Push for Rising Asia Currencies May Not Cut Trade Gap (Update1)

June 5 (Bloomberg) -- World financial leaders meeting in Russia this week are counting on a rise in Asian currencies to significantly narrow the U.S. trade gap. It may not work.

Exchange rate fluctuations have lost much of the power they once had to influence the prices consumers pay for imports or to compensate for disparities in manufacturing costs, say economists Stephen Roach and Ronald McKinnon.

Even a gain in Asian currencies great enough to push the dollar close to its 1995 low ``will accomplish surprisingly little in fixing all that ails the unbalanced world,'' says Roach, chief economist at Morgan Stanley in New York.

Competition now makes it harder for U.S. companies to raise prices to recover currency-related cost increases, economists say. Even when prices do go up because of foreign-exchange fluctuations, American consumers won't lose their taste for imports, and Asian companies will still be able to underprice U.S. competitors, they say.

``Conventional wisdom suggests that if exchange rates are changed, the trade deficit problem will be resolved,'' says McKinnon, an economics professor at Stanford University in California. ``Unfortunately, the way the world works now, that model is deceptive.''

April 21 Statement

The dollar has dropped about 4 percent against the euro and the yen since finance ministers from the Group of Seven industrial countries called in Washington on April 21 for China and other Asian nations to ``allow necessary appreciations'' in their exchange rates to correct ``distortions in the global adjustment process.'' That's a reference to the U.S. current account deficit, which topped $800 billion for the first time last year.

The G-7 ministers meet again June 9-10 in St. Petersburg where they will be joined by their Russian counterpart to plan next month's meeting of leaders from the Group of Eight countries, which Russia is hosting. Russia is not a member of the G-7 and so not a signatory of the April statement on exchange rates.

Michael Schubert, an economist at Commerzbank AG in Frankfurt, says a dollar decline won't narrow the trade gap unless it's accompanied by policies to boost savings in the U.S. and reduce barriers to growth in Europe and Japan.

Other Steps

``Major exchange-rate shifts would not on their own trigger a process of adjustment,'' Schubert says. ``Governments have to take other steps.''

The G-7's lobbying of Asia escalates the rhetoric of the past three years, when ministers just sought greater flexibility in exchange rates. China, Taiwan and South Korea all seek to limit increases in their currencies, handing their manufacturers a competitive advantage while fueling protectionist pressures in the U.S. China has allowed the yuan to rise just 1.1 percent since a revaluation last July.

Departing U.S. Treasury Secretary John Snow, who some investors say has acquiesced in the dollar's decline, said in a May 19 interview that if ``we have open competitive currency markets setting currency values, we'll get good results that provide that adjustment mechanism for the global economy.''

While the G-7 ministers said their April pressuring of Asia wasn't an outright push for a weaker dollar, investors decided otherwise and sold the U.S. currency after the talks.

Dollar Depreciation

``Global structural imbalances are being addressed and a depreciation of the dollar is a big part of the adjustment,'' says Jesper Koll, Merrill Lynch & Co.'s chief Japanese economist, in Tokyo. ``We now have a multilateral agreement for a weaker dollar.''

Whether to embrace that strategy will be an early decision facing Henry Paulson, President George W. Bush's nominee to replace Snow. The dollar fell the most in six weeks against the euro May 30 on speculation Paulson wouldn't stop the currency's slide, unlike Robert Rubin, who preceded Paulson both at Goldman Sachs Group Inc. and, under President Bill Clinton, at the Treasury.

Rubin's ``strong dollar'' policy helped buoy the currency from its 1995 lows, quelling speculation then about whether the dollar could maintain its role as the world's sole reserve currency. Now, economists such as Barry Eichengreen of the University of California, Berkeley, are again raising that question.

Do the Math

Economists who caution against excessive reliance on a lower dollar argue that the power of a weakening currency has been diluted by globalization. While the dollar has dropped 25 percent on a trade-weighted basis since the start of 2002, the U.S. deficit keeps swelling.

``The maths just don't do it, even though the dollar has corrected,'' says Harvinder Kalirai, head of research in Sydney at State Street Corp., the world's largest provider of investment services to institutions. Demand for imported goods such as oil is ``inelastic,'' meaning dollar depreciation won't hinder purchases, he says.

Increased global competition deters companies from raising consumer prices to compensate for currency fluctuations, according to recent studies by economists at the Federal Reserve and the Bank for International Settlements.

That ``may have blunted the incentives to reallocate spending from imports to domestic goods,'' thus ``aggravating'' the trade gap, the Basel, Switzerland-based BIS said in its 2005 annual report.

Competitive Edge

A lower dollar isn't the advantage it once was for U.S. exporters because foreign rivals, especially in Asia, still have a competitive edge thanks to lower labor costs, says Drew Matus, senior economist at Lehman Brothers Holdings Inc. in New York. ``Relative price levels are so far below what's possible in the U.S. that we can't produce and sell in some sectors even if the dollar goes down,'' he says.

In any event, governments aren't likely to let the dollar fall far enough to have a significant effect on the trade gap, says Roach. He calculates a 30 percent depreciation in the trade weighted dollar would require the U.S. currency to reach a record $1.70 per euro and 90 yen.

``These thresholds would evoke howls of protest and massive intervention,'' he says. ``They can hardly be considered a realistic option.''

Already, Japanese Finance Minister Sadakazu Tanigaki said May 12 that his government is on ``alert against rapid changes'' in the yen. French Finance Minister Thierry Breton said the following week that France ``will do everything'' to cap the euro's gains.

More Harm

Their concern is a declining dollar could do more harm than good to the global economy by fanning inflation in the U.S., where imports account for 17 percent of consumer spending, and threatening expansions in Europe and Japan.

Those who want a weaker dollar risk setting off an uncontrolled slide, says Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York.

In the 1980s, governments had to reverse a coordinated effort to weaken the dollar after it went too far, undermining international demand for U.S. assets and forcing up interest rates. Foreign demand in the May 11 auction of 10-year U.S. Treasury notes was the weakest since February 2005.

``The dollar's depreciation is tantamount to a partial default,'' says Chandler. ``The risk is officials will find it increasingly difficult to arrest the greenback's decline as this becomes more evident.''

To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net