Is the dollar facing collapse?

MONEYWEEK
‘Dollar bills are looking rather scrunched up,’ says John Authers in the FT. The greenback posted a marginal recovery last week after hitting an all-time low of almost $1.37 against the euro a fortnight ago, and it also recently touched a 26-year low of more than $2 to the pound. On a trade-weighted basis - against a basket of its major trading partners’ currencies - it has fallen by around 27% over the past five years.

There are several influences on currencies and, as Edward Hadas points out on Breakingviews.com, ‘all of them are pointing to a lower dollar’. A key factor over the short to medium term is interest rates; high rates boost the yield on a currency’s assets. With US growth disappointing - the IMF expects it to marginally underperform Europe in 2007 - many analysts are pencilling in US rate cuts later this year; in Europe and the UK, they are set to rise. Stronger growth outside the US means ‘there’s a depreciation bias in the dollar’, Kenneth Rogoff of Harvard University told Bloomberg.com. Meanwhile, US inflation is uncomfortably high, which undermines the dollar’s appeal as a store of value, notes Hadas.

Then there’s the key long-term influence on currencies, the current-account balance. The US current-account deficit appears to have stabilised of late, but it still comprises a ‘scary’ 6% of GDP, says Hadas. Given all this, it’s no wonder BNP Paribas is expecting the dollar to fall to $1.40 amid a hard landing in the US, while Rogoff foresees another 10% drop in the trade-weighted index by the end of 2008.

And a dollar collapse ‘cannot be ruled out’, says the FT. The hole in the current-account deficit is being plugged by purchases of US government bonds by oil-producing nations and, crucially, Asian central banks determined to keep their currencies low against the greenback to bolster their exports. China’s reserves alone amount to about $1.2trn. A further decline in the dollar could ‘push forward the day on which the world’s dollar holders begin to worry that they have a trillion or two too many’, says Dailyreckoning.co.uk. The FT highlights IMF worries that investors appear increasingly willing to dump their underperforming dollar holdings. So the dollar looks set to either keep drifting lower - or plummet. The latter, says Dailyreckoning.co.uk, should cause ‘real excitement’ in world markets.