influences the foreign exchange reserves and foreign exchange transactions of various countries worldwide. An unstable dollar exchange rate may stimulate the fluctuation and speculation in the international financial market, international gold market and international energy market. Influenced by dollar depreciation, the prices of gold and oil on the international market have fluctuated wildly, creating instability in international finance.

Dollar devaluation against the yen is not that large as it’s been against the euro, and it exerts comparatively less of an influence on the yen. Asian countries purchase a great quantity of dollars as their foreign exchange reserves when dollar goes down. Objectively, this can prevent the dollar from further devaluation and ease the pressures of having to revalue their own currencies.

Developing countries in Asia are facing a hard choice. They could stop buying or selling their dollars in order to avoid the risks brought by dollar devaluation. However, selling dollars will further accelerate the process of dollar devaluation, causing greater losses to them. Some people suggest that Asian countries sell large quantities of U.S. public debt, forcing Washington to balance a weakened dollar and its long-term debts.