Indeed, the U.S. dollar is no longer the "only superpower" currency. Fortunately, however, the U.S. dollar's slide has taken place in a gradual fashion that has not spooked the world financial markets so far. The dollar started to come under pressure following the Iraq war. It slipped from 1.06 per euro when the Iraq war started, to 1.11 per euro when Bush gave a speech announcing the end of major combat operations in the Iraq war. In the past year, the dollar then stabilized at around 1.2 per Euro and 108 till the U.S. presidential election.

As predicted, both currencies were only gyrated heavily just after the U.S. presidential election. Only one month after Bush's reelection, the beleaguered dollar fell 4.3 percent to a record low of 1.32 per euro at the beginning of this week. Against the yen, the dollar in the same period was also setting multi-month lows, slipping to 102.9, its lowest level since March 2000.

The reasons for the U.S. currency's weakness are still the classic one as over the past two years, namely concerns related to the yawning U.S. current account and budget deficits. According to the U.S. Treasury Department, the U.S. budget deficit is expected to widen to US$412.6 billion or 3.6 percent of GDP in the 2004 fiscal year, making the final 2004 figure the largest budget deficit in U.S. history. And, at the same time, the U.S. trade deficit is forecast to reach $600 billion in 2004.

The dollar's recent woes, however, seem to have been mainly triggered by the fears of the re-elected President Bush's record of fiscal recklessness. The foreign exchange market is terrified that Bush may launch a pre-emptive strike on Syria or Iran's key nuclear targets that could trigger dire consequences for the global economy. Basically, the market is only pricing this possibility in early as it is also worried of the impact of the privatization of social security and the moves to make the massive tax cuts permanent on the growing U.S. budget deficit.

Nonetheless, the U.S. Congress would be unlikely to agree to any plan by the Bush administration to broaden its pre-emptive strategy or its fiscal deficits. The initiative may come from the Congress to slow spending as the President himself has yet to veto even a single congressional spending bill so far. With the federal government reaching its debt ceiling of $ 7.4 trillion, the Congress may limit Bush's political choices by not authorizing an increase in government borrowing.

Hitherto, there have been several ramifications of the recent dollar slide on the American economy and the global economy in general. To maintain the dollar's value and to finance its current account deficit with the rest of the world, America has to import at least $2.6 billion of foreign capital each day, which is around 80 percent of the world's net savings. Given the declining confidence of foreign creditors, a rise in bond yields is also demanded to compensate for the currency risk.

Furthermore, to keep foreigners buying U.S. assets and to prevent a resulting rise in inflation, the Fed will be forced to raise interest rates further and faster than it wants. As a result, U.S. consumers, who are already buried in a pile of debt (the total debt of U.S. households is equal to 85 percent of the size of U.S. economy), will be further burdened by an increase in borrowing costs. This will, of course, raise the default risk as higher interest rates may lead to a higher share of disposable income being used to pay off interest bills.

Apart from the U.S. economy, the Japanese and European economies seem to crimp as the yen and euro have strengthened during the past month. Albeit, the U.S. dollar bear is also seen on the other hand as benefiting as it eases inflationary pressures, particularly energy prices. However, if we compare the Japanese and European economies, the euro has seemingly been taking most of the strain in terms of the U.S. current account deficit adjustment. The yen's appreciation against the dollar in the past one year is less than the euro's due to Japan's heavy intervention against its own currency. Since January 2003 to mid-2004, the Bank of Japan has spent a staggering 36 trillion buying U.S. dollars. This highlights the fact that Japan actually has no other fiscal or monetary tools to boost its stagnating economy. This has made Japanese exporters somewhat more competitive than their European counterparts globally.

In contrast to the European or Japanese economies, the dollar depreciation allows China to remain super competitive, as it has fixed the yuan at around 8.3 per dollar since 1995. The yuan's peg means it has matched the dollar's 5.4 percent decline against the euro this year. Although the Chinese authorities have talked about having a more flexible exchange rate recently, there was not any strong pressure on China to de-peg its currency; moreover, the country's financial system is actually not ready.

As such, we reiterate our argument last year that the dollar depreciation will not take place in an abrupt way. The European economy is the only big economic zone that has absorbed the meaningful burdens of the U.S. dollar correction so far. Countries like Japan or other East Asian countries in contrast are still spending their currencies to sterilize their currencies from rising too rapidly. These countries are seemingly still traumatized by the 1997 financial crisis. As such, they still have been building up their reserves as well as protecting their trade competitiveness by sterilizing their currencies since the Asian crisis.


Note: About the Author:
David E. Sumual is an analyst of Danareksa Research Institute This article is a personal view and it is intended only to enhance public debate.