Monday, May 15, 2006

Dollar's Loss of Favor Stokes Inflation, Global-Growth Concerns

May 15 (Bloomberg) -- Central bankers from Stockholm to Dubai, seeking shelter from the falling dollar, may help weaken it further, creating a new inflation headache for the Federal Reserve and threatening growth in Europe and Japan.

Sweden's Riksbank said last month it had almost halved its dollar holdings in favor of the euro, and central banks in Kuwait, Qatar and United Arab Emirates said they were buying Europe's common currency. Russian Finance Minister Alexei Kudrin complained about the dollar's ``instability.''

The reshuffling of reserves adds to pressure on the dollar, already near its lowest in a decade in trade-weighted terms. The slumping currency may push up the price of imports, which account for 17 percent of the purchases Americans make, just as the Fed considers a pause in its two-year war on inflation. A cheaper dollar could also hinder the European Central Bank and Bank of Japan as they aim for sustainable recoveries.

``Central banks are trying to avoid large capital losses that could result from a drop in the dollar,'' says Barry Eichengren, an economic historian at the University of California, Berkeley and former adviser to the International Monetary Fund. ``Likely impacts include an additional fillip to inflation and more pressure on the Federal Reserve to raise interest rates.''

The dollar has been weakening against the euro since the common European currency replaced national bills and coins in 2002. The dollar has declined 28 percent since January 2002 against a trade-weighted basket of seven currencies tracked by the Fed, and is just 1 percent above its 1995 low.

Reserve Currency

A decade ago, the dollar was protected by its role as the world's sole ``reserve currency,'' dominating international accounts and used in pricing oil and gold. The dollar rallied from its 1995 lows, gaining 40 percent in seven years, after a switch in U.S. policy under Treasury Secretary Robert Rubin in favor of a ``strong dollar.''

Now, the euro provides a possible alternative reserve currency and may become more attractive as the advantage of higher-yielding dollar assets is eroded by the U.S. currency's decline. Currently, 10-year U.S. government debt yields 5.19 percent, compared with 4.07 percent for the German 10-year bund and 1.97 percent for comparable Japanese government debt.

``We're seeing an erosion in international conviction about the dollar as a reserve currency and that negative psychology is overwhelming the advantage of holding U.S. assets,'' says Lara Rhame, currency strategist at Credit Suisse in New York and a former Fed economist.

Buying Euros

Almost 60 percent of central banks that changed their reserves last year boosted euro holdings, and almost four in 10 shed dollars, according to a survey by Central Banking Publications Ltd. and Royal Bank of Scotland Plc.

``For central banks, growing dollar reserves also mean a growing risk of losses should the U.S. dollar depreciate,'' says Hermann Remsperger, chief economist of Germany's Bundesbank. ``Their incentive to give more consideration to other currencies in the portfolio may become stronger.''

By making U.S. exports cheaper and imports more expensive, a softer dollar can fan higher growth and inflation. That may keep the Fed raising interest rates even after 16 straight increases since June 2004.


A weaker dollar also ``creates a headwind'' for expansions taking shape in Europe and Japan, says Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts.

Heidelberg, Germany-based Heidelberger Druckmaschinen AG, the world's largest printing machine maker, said May 3 that exchange rates remained a risk to earnings. Hiroshi Okuda, chairman of Toyota Motor Corp., the world's second-largest carmaker, said last week that ``measures may have to be taken'' if the dollar doesn't rise.

One plus for the U.S. economy from a falling dollar would be a narrowing of the current account deficit, which last year topped $800 billion for the first time and is one cause of the dollar's drop. Harvard University's Kenneth Rogoff, a former IMF chief economist, says the dollar might need to fall 40 percent for the gap to shrink. Finance ministers and central bankers from the Group of Seven nations last month said ``vigorous action'' was needed to address such imbalances, compounding pressure on the dollar.

Developing countries, whose reserves are the fastest growing, are also shedding dollars most rapidly. Foreign currency reserves in developing countries have almost tripled since 1999, reaching $2.9 trillion last year, while industrial nations' holdings rose 78 percent, according to the IMF. Meanwhile, the share of developing nations' reserves held in dollars dropped to 60.5 percent from 71.1 percent.

The dollar's share of reserves held globally dropped to 66.5 percent at the end of 2005 from 71.1 percent in 1999, while the euro's share increased to 24.4 percent from 18.1 percent, the IMF says.

No Sell-Off

That doesn't necessarily mean the dollar's status is threatened, says Stephen Jen, global head of currency strategy at Morgan Stanley in London. ``Whether there is diversification in the future remains to be seen, but so far there has been zero,'' he says.
The U.S. Treasury, which is responsible for dollar policy, says there is ``little evidence'' either that the dollar share of foreign central-bank holdings is declining or that banks might sell off dollar holdings in the future. IMF figures show the dollar's share of foreign exchange reserves ``has remained constant for the last few years at around two-thirds,'' the Treasury said May 10 in its semiannual report on international exchange rate policies.

Central banks with the largest dollar holdings and economies that rely on exports, such as China's, have no interest in triggering a dollar sell-off, so any reserve adjustment they make will be minimal, says Dick McCormack, a senior adviser at the Center for Strategic & International Studies in Washington and former U.S. undersecretary of state for economic affairs.

China's Holdings

People's Bank of China Governor Zhou Xiaochuan said March 5 China won't reduce its dollar holdings as it changes the composition of its reserves. China in February overtook Japan as the world's largest holder of currencies with reserves at $853.7 billion versus Japan's $831.6 billion.

Still, shifts in central bank reserves may mark ``the beginning of a trend questioning the dollar's currently undisputed status as the major reserve currency,'' says Thomas Stolper, global markets economist at Goldman Sachs Group Inc. in London.

Even speculation that central banks are mulling sales may harm the dollar. The currency dropped last November, after Russian Central Bank First Deputy Chairman Alexei Ulyukayev said Russia may lift the amount of euros in its reserves.

``Psychology is pretty important in these markets,'' says John Williamson, an economist at the Institute for International Economics in Washington and former adviser to the IMF. ``People can get pretty excited about even small moves by central banks.''

1 comment:

panicearly said...

David Walker is about to give a speech there. The audio or transcript should be available in a couple of days.