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William Pesek Jr.: Is Kafka running Korea''s currency policy?
Expert View:
Diversification From the East
Could Send the Dollar South
By Bill Robinson
The Independent, London
Sunday, February 27, 2005
The renewed weakness of the dollar last week may be the beginning of
the end of a set of fundamentally unsustainable arrangements that
have nevertheless proved surprisingly durable because they have
suited all the participants rather well.
The weakness of the dollar is usually blamed on the US twin
deficits, the budget deficit and the balance of payments deficit --
especially the latter. That deficit did not matter too much as long
as the rest of the world wanted to buy US assets. While Wall Street
was rising they did. But the long period of sideways trading,
following the dot-com crash, has reduced the world's appetite for US
assets. As a result, the US basic balance (current account less net
foreign investment flows) has deteriorated and the dollar has
weakened.
But that is only half the story. Emerging Far East economies,
notably China, have chosen to fix their exchange rates against the
dollar. A substantial part of the US deficit is with China, but as
long as the Chinese authorities hold down the renminbi against the
dollar, one important price mechanism (a rising renminbi), which
would help correct the US deficit, is blocked.
The Chinese policy is based on the desire to keep their exports
competitive in the US, and as the dollar falls, improve their
competitiveness around the world. They can follow this policy
indefinitely because any country can keep its currency weak by
printing and selling it. But the maintenance of competitiveness
comes at a cost.
Actually, what the Chinese authorities do is borrow from their own
citizens and use the proceeds to buy dollars, which go into their
official reserves. This is already expensive because the interest
received on the dollars is much lower than the interest paid on the
borrowed renminbi.
But the more serious problem is that by following this policy over
many years, the Chinese have built up a huge store of Western
assets, in particular US dollar assets. In effect, the industrious
Chinese have been lending the Americans the money to buy their own
goods. The value of those US promises to pay, measured by the
dollar's trade- weighted index, has fallen by around 30 percent from
peak levels in early 2002 and there is no end in sight to this
decline.
The Chinese thus face, in spades, the awful dilemma that confronts
any large holder of an asset that is declining in value. They would
like to diversify their reserves into other assets. To do so they
have to sell dollars and buy (let us say) euros. But if they do
that, they risk pushing the dollar over the cliff, causing a huge
loss in value of their remaining dollar reserves.
It is not just the Chinese who face this dilemma. Many Far Eastern
economies, including North Korea and Japan, are in a similar
position. The signs last week were that some, though not Japan, are
increasingly prepared to diversify, whatever it does to the value of
their remaining reserves. It is thus hard to see an early end to
dollar weakness.
Euroland is therefore entering a period in which steady capital
inflows will drive up the exchange rate, putting downward pressure
on inflation and on interest rates. The balance of payments will
deteriorate, allowing Europeans to live high on the hog on borrowed
money -- just as the Americans have been doing all these years.
If you think that doesn't sound too bad, you would be right.
Consumers will benefit from cheaper imports. Trips abroad,
especially to the States, will be remarkably good value. The strong
euro will offset the rise in (the dollar value of) the oil price,
also in the news last week. But European producers will be less
happy, because less competitive. And, believe me, it is their voices
we will hear, not those of the happy consumers.
-------------
Dr Bill Robinson is a director of economics at
PricewaterhouseCoopers.
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