The Falling Dollar

AHEAD OF THE TAPE
Why the Dollar Won't Regain Its Past Strength
October 3, 2007
By JUSTIN LAHART

(WSJ) America's heady deficit with the rest of the world has long looked like an accident waiting to happen. With the dollar's recent slide, it doesn't look like it's waiting anymore.

If such alarmism sounds familiar, it should. In 2004, the dollar was falling amid mounting worries about America's trade imbalance with the rest of the world. That year the U.S. current-account deficit -- a broad measure of the trade imbalance -- swelled to $640 billion, or 5.1% of gross domestic product.

Nouriel Roubini and Brad Setser, two academics who predicted a sharp decline in the dollar, became required reading on Wall Street desks.

Then in 2005, when everyone seemed to agree the dollar would fall further, it rallied instead. That put a temporary end to Wall Street's current-account obsession and singed a few hedge funds in the process.

Why should this time be different?

Worries about the current-account deficit have been popping up in currency markets for years. Broadly speaking, the deficit measures how much more the U.S. spends on goods and services from abroad than it earns on the goods and services it sells. To cover the difference, the U.S. is, in effect, borrowing from other countries. If they tire of this routine, they'll expect America to write bigger IOUs. The easiest way for that to happen is through a weaker dollar.

In practice, it seems like the current account is often just an after-the-fact explanation for declines in the dollar. The dollar bounces, and then something else grabs the market's attention.

What's different now, says Harvard University professor Kenneth Rogoff, is that the U.S. economy is looking weaker than many of its counterparts abroad.

At the moment, that's largely a housing story. In the longer term, he thinks it's also a productivity story. For a decade, heady U.S. productivity gains meant the U.S. economy could grow faster without fueling inflation -- a key reason for why it became such an attractive investment destination and why that unsustainable current-account deficit was sustained.

Now, productivity growth in the U.S. appears to be slowing. At the same time, the rest of the world has been adopting the technology and practices U.S. companies pioneered, boosting productivity abroad.

That means U.S. growth may be slower relative to that in other countries for some time, with the upshot that investing in the U.S. -- put another way, buying U.S. IOUs -- won't be as attractive as it once was.

In addition to pushing the currency lower, foreign investors could force U.S. interest rates higher relative to the rest of the world. Already, the spread between emerging-market bonds and U.S. Treasurys has narrowed substantially. They could also reduce the premium they'll pay for U.S. stocks relative to other stocks.

In late 2005, Mr. Rogoff and Berkeley professor Maurice Obstfeld calculated that the current-account adjustment could push the dollar down by 30% against the Fed's weighted basket of U.S. trading partners' currencies. Since then, it's fallen 11%, leaving about 20 percentage points to go. But rather than the sudden drop that current-account Cassandras sometimes envision, he expects the decline to be gradual.

"We're only going to see a radical adjustment if the U.S. tips into recession," he says.

Yuan strengthening on rumours of tightening monetary policy

Yuan Rises Past 7.6 for First Time Since July 2005; Bonds Fall
By Christina Soon and Belinda Cao

July 3 (Bloomberg) -- The yuan rose past 7.60 to the dollar for the first time since the end of a link in 2005 on speculation the central bank is using the currency's gain as one of the tools to cool economic growth. Bonds dropped.

The currency strengthened by the most in two weeks also on speculation the central bank will sell dollars as China sets up a fund to manage the country's $1.2 trillion foreign-exchange reserves. The government on June 29 approved a 1.55 trillion yuan ($204 billion) sale of government bonds to establish the new asset-management company, which will seek to boost returns.

``The central bank is likely to accelerate the pace of yuan gains to help resolve the economic problems,'' said Jeffrey Tan, a treasury dealer at Maybank Shanghai. ``There has been talk that China's selling dollars, affecting the U.S. currency's performance in global markets.''
The yuan climbed 0.14 percent to 7.5944 against the dollar as of 5:30 p.m. in Shanghai. The currency has risen 9 percent since China dropped a fixed exchange rate to the dollar in July 2005. It may rise as much as 7 percent this year, said Tan from Maybank, a unit of Malayan Banking Bhd., Malaysia's biggest lender.

China is the world's second-biggest holder of U.S. Treasuries after Japan, with $414 billion compared with Japan's $615 billion, according to the Treasury Department. A weaker dollar reduces the returns.

The central bank on May 10 said it won't slash holdings of dollar assets while diversifying its record reserves.

All but three of the 10 most-actively traded Asia currencies rose against the dollar today and 14 of 16 of the world's major currencies gained.

The People's Bank of China reiterated pledges to continue its exchange-rate reform and to give the market a bigger role in setting the yuan's rate, the central bank said today.

New Stock Sales
The trade surplus in China climbed 73 percent to $22.5 billion in May after reaching an all-time high last year. Gross domestic product may increase 10.8 percent in 2007, according to a report by economists at the People's Bank of China's research department, the Beijing-based China Securities Journal reported on June 29. That would be the fastest in 12 years.

China's government bonds declined as new stock issues this week attracted funds away from the bond market.

``The yields on short-term bills are still rising,'' said Li Gang, a Beijing-based bond trader at the Agricultural Bank of China.
The yield on the three-year bond rose 5 basis points to 3.6 percent, according to the China interbank bond market. The price of the 2.66 percent security due August 2010 declined 0.14, or 1.4 yuan per 1,000 yuan face amount, to 97.26. One basis point is 0.01 percentage point. Yields move reversely to bond prices.