The US dollar is plunging in world currency markets – and bringing down share prices in its wake.
But why is the dollar under pressure – and what would be the consequences for the US economy if it continues to fall?
Behind the problems of the dollar lies the huge and growing US trade deficit, and the large Federal budget deficit.
A fall in the greenback could hit Asian countries whose governments hold huge foreign currency reserves in dollars For many years financial markets have worried about the growing size of the US trade deficit – the difference between the amount the US imports from the rest of the world, and the amount it can sell to the rest of the world.
That deficit is now heading above $800bn for 2006, or 7% of the US economy, and shows no signs of diminishing.
At the same time, tax cuts and the war in Iraq have led to a US budget deficit of several hundred billion dollars despite the booming economy.
Asian giants
Much of the trade gap relates to US commerce with East Asian countries such as China, Japan, and Korea, who sell much more to America than they buy.
Together, the East Asian countries have accumulated foreign currency surpluses of nearly $1 trillion, much of it held in US Treasury bonds denominated in dollars.
Thus they are funding both the budget gap and the trade gap.
These huge global imbalances are threatening to derail the world economy, the IMF and other international organisations have warned.
The classic economic view of how to correct such changes is to adjust the exchange rate in order to make US goods cheaper and Asian goods more expensive.
But many Asian currencies – especially the Chinese yuan – do not float freely on international currency markets, and the US has long been pressuring China to revalue its currency.
Now the markets are beginning to take matters into their own hands, by forcing the US dollar down. In the long run, the fall in the dollar could lead to a cut in the trade deficit and a boost to US exports.
But this process often takes a long time, and in the meantime, it is fraught with dangers. The fall in the dollar is worrying the IMF, the international organisation charged with surveillance of the world economy.
“A disorderly unwinding of global imbalances would be very damaging,” IMF managing director Rodrigo Rato warned at its spring meeting in April.
Run on the dollar
In the first place, a rapid fall in the dollar, if it accelerates, could cause short-term problems for the US economy.
The higher price of imported goods could lead to a hike in domestic inflation, and it could take several years before consumers switch back to buying more US goods.
High inflation, combined with the stronger-than-expected growth of the US economy, could force the US central bank, the Federal Reserve, to keep raising interest rates.
They have already been raised 15 times, and now stand at 5%, partly on fears of a growing housing boom. But the fears of inflation are also likely to affect the interest rates on long-term bonds, which determine mortgage rates.
The rising mortgage rates, while they may eventually dampen the housing boom, will also give a further boost to inflationary pressures.
International exporters hit
Meanwhile, foreign companies who have derived an increasing proportion of their sales and profits from the US market could also be hit by falling demand for their exports.
The sharp falls in non-US stock markets, especially in Asia, are a response to this fear, with electronics and car companies like Toyota and Sony especially vulnerable.
And that in turn could affect the growth rate of countries like China, who derive much of the growth in their economies from exports.
But the Asian exporters also have another reason to feel vulnerable.
As the value of the dollar falls, their reserves of the currency also reduce in value, as do the yields on the US Treasury bonds held by many of their central banks.
In buying such bonds these governments are, in effect, underwriting the large US Federal budget deficit as well.
This deficit is set to increase as the baby boomer generation faces retirement.
The Asian governments and investors may be tempted to sell many of their dollar holdings in order to protect themselves – but this would have the effect of weakening the dollar further.
And it would force the Fed to raise interest rates even more to protect the dollar.
Countries like China are reluctant to massively revalue their currency – because it would make investing in China much more expensive and could deter valuable foreign investment.
Managed float
This problem with the dollar has happened before, in the 1980s, when it was Japan rather than China that was seen as the main threat.
At that time, the main industrialised countries worked together for a managed currency float in an agreement called the Plaza Accord.
The coordinated approach led to a managed decline in the value of the dollar, which then stabilised at a more sustainable level, supported by central banks.
However, the current US administration does not favour such an approach, believing that the markets should be left to their own devices.
And given the vast size of foreign currency markets today, it is doubtful that central banks could make such an effective intervention again.
The downside for the US in the 1980s was that it was forced to enter into an international agreement with other governments that reduced its freedom to set its own domestic policy.
But in the absence of such an agreement, it looks like the markets themselves are finally deciding that the US ‘twin deficits’ are no longer sustainable.
And when the world’s largest economy begins to look shaky, it is not surprising that confidence among financial markets is weakened around the world.