Volatile dollar may not be scary to Washington

By Steven R. Weisman
The New York Times
Friday, December 1, 2006

http://www.nytimes.com/2006/12/02/business/02dollar.html

WASHINGTON, Dec. 1 -- As the dollar tumbled against the euro this week, reflecting fresh concern about a possible weakening of the American economy, Treasury Secretary Henry M. Paulson Jr. issued the usual phrase from the catechism: "A strong dollar is clearly in our nation's best interest."

Treasury secretaries since Robert E. Rubin in the 1990s have, with rare exceptions, offered precisely that formula whenever the subject comes up.

But many economists say that Mr. Paulson's statement does not reflect what the United States actually seeks right now. For one thing, the Bush administration is in active pursuit of a weaker dollar against China's currency, which would probably encourage similar changes with other Asian competitors. The goal would be making American exports there less expensive, and imports more expensive, helping to spur an industrial revival at home. And though there are high risks if the dollar were to continue to fall rapidly against the euro and the British pound, the United States is generally seen as hoping for the economic gains delivered by a lower dollar as American exports become more competitive against planes, machinery and other goods produced in Europe.

"Paulson has got to like a euro that's appreciating in value," said C. Fred Bergsten, director of the Peterson Institute of International Economics and a longtime advocate of a weak dollar. "He came into office facing an overall American trade deficit that is close to $1 trillion a year. He's got to welcome something that shows the trade deficit likely to go down."

Still, the fluctuations of the dollar have unsettled many in the world of finance this last week, when it sagged about 2 percent against the euro, bringing its decline this year to more than 12 percent. On Friday, the dollar fell to 1.33 euros; it dropped against the British pound as well, with it now taking $1.98 to buy a pound.

By contrast, against the Japanese currency, the dollar has slipped much less, closing Friday at 115.35 yen.

In Europe, the French finance minister, Thierry Breton, has expressed concern about a weakening dollar, noting that exports have helped Europe's recent economic recovery.

But other European finance ministers said this week that at least for now, gains in the euro do not appear to threaten prospects for growth in Europe.

The gyrations of the dollar highlight the sensitivity of Mr. Paulson's role at this particular moment, as he prepares for his biggest overseas trip so far as Treasury chief: a veritable expedition to China, accompanied by five cabinet members and by Ben S. Bernanke, the Federal Reserve chairman.

The goal of the trip, which starts Dec. 14, is to engage China on a range of economic issues but most particularly to press Beijing to let its currency, the yuan, rise in value against the dollar. That would help, American officials hope, to narrow a Chinese trade surplus with the United States that soared past $200 billion last year.

As a former investment banker who lived and breathed the logic of international markets for decades at Goldman Sachs, Mr. Paulson is trying to engineer a kind of correction in which China would cease what American officials say have been currency manipulations aimed at pumping out exports.

Against the background of the rise of the euro, the China trip illustrates the three-cornered complexities of the world economy and of Mr. Paulson's dollar diplomacy. Suddenly with a declining dollar, Europeans are stepping up their purchases of American goods, and it has become more expensive for Americans to visit Europe as tourists or business officials. American investors overseas, meanwhile, are enjoying the extra kick that a falling dollar delivers on their foreign profits.

The decline of the dollar against the euro, while the dollar-to-yuan ration remains stable, also has the effect of increasing tensions between Europe and China. European businesses, like their American counterparts, are already upset about cheap Chinese exports to Europe. Now these goods are even cheaper because the yuan is declining against the euro, pulled down by the dollar.

The Chinese, meanwhile, are likely to get more nervous than ever that a decline in the dollar against the yuan will damp their exports and reduce the value of their dollar-denominated assets, putting pressure on Chinese banks that are holding those assets.

China has resisted American appeals to let the yuan rise in value, arguing that China is already undertaking painful economic reforms -- writing off bad loans and closing money-losing state enterprises -- and cannot afford further social disturbance brought on by new difficulties in exports.

"We are committed to a market-based exchange-rate mechanism," said a senior Chinese official, speaking anonymously under Chinese ground rules. "But we will do it in a responsible way -- responsible to the health of our country, the United States, Asia, and beyond."

Part of the reason for the dollar sell-off, many analysts say, has been a recent sense of disappointment about the American economy even as Europe has picked up some momentum, prompting traders to look for more promising investments in markets overseas. The prospect of higher interest rates in Europe while rates remain stuck or drift lower in the United States has also drawn funds out of the dollar.

Some analysts also say that the dollar decline has been partly seasonal -- that there is always a decline in investment in dollar-denominated investments at the end of the year, despite the huge need by the United States to finance its current-account and budget deficits.

"There's always a little seasonal weakening of the dollar at year-end," said Robert Sinche, head of global currency research and strategy at Bank of America. "With its large imbalances, the United States needs to attract capital every day. Capital flows tend to slow down at this time, because people go on holidays or are closing their books."

"It's like musical chairs," he added. "When the music stops, those who have deficits are going to suffer."

If American policy makers are pleased about the prospect of the dollar's providing a kick for exports, they fear a dollar falling so far and fast that it fuels inflation in the United States. Higher inflation might force the Federal Reserve, which is still concerned that price increases are outside its comfort zone, to raise interest rates, slowing the American economy further.

"The fall of the dollar has both benefits and risks," said Nouriel Roubini, chairman of Roubini Global Economics. "The danger is that the willingness of foreign investors to buy dollars is shrinking. If the fall of the dollar accelerates, investors could start dumping U.S. assets, and you'll get a hard landing for the economy."

The fear of a loss in the value of its assets is a factor in China's rebuffing American imprecations to let its currency float more flexibly against the dollar, many analysts say. China has amassed $1 trillion in foreign exchange reserves after years of trade surpluses with Europe and the United States.

About $700 billion of those reserves are said by many economists to be in dollars. One reason China does not want a cheaper dollar against the yuan, these economists say, is that the value of its holdings would decrease, limiting the lending ability of its banks. Nevertheless, Mr. Paulson’s trip is organized around the principle that China needs a bit of a weaker dollar now because its current path of binging on exports will overheat the Chinese economy -- it is growing at 10 percent a year -- and cause a collapse sooner or later if it is not cooled off slowly.

The dollar has declined about 5 percent against the yuan in the last year and a half, but American policy makers say that the yuan is still artificially low. That is also the view of leading members of Congress, especially Rep. Nancy Pelosi, the California Democrat who becomes the speaker of the House in January.

Not all economists agree that am upward revaluation of the yuan will benefit the American economy. They note that cheap exports from China are desired by American consumers, and that Chinese imports have not led to rising unemployment, as critics charge.

"Let's say China revalues by 10 percent overnight," Mr. Sinche said. "Then prices at Wal-Mart go up by 10 percent. So we then see worse inflation numbers, the Fed tightens monetary policies, and we end up with higher inflation, higher prices, and higher interest rates. Remind me again why that's what we want."

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