The dollar danger is not over yet

Published: May 8 2008 19:35 | Last updated: May 8 2008 19:35

When a currency rises after government officials say that it should, you learn one thing: that the
fundamentals were pushing it up anyway. It makes sense for senior US and European officials to talk up
the dollar against the euro – as they did this week in the Financial Times – especially now that optimism
about the US economy makes their arguments plausible. In the long run, however, the real risk of a dollar
crisis is against the managed currencies of Asia and the Middle East.

Early March was a time of danger for the dollar. There were forecasts of a deep depression, liquidity fears
around some of the mightiest banks on Wall Street, and the dollar’s decline against the euro, already
rapid, began to accelerate. That decline could have become self-sustaining if investors had begun to
dump US assets, but the decisive rescue of Bear Stearns by the Federal Reserve shifted expectations
about future US interest rates and restored confidence.

Through good judgment, as well as a little good luck, policymakers have so far avoided turning a credit
crisis into a currency crisis. Without a run of fresh bad news on the US economy there is little reason for
the dollar to fall further.

But while the dollar may now be stable, it is stable at well above $1.50 to the euro, a level that is below
most estimates of its fundamental value. That probably suits the US – a cheap but stable dollar should
boost exports and encourage foreigners to invest – even if it raises the bill for imported oil. The drag on
exports is less comfortable for the eurozone, but while the US is an important trading partner, it takes less
than 15 per cent of total eurozone exports.

But the trouble for both the US and Europe is not each other – it is China, India, Middle Eastern oil
producers and a host of other countries that peg or manage their currencies against the dollar.
For the eurozone that means that currency overvaluation against the dollar puts pressure not just on
exports to the US, but on exports to most of the rest of the world.

For the US it is both blessing and curse. Dollar falls would have been far more severe had Asian central
banks stopped buying it, but as long as Asian currencies are held down it will be impossible to resolve
global imbalances, and the risk of a dollar crash, one day, will grow. The pressure mounts steadily: with
US interest rates down at 2 per cent, China is now losing vast sums of money on its foreign exchange
reserves. Verbal intervention on the dollar and euro is welcome – but it is time for verbal intervention on
the rupee and renminbi as well.

Financial Times Online