Slumping dollar puts G7 back in spotlight

By Greg Robb
MarketWatch.com
Monday, October 15, 2007

http://www.marketwatch.com/news/story/slumping-dollar-puts-g7-back/story...

WASHINGTON -- For the last five years the global economy has sailed along, allowing meetings of the Group of Seven finance ministers and central bank governors to take place in relative obscurity.

But with the financial market turmoil and the slumping U.S. dollar now on center stage, the G7 will again be thrust into the spotlight on Friday as ministers have their closed-door meeting in Washington.

The G7 is facing two difficult tasks.

Financial markets are counting on the G7 ministers to support the slow rebuilding of confidence in international financial markets after August's financial turmoil.

In addition markets are also counting on officials to coordinate efforts to keep the U.S. dollar's decline on a gradual path.

The dollar has been declining slowly since 2002. Against a basket of 26 currencies, the dollar is down 23% since February 2002. But the recent financial market turmoil has stirred fears that the dollar's fall could turn into a rout.

Since the surprise Fed rate cut on Sept. 18, the dollar's decline has accelerated, dropping 2.3% against those currencies.

The problem is that many analysts don't think the G7 is up to the job. They say the G7 is too dysfunctional to expect any coordinated action.

"The G7 won't resolve anything," said David Hale, chairman of Prince Street Capital Management, in Chicago.

The G7 will meet behind closed doors on Friday, Oct. 19. After that, officials will remain in Washington for the weekend annual meetings of the International Monetary Fund and World Bank.

In the run-up to the G7, all of the parties seem to be talking past each other.

Currency experts said the G7 statement released after the meeting will stress "excess volatility" is undesirable and that exchange rates should reflect fundamentals calling for increased flexibility for China and other Asian forex markets.

No reference to a stronger dollar is expected.

"I don't think you are going to get much more in the headlines. Who know what goes on behind the scenes," said Meg Browne, senior currency analyst with Brown Brothers Harriman in New York.

"I don't think we'll see any major new developments in terms of an agreement on currencies," agreed David Gilmore, a partner at Foreign Exchange Analytics. "To usher in any changes in G7 communiqué language, the U.S. and the Japanese have to sign on and they are not likely to sign on a statement that points a finger at a weak dollar and a weak yen," he said.

"The bottom line is that the lowest common denominator is that everyone can agree on is that the Chinese yuan needs to be higher," Gilmore added.

...Problem long in coming

The problem of the dollar and the U.S. trade imbalance has been around for a long time. Simply put, the U.S. has been living beyond its means, consuming more that it is producing. Accordingly, the U.S. current account deficit has ballooned to over $800 billion in 2006 or more than 6% of GDP.

And the U.S. is now the world's largest creditor nation.

"As a result, not only does the United States now need in excess of an additional $2 billion a day in external financing, but it also needs the rest of the world to continuously add to its already outsized dollar asset holdings," said Desmond Lachman, resident fellow at the American Enterprise Institute, a conservative think tank.

The IMF has been calling for a gradual decline in the dollar for years.

A gradual decline in the dollar is "least worst way for us to adjust to the imbalances we have in the global economy," said Robert McTeer, the former president of the Dallas Fed.

The worry continues to be about a sharp downturn in the dollar, which could have drastic consequences for the already weakened U.S. economy.

Any sign that foreign investors are reluctant to acquire and hold U.S. financial assets could lead to an accelerated weakening of the dollar, said Charles Dallara, managing director of the Institute for International Finance, a lobbying group for the world's largest financial institutions.

Allan Meltzer of Carnegie Mellon University, an expert on monetary policy, recently told a panel discussion at the AEI that Treasury Secretary Henry Paulson's dollar policy is simply to pray every night that the dollar's decline will be orderly.

"A plunging U.S. dollar would make it all but impossible for the Federal Reserve to achieve its dual mandate of promoting satisfactory economic growth and keeping inflation in check," said Lachman.

A weaker dollar could fuel inflation through rising import prices.

Another problem is that a weaker dollar might result in a significant backing up of long-term U.S. interest rates as foreigners exit from the market. This would only deepen the housing market meltdown, Lachman said.
The dollar's decline has been met with quiet calm from the Bush administration and the Federal Reserve. There has been no deviation by Paulson from the mantra that the U.S. supports a strong dollar.

At the same time, many European leaders are clearly agitated by the drop in the dollar, believing that they are bearing the brunt of the dollar's decline.

Jean-Claude Trichet, president of the European Central Bank, reiterated on Monday that he was paying "great attention" -- a week ago he spoke of his "extreme attention" -- to American statements in support of a "strong dollar."

As many Asian countries, especially China, continue to essentially peg their currencies to the dollar, the exchange rate has fallen against floating-rate currencies, such as the euro, the Canadian dollar and a few others.

Current Fed officials won't comment on the dollar, but former Fed officials are probably saying what current officials can't.

Former Fed Vice Chairman Alice Rivlin said Fed officials understand the world of a failing dollar better than they did when there was the huge current account deficit and the dollar wasn't falling.

Asked if there was a point beyond which the Fed cannot tolerate dollar declines, Rivlin replied: "If there is, we are not there now."

"The Fed can't do anything about the dollar; it is background noise," said Hale.

...Avoiding recession

In fact, for some U.S. economists, the weakening dollar is an important part of their forecast for the U.S. to avoid a recession from the recent financial market turmoil.

The weaker dollar supports U.S. exports and hurts European exporters.

The weaker dollar was a "sensible trend" given the economic forces, said Douglas Holtz-Eakin, former director of the Congressional Budget Office and senior fellow at the Peterson Institute for International Economics.

But Europeans who continue to press the U.S. to take action to stem the dollar's decline are "oblivious to the fact that, even were it inclined to do something there is little that the Federal Reserve can realistically do to support the dollar at the time that the housing market bust is in full train," Lachman said.

Lachman said a cut in interest rates by the European Central Bank is "the only real hope of preventing the dollar from going into free fall."

Little has changed in the 36 years since Treasury Secretary John Connally told the Europeans that the dollar was "our currency but your problem."

After a meeting in Luxembourg last week, European finance ministers could not come to a consensus about the dollar, but began to emphasize that China should allow its currency to strengthen.

"China and other emerging-nation economies should introduce more flexibility in their exchange-rate management," said Joaquín Almunia, the European commissioner for monetary affairs.

Almunia and Trichet announced they will visit China before the end of the year to discuss the exchange rate with China.

...Good cop/bad cop

This is a change in Europe's approach, analysts in Washington said. In the past, Europe has sought to play the "good cop" by sympathizing with China, reaping trade benefits, while the U.S. played "bad cop" and badgered China to strengthen its currency.

Europe only dropped the good cop routine when it "saw the whites of the eyes of the problem coming at them," said Fred Bergsten, the director of the Peterson Institute.

"It is better late than never to get on the train and try to balance adjustments," Bergsten said.

Bergsten said he would not be surprised to see further upward adjustment of the dollar to $1.50 or $1.60 if China were to continue to block appreciation.

Carl Weinberg, chief economist at High Frequency Economics, said European leaders would get the same treatment about yen appreciation as U.S. officials have.

"European finance ministers can moan all they want about economic evidence of yuan overvaluation. Chinese President Hu Jintao has more important problems on his plate to be concerned about helping out European finance ministers with their currency agendas," Weinberg said.

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