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Straight from the Specialists

Will a weak dollar strategy work?

November 11, 2010

(The views expressed in this column are the author’s own and not that of Reuters)

The U.S. has always been proud of a strong dollar. Even at the peak of the financial crisis the U.S. dollar had hardened. But in the past four months it lost its verve, not from chance but policy.

U.S. Treasury Secretary Timothy Geithner publicly admitted that “a weak dollar may be in national interest” and the Federal Reserve seems to be doing everything to keep the dollar down.

In the next eight months, the Fed will pump in $600 billion. That money is not going to stay in the U.S. alone. There are different channels though which it will rush to other markets and other countries. The quantitative easing of the Fed has therefore become a concern for the rest of the world.

Even before QE2, the dollar had been weakening. In the last four months, it depreciated against the euro by 14 percent, against the yen and won by 11 per cent and other Asian currencies and Brazilian real by 6-9 percent.

The emerging market economies are the real target since they are the only ones that are growing rapidly and can buy more from the United States. American investors are also attracted to these markets because of the huge earnings differentials. In India, in the first 10 months of 2010 FII investment was $23 billion, the highest so far.

The danger, however, is that the surfeit of dollars is bound to cause inflation in commodity and asset prices. Already crude oil has jumped to $87 a barrel and gold crossed $1400 an ounce. Food prices are rising and stock prices are shooting up, all indicating that a bubble is building up.

In spite of that, the weak dollar strategy seems to be working for the U.S. Its exports have been rising and imports falling. Exports in September were the highest in the last two years and imports down by 1 percent. As a result, the trade deficit shrank 5.3 percent to $44 billion. Even the trade deficit with China declined.

The weak dollar will, however, hit other countries. First, their exports will decline or at least not rise as much and their imports will increase, leaving a larger trade deficit and a lower rate of GDP growth. Naturally, some central banks are intervening in the currency markets and follow devious routes to check appreciation of currencies. Second, the value of foreign exchange reserves held in dollars has declined in terms of national currencies.

The weak dollar strategy has possibly been adopted because the protectionist measures failed. The weakening of the dollar seems to be more effective with even the number of unemployed claiming social security benefits dropping to its lowest in four months.

The fact is that having failed to force China to revalue the yuan, the U.S. is now following the other option — weakening the dollar against marketed currencies. That strategy may not succeed and only result in the much talked about currency war.

(You can email Dinker H. Pai Panandiker at: dpanandiker@gmail.com )

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