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Thursday July 7, 2005 - 14:54:41 GMT

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Banks may deter dollar gains

It is certainly not the case that a weak dollar in isolation will cure the US current account deficit. A competitive dollar in global markets is, however, one of elements needed to help maintain US export growth and ease the trade imbalances over the medium term. It is also the case that a renewed dollar advance would risk putting renewed upward pressure on the US trade deficit, especially if oil prices stay at very high levels.

If the dollar appreciates further at the same time as there is renewed upward pressure on the US current account deficit, there would eventually be the threat of a sudden shift in market confidence and a destabilising plunge in the US currency together with a hard landing for the US and global economies.

Global central bank officials are, therefore, likely to be wary of further strong gains. The position should certainly not be overstated and the US will maintain its preference for market-set exchange rates. There will, however, be the potential for some mild central bank warnings over further dollar gains if the US currency continues to advance.

Dollar advance watched carefully

There will be relief within the G8 countries that the dollar rallied from lows beyond 1.35 seen at the end of 2004 as the dollar downturn at that point was threatening to become disorderly and was also threatening to destabilise wider global markets. There is, however, likely to be some concern over the possible impact of any further strengthening in the US currency.

The dollar came under downward pressure over the last 2-3 years due in part to fears over the US current account deficit and general imbalances in the economy. Dollar depreciation was certainly not the complete answer to securing a moderation of the US current account deficit, but a weaker US currency is still likely to have an important part to play in helping to ease the trade imbalances. There is the need for the dollar to be generally undervalued over the next few years to help ease the trade imbalances. There will now be concerns that a fresh dollar advance will put renewed upward pressure on the US trade deficit within the next few months. US import levels will tend to rise as relative prices shift and US exports will find it more difficult to increase their share of global trade, particularly in the European market.

US export growth could falter

The latest US economic data will raise some concerns over export trends. The export component in the ISM services index weakened sharply to 50.0 in June from 62.0 the previous month and the equivalent index for the manufacturing index fell to 50.4 from 54.9 in May which suggests that dollar gains are starting to have an impact on export orders. The potential upward pressure on the trade deficit will be magnified by the impact of high oil prices given that the US imports a substantial amount of oil. In April 2005, for example, the US imported oil to the value of around US$14bn. A sustained 50% increase in the oil price would be likely to increase annual US oil imports by at least US$60bn.

The stronger dollar could also lead to some complacency in the US administration with a greater risk that the political pressure for a lower budget deficit and a lower trade deficit will ease. The administration will tend to relax reform efforts and there will be the risk that spending levels will increase. The most recent budget data has been generally encouraging which will lessen market concerns over the deficit, but there is no scope for complacency and the issue will certainly return to prominence if there is a significant slowdown in the US economy.

Intervention unlikely

The G8 central banks are likely to be looking closely at the dollar trend. There should be no major cause for alarm in the short term, especially as the dollar has moved back to levels that are close to fair value relative to the Euro on a purchasing power parity basis. The banks will, however, be more concerned if the dollar shift back to levels that would be seen as overvalued. If the dollar strengthens too far, there would be an increased risk that the dollar could then be vulnerable to a destabilising plunges if the market concerns over the US deficits increased again. If, for example, the current account deficit increased to over 8% of GDP, there would be a high risk of a rapid slide in the US currency.

There is the potential for the central banks and government officials to express some concerns over the dollar and discourage a further advance. US Treasury officials, however, are likely to be just as wary of intervention and measures to curb dollar gains as there were in combating dollar losses last year. There is no real prospect of intervention to weaken the US currency, but some covert dollar selling by central banks is a possibility.


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