The fallout from a falling dollar

As foreign buyers shun the currency, it could be harder to finance the US trade deficit.

For two weeks, the dollar has been hammered as foreign buyers shun the US currency.

As a result, the Canadian "loonie" is at its highest point in 30 years. The British pound is at its uppermost level since last September. Even the closely managed yen is at a six-month peak.

If the dollar were to continue falling, it could have wide ramifications:

• It could imperil the economy next year because Fed Chairman Ben Bernanke might have to defend the currency with higher interest rates.

• A lower-valued dollar makes imports more expensive, possibly ratcheting up the inflation rate. But it could also stimulate US exports, thus providing more jobs.

• This summer, Americans traveling abroad will feel as if everything is expensive. However, foreigners coming to America will feel as if the country is one giant Wal-Mart.

Behind the falling currency is a changing global economy. As the US Federal Reserve appears to be near the end of its round of interest-rate hikes, foreign banks are starting to hike their rates - which puts foreign currencies in higher demand, thus making the dollar less attractive. Thursday, in fact, the president of the European Central Bank indicated that rates could rise in Europe next month. At the same time, the giant US trade imbalance has produced a huge outflow of dollars to other countries, as well as the need to finance the ever-bigger US deficit. The deficit has attracted increasing scrutiny, most recently at a meeting of finance ministers in Washington last month.

In addition, the central banks of some foreign countries, which are key in financing the US deficit by buying US Treasury bills, are now less willing to do so. Instead, they're diversifying their reserve holdings with euros and yen.

"We seem to have reached a crossroads," says Anthony Chan, chief economist at JPMorgan Private Client Services in Columbus, Ohio. With foreign interest rates on the rise, he says, it will become harder to finance the US current account deficit.

Last year, the trade deficit in goods and services hit a record $726 billion, as US imports far exceeded exports. The gap has now reached 7 percent of the nation's gross domestic product, says Robert Scott, senior international economist at the Economic Policy Institute in Washington.

A big part of the rise - some 63 percent - is because of the surging price of oil. US energy officials expect the price to remain at these levels, if not higher, for some time.

The largest non-oil deficit is with China, which last year recorded a $202 billion surplus with the United States. On April 21, the world's finance ministers issued a statement calling for "exchange rate flexibility" in emerging economies with large current account surpluses, "especially China."

On Wednesday and Thursday, finance ministers in Japan and Europe tried to stem the dollar's fall. The Japanese Finance Minister Sadakazu Tanigaki warned that flexible exchange rates could cause speculation that could hurt the world economy. Both the euro and the yen were little changed after the comments.

In the 1980s, there was also a large trade deficit, and the greenback was devalued by 50 percent, Mr. Scott says. "The trade gap, which had been 3 percent of GDP, was reduced to 1 percent of GDP in two years," he says.

Financing the current US trade deficit is requiring increasing agility. "Every business day requires $3.5 billion of net new money entering the country to finance the current account deficit," says Jay Bryson, an international economist at Wachovia Securities in Charlotte, N.C.

Most of that money comes from foreign central banks, which own large amounts of dollars. Recently, however, the central banks of Sweden, Finland, and Russia have said they will diversify their foreign reserve holdings and reduce their US dollars.

Behind the shift may be concern that the dollar will be devalued, making their holdings worth less. Ten-year US securities, for example, have started to reflect this risk.

To date, the imbalance has not caused much economic pain, Mr. Bryson says. The dollar, on a trade-weighted basis, is actually higher than it was last year at this time. But it's down about 12 percent from its highs at the end of the 1990s.

He cautions, however, "My guess is that sooner or later, probably later, foreigners will get tired of financing us, and at that point, long-term rates will start to rise."

One way to keep foreign investors interested in US dollars is to raise interest rates, says Mr. Chan. But the risk, he says, is that "we slow down to the point where it may even become a recession."

The large US budget deficit doesn't help, says Bryson. "The US is spending more than it produces, and to the extent government is spending more, it becomes a compounding factor," says Bryson.

It's possible that the trade imbalance will be discussed in July when the world's leaders meet for their annual economic summit in St. Petersburg, Russia. "They should invite China and India and come up with some deal to adjust currencies, consumption, and savings rates around the world," says Clyde Prestowitz, head of the Economic Strategy Institute.

Even now, Americans traveling in other countries will notice a difference from the late 1990s, when the dollar was strong. For a family of four, tickets to a Toronto Blue Jays game will cost $18 more, a room at the Hotel Duret in Paris is an additional $44, and a ride on the London Eye is an extra $3 per person.

Wire services were used for this report.

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