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Diversification from the East could send the dollar south
By Irwin Stelzer
The Times, London
Sunday, February 27, 2005
http://www.timesonline.co.uk/article/0,,2095-1502209,00.html
Happenings in the two global markets that do not conform to Adam
Smith's model frequently roil free-market economies such as
America's. The foreign-exchange market is dominated by central banks
that manipulate the value of national currencies for reasons
unrelated to what we think of as natural economic forces. And the
oil market is heavily influenced by a producer cartel that is
determined to keep prices well above those that would prevail in a
competitive market.
So when the Korean central bank announced that it had lost interest
(no pun intended) in acquiring more dollar assets to add to the $200
billion it already holds, and the Opec oil cartel drove prices above
$50 a barrel by suggesting that it would cut output, shivers ran up
the spines of investors. Share prices and the dollar both lost some
1.5% of their value in a single day.
Panicked investors foresaw a run on the American currency. That
would force the Federal Reserve Board's monetary policy committee to
abandon its policy of "measured" interest-rate increases in favour
of much more rapid increases. The so-called house-price bubble would
be pricked, consumers rattled, the economy slowed, profit growth
curtailed and share prices driven down.
Worse still, the oil cartel plans to reduce output despite rising
demand due to a cold snap in America, and China's insatiable
appetite for oil, and shrinking supplies due to a decline in Russian
oil production as Vladimir Putin's old KGB pals take control of the
industry.
The resulting higher prices would, in the words of the new annual
report of the president's Council of Economic Advisers,
constitute "a headwind for the economy because they raise the cost
of production, thus weakening the supply side of the economy, and
absorb income that could have been used for other purchases, thus
weakening the demand side of the economy."
Worse still, prices of commodities other than oil are soaring, in
part because of China's huge purchases. Last week, the Anglo-
Australian company Rio Tinto raised the price of the iron ore it
sells to Nippon Steel by 72%. Many investors fear this commodity-
price surge would add to the inflationary pressure created by high
oil prices just as the US economy slows, reintroducing America to
the stagflation it thought it had seen the back of when voters
ejected Jimmy Carter from the White House.
It is not unreasonable to ask, in the face of this plausible and
unsettling scenario, just how the president's economists can
conclude that the American economy will grow this year at an annual
rate of 3.5%, "faster than its historical average," driven by
consumer spending, investment growth, and stronger exports.
The answer, in part, is that the Asian central banks have watched
their Korean colleague dip its toe in the water of "let's get out of
dollar assets" and get scalded in the process. So they have rushed
out statements saying that they have no intention of unloading
dollars.
Even the Bank of Korea looked at what it had wrought and was
displeased. In its report to the national assembly, the Bank had
said that to increase earnings on its reserves it would "expand
investments into non-government bonds ... and diversify the
currencies in which it invests." Surveying the carnage that this
statement created, Kang Myun-Mo, head of reserve management, hastily
issued a "clarification." He said that although he indeed intends to
invest in higher-yielding non-government bonds, he has no plan to
cut the share that dollars represent in the bank's total holdings.
The dollar recovered as it became clear that the Asian banks were
aboard a tiger, and would see the value of their assets eaten if
they climbed off. Were they to unload dollars, they would lop
billions off the value of the dollar reserves they hold in their
vaults.
So they will continue to buy dollar assets, although at a slower
pace and shifting to non-government bonds.
Unless the gradually declining dollar sufficiently stimulates
exports and shrinks imports, the American trade deficit, running at
6% of GDP, will at some point become difficult to finance without a
significant rise in interest rates.
But that day has not yet arrived. The American economy is far more
attractive to investors than the sclerotic EU, a Russia led by a
president unfamiliar with the concept of private-property rights, a
Middle East in turmoil, and a Britain heading down the European path
of ever-higher taxes. So investors still want to acquire dollar
assets in sufficient quantities to prevent a run, although not a
slide, in the dollar.
The more difficult problem relates to oil prices. Opec has decided
to adjust output to prevent consuming nations from accumulating
inventories to dampen price run-ups. The cartel will henceforth aim
to maintain prices in the $40-$50 a barrel range, Saudi Arabia
announced late last week, finally officially abandoning it previous
target of about $25.
The higher price confers political as well as economic advantages on
producing countries. Iran can resist pressure to abandon its nuclear-
weapons programme because it is so awash in cash that it doesn't
need western investment. Saudi Arabia can hold its American critics
at bay by playing the crucial role of supplier of last resort. And
Venezuela has the funds to finance Fidel Castro and anti-American
groups in Latin America.
The disadvantages to America are obvious. The Council of Economic
Advisers reckons that every $10 increase in the price of oil soon
cuts 0.4% off real GDP. This means that current prices are shaving
about a full point off the growth America might be experiencing had
Opec been content with its previous target ceiling. That, and
constraints on its foreign-policy flexibility, are high prices to
pay for the administration's refusal to develop a policy to reduce
dependence on foreign oil.
-------------
Irwin Stelzer is a business adviser and director of economic policy
studies at the Hudson Institute.
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