When they're not talking about the emergence of China as a global economic powerhouse, attendees at the World Economic Forum's annual meeting in Davos, Switzerland, pondered what impact the continuing decline of the dollar will have on international companies and the world financial system. The assumption of most executives, academics, and policymakers who have gathered to brainstorm in the upmarket Swiss ski resort is that despite strong U.S. economic growth, the dollar will continue to fall, especially against the euro.
Given the vast U.S. current-account and budget deficits, the greenback's further depreciation "is all but inevitable," says Alan S. Blinder, professor of economics at Princeton University. The widespread assumption in Davos is that it'll likely lose 10% to 20% more value against the euro over the next year. That would send it from $1.27 on Jan. 23 to between $1.40 and $1.50 in early 2005.
Such a large drop -- coming on top of the 35% fall since early 2002 -- would put severe strains on the international financial system and the global economy. "It would be a disaster," says Hussain M. Sultan, group chief executive of Emirates National Oil Co. in Dubai.
RISING TENSIONS. The euro zone would likely bear the brunt of that readjustment. "Europe could have a tsunami coming its way," warns Moises Naim, editor of Foreign Policy magazine. The dollar's fall to date is having a dampening effect on Europe's already weak export-led recovery. A further decline would make matters much worse. Companies would find it much harder to sell their goods abroad. They would also lose domestic market share to cheap foreign imports, which would sap corporate profits and damage economic growth.
European companies would probably react by moving more manufacturing and back-office operations to cheaper locations. "It would mean even higher unemployment in Europe," says one euro-zone manufacturer.
An even weaker dollar also would exacerbate strained U.S.-Europe economic relations. "We'd want Washington to help stem the dollar's slide, but they probably wouldn't want to do that, given that it helps U.S. exports," says the manufacturer. "I think cross-Atlantic tensions would increase dramatically."
"WE'VE ALREADY SUFFERED." Other regions would suffer, too. The Middle East's energy-producing countries, which price oil and gas exports in dollars but import large quantities of goods from Europe, would clearly be hurt. "We've already suffered a lot from the dollar's decline to date, and the pain will only get worse if it falls further," says Emirates' Sultan.
The same can be said of Russia, according to Andrei Illarionov, an adviser to President Vladimir Putin. "Russia is already facing problems because our revenues are mostly in dollars and our costs largely in euro," he explains.
And emerging markets could find it harder to attract capital, says Alfonso Prat-Gay, Argentina's central bank chief. His theory: The markets might worry that a weaker dollar would ignite U.S. inflation and force the Federal Reserve to raise interest rates, which is always bad news for dollar-hungry emerging-market borrowers.
DAMAGING DEVALUATIONS? At first sight, China would seem to be a big beneficiary of a weaker dollar -- at least when it comes to attracting investment. According to Victor L. L. Chu, chairman and CEO of First Eastern Investment Group, a Hong Kong-based fund that has been investing in China for 15 years, a radically weaker dollar could attract even more money to the country. That is, if the peg between the yuan and the dollar stays in place.
"I'd expect foreign direct investment to go up from $52 billion last year to as high as $150 billion in 2004," he says. But China could find it hard to absorb so much money. And such strong inflows would almost certainly irritate its neighbors, which already complain that China gets more than its fair share of foreign investment. The result could be a damaging round of competitive devaluations by countries in Southeast Asia.
Not a pretty picture. Another worrying prospect is that Beijing would come under even greater pressure to loosen the peg between the yuan and the dollar. It would probably do so either by introducing a wider trading margin or linking the yuan to a basket of currencies -- not just the dollar. In theory, that should lead the yuan to rise slightly, which would take at least some of the pressure off the euro. But if Beijing moves more of its foreign-currency reserves into euros, as it probably would have to do, that could actually drive Europe's single currency higher.
NO STRATEGIC CHANGE. Even in the face of real economic pain, Europe probably wouldn't intervene unilaterally in the markets to nudge the euro down. The European Central Bank (ECB) only has $50 billion of reserves at its disposal -- hardly enough to take on the currency markets. The Japanese spent more than twice that amount last year in their attempts to slow the yen's rise.
Of course, the ECB could probably drive the euro down by cutting interest rates from today's 2% -- twice the U.S. level -- to 1.5%. But the ECB would find that hard to swallow, given its mandate to ensure price stability. Europe's rigid economy is more prone to inflation than its flexible American counterpart. So an interest rate cut could push inflation -- now about 2% -- way up.
Speaking in Davos on Jan. 23, ECB President Jean-Claude Trichet hinted that the bank would not change tack to weaken the euro anytime soon. "I haven't changed my opinion since last week," he said.
DEREGULATION REMEDY. That's why European Finance Ministers want the dollar's weakness to be high on the agenda when G7 Finance Ministers and central bankers meet in Boca Raton, Fla., on Feb. 6-7. They hope to persuade the U.S. to try to stem a further dollar decline.
They're likely to get short shrift. The weaker dollar is boosting U.S. exports in an election year. And so far, at least, it doesn't seem to be fueling inflation or riling the bond or equity markets. "The general feeling in the U.S. Administration is that the dollar is our currency, but your problem," says Blinder.
U.S. officials generally say Europe should respond to exchange-rate movements by deregulating its economy. Many European companies want that to happen and are pressuring their governments to embrace far-reaching structural reforms.
SLOW-MOVING FIX. Should that occur, something positive will have come out of the dollar's fall. But wide-ranging reforms in Continental Europe seems unlikely. Large sections of its society, including organized labor, favor protectionism over reform. In any case, it takes years before structural changes work through the economy and start having a positive effect.
With a further fall in the dollar likely, 2004 could be a very uncomfortable year for many parts of the global economy -- though not by the looks of it for the U.S. By David Fairlamb in Davos, Switzerland