Easing The Dollar Dilemma

We appear to have a dollar crisis every 10 years. We had one in the mid-1970s, one in 1985, and one in 1995. Is another looming for 2005? After smoothly falling 25% on a trade-weighted basis for two years since its peak in 2002, the dollar hasn't crashed yet. But currency markets tend to overshoot, and there's a good chance that the dollar will hit its low for this cycle next year, perhaps with a thud loud enough to require intervention by central banks. Certainly the growing uncertainty about the size of future federal budget deficits makes a sharp, hard landing all the more likely. Recent reports about the Chinese buying fewer Treasury bonds sent both the dollar and bond prices down. But before we panic about the dollar, let's focus on what is real and what is not.

First, it is true that over the past 12 months, foreigners bought a huge $839 billion of American securities. It is also true that nearly all of the $381 billion of U.S. Treasuries sold were purchased by the central banks of Japan and China. What is lost in the conversation about the dollar is that private investors from overseas also purchased $297 billion of corporate bonds over this period, and some $203 billion of government agency bonds were sold, mostly to private institutions and individuals. So about half of the current account deficit is being financed by private interests investing in the future growth, productivity, and profitability of the U.S. economy. This is very good news.

The bad news is that the dollar probably has 10% to 15% more to drop and that it is falling mainly against the euro and the yen. The Chinese yuan remains pegged to the dollar and is declining in tandem with it. This linkage is promoting growth in both the U.S. and China as the dollar and yuan fall together against the euro and yen. But it also distorts the market mechanism for redressing America's current account deficit. A third to half of the U.S.'s total trade deficit is with China, and the peg prevents the market mechanism from working to improve it. In the end, the yuan will probably be forced to rise 20% to 30% against the dollar. But the longer Beijing waits to begin the process, the more abrupt and disruptive the jump may be for both the yuan and the dollar.

If policymakers want to avoid a dollar crisis in 2005, they should attend to the one link in the currency market chain that is the weakest. And that is the dollar-yuan peg.

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