Weakening dollar creates dilemma on both sides of the Atlantic

23 Sep, 2007
Economic Times

PARIS: The fall in the value of the dollar against the euro is gathering pace, creating some advantages but also serious difficulties on both sides of the Atlantic, analysts say. Exporters are under pressure in Europe, inflationary pressures are likely to rise in the United States and funding the US current account deficit will become more difficult.

The euro continued its ascent on Friday, passing 1.41 dollars for the first time, with analysts saying there was nothing to stop it going on to smash 1.45 dollars or higher. "We see nothing to interrupt the trend," said Veronique Riches-Flores, chief economist at Societe Generale.

John Silvia, chief economist at Wachovia, predicted that conditions were such that the euro could soon climb to 1.45 dollars. The US Federal Reserve bank last week dropped its main interest rate from 5.25 percent to 4.75 percent, in a bid to galvanise the embattled US economy, which has been battered by the crisis in the "subprime" home loan sector.

The central bank signalled that it could drop rates even further. At the same time the European Central Bank has dug in and continues to point to inflationary pressures -- auguring ill for a drop in rates despite pressure for action from some European political leaders.

"It is probable that the Fed will drop again its main rates, while the ECB will perhaps leave its own unchanged, or even raise them," said Rafael Martorell at BNP-Paribas. The cut in US interest rates reduces interest in the dollar and boosts the attractiveness of the euro. In Europe, the strong euro has a number of benefits, most notably it makes oil imports cheaper because crude is priced in dollars.

It also reduces the price of other imports from outside the European Union: an advantage for consumers, as well as certain industries that rely on imports. The strong euro also allows large European groups to buy assets overseas at lower prices.

However, European exporters are starting to feel the pinch because the strong euro makes their exports more expensive for overseas consumers whose currencies follow the fluctuations of the dollar. The eurozone's trade account, a measure of its trade relations with the rest of the world, dropped to a surplus of 4.6 billion euros in July from 7.6
billion euros.
France is particularly affected, with its trade deficit rising above 30 billion euros year on an annual basis in July. Concern is also setting in in Germany, the EU's export champion, whose trade surplus nevertheless increased in July despite the surging euro and troubles on financial markets.

"If the dollar continues to fall that will cast a shadow over our export prospects," German Economy Minister Michael Glos said in the newspaper Bild last week.

However with the notable exception of France, which is increasingly critical of the European Central Bank, most European governments have maintained their silence faced with the euro's new records. On the other side of the Atlantic, the weakness of the dollar, which for the first time for 31 years is at parity with the Canadian dollar, is an advantage for exporters, but makes imports more expensive.

This can help reduce the country's trade deficit, but also accelerates inflationary pressures because imports become more expensive.

It also makes life more risky for buyers of American treasury bonds, making it difficult to finance US public debt, Societe Generale's Riche-Flores said. The Federal Reserve Bank, which appears to want to continue to drop its rates again "finds itself in a delicate situation," said Evariste Lefeuvre, an economist at Natixis.

And some analysts predict the trend of falling dollar is set to continue. "With memories of the dollar collapses seen in the fourth quarters of 2002, 2003 and 2004 still fresh in the memory of many people, the risk seems to be growing of a dramatic acceleration higher in euro/dollar," said Simon Derrick at the Bank of New York Mellon.