FALLING U.S. DOLLAR

The Economist has published a sound analysis of a falling U.S. dollar (link).

An interesting article brought up a couple of issues to be discussed. First, dollar crisis would be disastrous. The U.S economy is now expecting a recession. Even if it looms, the financial markets would force FED to raise the rates, slowing the recovery from recession. Consequently, euro would probably soar to new record-highs.

A major slice of global traded is accounted in dollars and most central banks hold the majority of foreign reserves in dollars. The tightness of euro has handed a chance of switching from one currency to another, pushing the value of U.S. dollar downward. However, different gueses about the possible worst-case scenario are nothing else but pure fears.

On the other hand, U.S. government bonds have fallen as investors haven't expected higher asset premiums. The dollar has peaked in 2002. Since then, consumption-induced borrowing has boosted current-account deficit. Recently, various incentives to import less and export more, have lifted the account deficit from 7 percent of the GDP to 5,5 percent.

The state of the U.S. currency is very much related to so called "cyclical divergence" between the U.S. and the economies in the rest of the world. Financial markets have prolonged the expectations about the interest rate cut. But, a weakening dollar is not a consequence of a single feature. A sizeable amount of assets have been stocked in the U.S. dollar, affected by credit-crunch mess. As growth prospects were weaker, the currency became cheaper. There is no doubt that a widening current-account deficit has left the dollar vunerable to external pressures.

In addition, rising oil prices and weak dollar has raised inflation expectations in gulf countries. Economically, those countries would have to let their currencies to rise to curb the inflation pressures and expectations. If their currency appreciate, other reserve currencies would arise. If the dollar-falling would continue to slide faster, the interest rate cut would have to be held back to prevent the decline in the value of dollar. True, there would be some trade-off pressures.

Speculations about the U.S currency situation are often overblown and there's little evidence, empirical and actual, that the dollar could slide deep into a chaotic slump. Yet, there is a question how long will dollar remain the world's leading currency (link).