While the greenback may gain in 2008, the shift of economic power to Asia signals a longer-term decline for the U.S. currency.

By James G. Neuger and Simon Kennedy
Bloomberg Markets February 2008

The Taj Mahal, one of the world's architectural masterpieces, welcomes about 2.5 million visitors each year--provided they don't try to buy tickets with dollars. India's most popular shrine announced in November that it would stop accepting the plunging U.S. currency and take only rupees, hurling yet another insult at the once mighty greenback.

The dollar, which has been snubbed by everybody from government officials in Kuwait and South Korea to top-earning Brazilian supermodel Gisele Bündchen, may not recover its luster. Economists say the currency, which has declined in five of the past six years against the euro, is caught in a downdraft as investors pour into Asia, prompting a tectonic shift in economic power from the U.S. "Can it be turned around Probably not totally," says Riordan Roett, a professor of political science at Johns Hopkins University in Baltimore. "The century of Asia has arrived, and the U.S. and its European allies will need to adjust to that."

In Asia, an investment boom has boosted local currencies. China's roaring economy has grown an average of 10.4 percent in the past four years, fueled by record exports and a flood of foreign funds. That's pushed up the yuan since the government ended the currency's peg to the dollar in July 2005. As of Dec. 12, the yuan--managed against a basket of currencies--had climbed 12 percent against the dollar. In India, the economy has grown at its fastest pace in the past four years since independence in 1947. That's helped lift the rupee 12 percent against the U.S. currency in 2007 through Dec. 12.

Dollar bulls say the currency could rally in the short term. They cite the fiscal 2007 U.S. budget deficit, which fell to $162.8 billion compared with $412.8 billion three years earlier. And the current account deficit narrowed to $178.5 billion in the third quarter after reaching a record $217.3 billion in the 2006 period. Deutsche Bank AG, the world's largest currency trader, predicts the dollar will rise at least 5 percent in 2008 versus the euro, a currency now shared by 15 nations.

Longer term, the slowing U.S. economy--hurt by a banking and consumer credit meltdown that's only getting worse--will weigh heavily on the dollar. Since August, the Federal Reserve has cut interest rates three times to 4.25 percent in December, and traders in federal funds futures see about an even chance the rate will be 3.75 percent by May. The Fed's moves, coupled with the European Central Bank's threat in December to raise rates, have tilted the odds against the U.S. currency. In 2007, it fell 10 percent against the euro and 4 percent versus the British pound through Dec. 12.

Asian and Persian Gulf nations are concerned that the flight from the dollar is feeding on itself and may spur a crisis of confidence. Kuwait abandoned a dollar peg in May due to its weak buying power. South Korea's central bank in November urged shipbuilders to issue invoices in won, the country's currency, and take out more hedging policies to guard against the weakened dollar.

Peter Kenen, a professor of international finance at Princeton University, raises the possibility that the dollar's role as the world's dominant reserve currency may be coming to an end. The dollar's share of central banks' currency portfolios slid to 64.8 percent in the second quarter of 2007 from 71 percent in 1999, the year the euro debuted, the International Monetary Fund says. Cash-rich governments, mostly in Asia and the Middle East, may shift as much as $1.2 trillion in dollar holdings to other currencies in the next five years, Merrill Lynch & Co. economists say. "The dollar will not recover completely its dominant role in the system, although it may well share that role with the euro and even the pound," says Kenen, a former Treasury adviser. "What some of us thought could happen in the distant future may be upon us now."

Lester Thurow, a professor of economics at Massachusetts Institute of Technology, disputes the assertion that the dollar has lost its clout. Historical trends of developing nations suggest China's economic output and per- capita income may not catch up to the U.S.'s for about a century. "A reserve currency needs to be the currency of a world power," Thurow says. "China may pass the U.S., but not until 2100."

China, with $1.46 trillion in foreign exchange reserves, is a wild card. It's combing the world's markets for investments that pay more than the return of about 4 percent on 10-year U.S. Treasury bonds. Chinese investors reduced their holdings of U.S. Treasuries by 8 percent to $388.1 billion in October from a peak in March. Then, in December, China's Ministry of Commerce gave a boost to the dollar, saying it would encourage more businesses to buy American assets.

Economists debate whether U.S. Treasury Secretary Henry Paulson wants the dollar to appreciate. After U.S. trading partners in Europe and Japan criticized the currency's decline, Paulson in November stepped up his rhetoric about the economy's long-term growth prospects to instill confidence in the dollar, says Jens Nordvig, an economist at Goldman Sachs Group Inc. in New York. With the weak dollar spurring U.S. exports--one of the few bright spots in the economy-- some economists don't take Paulson at his word. "The Bush administration is not sincere in saying it wants a strong dollar," says Nobel laureate Paul Samuelson, a professor emeritus at MIT. "The long-run trend for the dollar is very likely to be downward."

The currency will be barred from more places than the Taj Mahal in the event Samuelson is right.

#<532782.18602.1.0.69.26862.25># -0- Jan/03/2008 21:28 GMT

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