Beijing, Riyadh will call shots on ailing dollar

By Liam Halligan
The Telegraph, London
Sunday, May 11, 2008

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/05/11/ccecon...

Only a month ago the dollar slumped to an all-time low against the euro. And it's just five weeks since the greenback hit a 12-year low against the yen.

But now, the US currency has started to strengthen -- with the markets talking about a "turning point." On Wednesday, the dollar reached a six-week high against the European single currency, closing in on $1.53 -- an improvement of more than 5 cents. And on the same day, the greenback climbed to a 10-week peak against the pound.

But does the dollar remain in danger? Could "the rope slip" and the world's pivotal currency still go into freefall? That would plunge America beyond recession and into depression -- as inflation ballooned amid soaring import costs, forcing the Federal Reserve to raise rates in the teeth of shuddering slowdown.

A plummeting US currency would also cause chaos globally, as central banks sought to protect the value of their reserves. And after the inevitable overshoot, the currency would snap back, sending financial markets into a tailspin, and threatening a fully-blown global slump.

That danger has been averted for now, but could soon come back with a vengeance. And while policymakers in Washington will be content with the current situation, those elsewhere shouldn't be.

It's instructive that the main reason for the dollar's "recovery" has little to do with the US economy. The greenback's relative strength is less about the robustness of America, than the weakness of the eurozone.

It's been widely assumed Europe has escaped the worst of the credit crisis. And with the exception of UBS et al., the writedowns suffered by continental banks have been much less than those in the United States.

But a slew of bad data has lately challenged such assumptions. Eurozone retail sales fell heavily in both February and March. Last month, the PMI Euro-manufacturing survey dropped to its lowest level since August 2005.

New data shows the bellwether IFO index tumbling in April -- contrary to market expectations. And in Germany, the eurozone's powerhouse, factory orders have just contracted for the fourth month in a row.

So while the US growth outlook has barely improved in absolute terms, its position now looks rosier relative to the eurozone -- which, of course, pushes the dollar up.

And while the European Central Bank last week held interest rates at 4 per cent, it's surely only a matter of time before political pressures prevail and euro borrowing costs fall. And, once again, that prospect makes the dollar look relatively more attractive.

As if to help the dollar's recovery, the European Commission last week published some interesting data. The eurozone suffers when the dollar is weak, of course -- as its exports are less competitive.

So I smiled when I saw the graph opposite in a Commission report on the 10th anniversary of the euro, showing America's superior growth performance. Eurocrats usually hate admitting the US grows faster than Europe.

But in the current climate, in a bid to reflate the dollar, they're shouting it from the rooftops. Brussels is even prepared to forecast that faster US growth will continue into the medium-term too.

After months of squabbling, not least at last month's G7 summit, an agreement has been struck that the greenback has become so weak it could soon slip into freefall.

So, in a co-ordinated move, ECB and Fed officials are now talking the currency up, whispering to journalists and the markets that if the dollar doesn't strengthen there'll be "intervention" -- which, for now at least, bolsters the greenback.

But the situation is by no means stable. One reason is that the US has got by far the better end of the deal. The dollar seems to have stabilised, but at a level well below most estimates of its fundamental value.

America likes this, of course, as a weak dollar boosts exports and encourages foreign investment, so helping the US climb out of its economic hole.

But until the currency strengthens further, Europe's acquiescence will be only partial, exposing the dollar to further speculative attack.

It's worth saying, also, that with oil hitting an incredible $124 a barrel last week, expensive crude will keep weighing down the trade balance of the world's biggest oil importer.

America external deficit remains the wrong side of $60 billion -- a figure that will escalate as long as oil stays dear. That reinforces the need for America to forego competitive benefits and allow the dollar to rise out of the danger zone to a level where its less prone to sudden collapse.

That level may not have yet been reached. I admit there are signs of flickering life in the US economy. Predictions of short-lived V-shaped recession could turn out to be true. But the upswing, if it comes, will be built on a combination of loose money and an unaffordable fiscal boost - hardly the platform for a solid recovery.

And, anyway, the biggest problem for the US isn't the eurozone: it's the rest of the world -- in particular China, the other emerging giants, and the Middle Eastern countries that peg their currencies to the dollar.

The weak greenback is harming these countries as it forces them to import inflation. All the signs are that their patience is now wearing thin.

And, at the same time, these countries now call the shots, accounting for 75 per cent of the world's foreign currency reserves.

So my prediction is that the US will soon reluctantly start talking the dollar up even more. But it won't be Brussels forcing them. It will be the likes of Riyadh and Beijing.

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