Dollar's fall is now a bigger political issue than an economic one

Bet Your Bottom Dollar Tensions Will Follow

By Liam Halligan
The Telegraph, London
Sunday, November 25, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/11/25/ccliam...

The weak dollar used to be an economic issue. But the greenback has now dropped so far, and has so much further to fall, that its decline is of profound political importance. The dollar isn't any old currency. And it isn't just the currency of the biggest economy on earth. The dollar is the world's "reserve currency" -- which means central banks everywhere use it to stockpile wealth. No less than two-thirds of all sovereign foreign exchange holdings are denominated in dollars.

Last week, the dollar dropped to yet another record low -- reaching the verge of $1.50 to the euro. On a trade-weighted basis, the currency has, in four years, lost a third of its value. That's done the US some favours, helping its exports stay competitive. But the dollar's long dive means countries worldwide, having used the currency to store their reserves, are sitting on massive losses. That's why the dollar's demise is of major diplomatic -- and even military -- significance. Before this summer, the dollar was falling for economic reasons. After years of over-consumption, the US had dug itself the world's biggest ever trade deficit -- 6 per cent of GDP.

These huge liabilities, and America's need to issue a steady stream of government debt, had long put pressure on the greenback. US officialdom feigned concern but, in reality, America laughed up its sleeve. A falling dollar shoved the burden of US adjustment on to the rest of the world.

In recent months, though, the dollar has headed south with a vengeance -- after Wall Street recklessly securitised $900 billion of sub-prime loans. And, of course, as US property prices fall and default rates keep rising, this sub-prime crisis gets worse.

Last week, Federal Reserve Chairman Ben Bernanke said $150 billion of loans will end up being written off. The Bank of England, in private, says $200 billion. The reality, as this column has long maintained, will be at least $300 billion.

Whatever the eventual figure, given that "only" $40 billion has so far been written off, there is a whole world of pain to come. And, remember, these ghastly securities are largely dollar-denominated -- so when foreign investors try to dump them that pushes the currency down even more.

On top of that, sub-prime is, of course, playing havoc with the broader US economy -- which is now slipping into recession. That's why the Fed has embarked on a series of interest rate cuts -- which other central banks won't follow due to fears about oil-related inflation.

All these factors -- which have nothing to do with traditional deficit-funding concerns -- are now dragging down the dollar. And the deeper the sub-prime crisis gets, the less attractive US assets look and the more the Fed will cut rates. In other words, as long as sub-prime remains a problem, the dollar will keep on falling.

The US currency then, faces some extreme economic pressures. But they're not nearly as significant as the political forces now in play.

For one thing, Europe has finally had enough of America's "benign neglect" dollar policy. As a large economic area, with a floating exchange rate, the eurozone suffers most. Over the past seven years, the single currency has risen by a shocking 82 per cent against the greenback. That's hammered eurozone exports -- provoking serious trade disputes between the EU and US, the world's two biggest trading blocks. No wonder French President Nicolas Sarkozy describes America's drooping dollar as "a precursor to economic war".

European leaders last week said the US currency's value now threatens the survival of Airbus -- whose cost-base is in euros, but which sells planes in dollars. For once, they weren't bluffing. And Airbus, the symbol of European unity, employs 60,000 across the four EU nations.

But America's currency-related tensions with Europe are as nothing compared to the brewing crisis with China, Russia and the oil-rich Gulf states. As is well known, these countries -- and emerging markets in general -- used to run big trade deficits. Strong exports and expensive oil means they now boast big surpluses. As a result, their foreign exchange reserves have ballooned, with China controlling $1,400 billion, Russia $450 billion, and the Arab world much more than it admits -- the vast majority in dollars.

The greenback's fall, of course, is costing these countries serious money. Until sub-prime, they didn't talk about quitting the dollar -- the world's "reserve currency".

But the decline has now gone so far, and the US looks so wounded, that tomorrow's economic superpowers are now "dollar divesting" -- despite the fact that doing so will further weaken the currency, undermining their reserve values even more.

This sounds technical, but it isn't. During the 19th century, sterling was the world's reserve currency -- when the UK bestrode the world. The dollar muscled in a century or so ago, confirming the start of the US hegemony.

Reserve currency status brings America huge power. It puts the dollar constantly in demand, meaning the US can secure cheaper debts and run bigger deficits at everyone else's expense. It means weaker nations "peg" to the dollar, greatly extending America's sphere of influence.

Incredibly, this long-standing system is now unravelling. Rather than keeping their reserves in falling dollars, the new economic titans are stuffing them into "sovereign wealth funds" -- which they're using to buy-up debt-distressed Western firms, African oil fields and any other canny investment they can find.

These upstart countries no longer want just stability and value preservation. They're looking for, and achieving, asset accumulation -- and all the power that brings.

The importance of "dollar divestment" cannot be overstated. At the very least it means the greenback has much further to fall -- plunging the US into recession. But it begs a bigger, more alarming, question: How will Washington react to the end of the US hegemony?

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