-->Crisis looms due to weak dollar

By Jiang Ruiping
China Daily
Tuesday, September 28, 2004

http://www.chinadaily.com.cn/english/doc/2004-09/28/content_378317.htm

Many international institutions and renowned scholars
have recently warned that the possibility of a U.S.
dollar slump is increasing and may even lead to a new
round of"U.S. dollar crisis."

Since China holds huge amounts of
U.S.-dollar-denominated foreign exchange reserves,
the authorities should consider taking prompt measures
to ward off possible risks.

It is still too early to conclude if the U.S. dollar is heading
toward a crisis. But it is an indisputable fact that it has
gone down continually. Its rate against the euro, for
example, has dropped by 40 percent since its peak
period and it lost 20 percent of its value against the euro
last year alone.

It is becoming more and more evident that the possibility
of a further slump of the U.S. dollar is increasing.

From a domestic perspective, the worsening fiscal deficit
will put great pressure on the stability of the U.S. dollar.

In 2001 when the Bush administration was sworn in, the
United States enjoyed a US$127.3 billion surplus. The
large-scale tax cuts, economic cool-down, invasion of
Iraq, and anti-terrorism endeavours have abruptly turned
the surplus into a US$459 billion deficit, which accounts
for 3.8 percent of the US gross domestic product (GDP).

By the 2004 fiscal year, the U.S. government's
outstanding debt stood at US$7.586 trillion, accounting
for 67.3 percent of its GDP, which exceeds the
internationally accepted warning limit.

The deteriorating current account deficit of the United
States is another factor menacing the future fate of the
dollar.

In recent years, the U.S. policy that restricts exports
of high-tech products, coupled with overly active
domestic consumption and the oil trade deficit caused
by rising oil prices, has deteriorated the U.S. current
account balance. This poses a great threat to a stable
U.S. dollar.

During the 1992-2001 period, the average U.S. current
account deficit was US$189.9 billion. In 2002 and 2003,
however, the figure soared to US$473.9 billion and
US$530.7 billion respectively. Experts predict that
following its increasing imports in the wake of its
economic recovery and continuing high oil prices, the
United States will hardly see its current account
balance improve.

Given the huge U.S. current account deficit, the U.S.
dollar, if it is to remain relatively stable, must be
backed up by an influx of foreign direct investment
(FDI).

In 1998, 1999 and 2000, FDI that flowed into the
United States was US$174.4 billion, US$283.4 billion
and US$314 billion respectively. Starting from 2001,
however, global direct investment began to shrink and
U.S.-oriented direct investment also decreased. In
2003, FDI into the United States was 44.9 percent
less than that in the previous year.

The decrease in FDI will put more pressure on the
U.S. dollar, which has been endangered by the huge
U.S. current account deficit.

Internationally, the Japanese government's intervention
in the foreign exchange market may become less
frequent following the gradual recovery of the Japanese
economy.

To deter the Japanese yen's appreciation and promote
exports, the Japanese government used to intervene in
the foreign exchange market to keep the yen at a
relatively low level. In 2003 alone, it put in 32.9 trillion
yen (US$298.76 billion) to purchase the U.S. dollar.
The intervention constituted a major deterrent to U.S.
dollar devaluation.

As the Japanese economy fares better, the Japanese
government tends to back away from the market. Since
April, it has not taken any steps to swing its foreign
exchange market.

Another factor behind the risks of a U.S. dollar slump
is the weakened role of the so-called"oil dollar."

Given the deteriorating relations between the United
States and the Arab world, quite a few Middle Eastern
oil-exporting countries have begun to increase the
proportion of the euro used in international settlement.
Reportedly Russia is also going to follow suit.

If an"oil euro" is to play an ever increasing role in
international trade, the U.S. dollar will suffer.

In China's case, its rapidly increasing foreign exchange
reserve will incur substantial losses if the U.S. dollar
continues to weaken.

At the end of 2000, China's foreign exchange reserve
was US$165.6 billion. By the end of 2002, it rocketed
to US$286.4 billion before it soared to US$403.3 billion
by the end of 2003. By the end of June this year, the
reserve was registered at a staggering US$470.6 billion.

About two-thirds of the reserve is dominated by the U.S.
dollar. As the dollar goes down, China will suffer great
financial losses.

Experts estimate that the recent U.S. dollar devaluation
has caused more than US$10 billion to be wiped from
the foreign exchange reserve.

If the so-called U.S. dollar crisis happens, China will
suffer further loss.

The high concentration of China's foreign exchange
reserve in U.S. dollars may also incur losses and bring
risks.

The low earning rate of U.S. treasury bonds, which is
only 2 percent, much lower than investment in domestic
projects, could cost China's capital dearly.

Due to high expectations of U.S. treasury bonds,
international investors used to eagerly purchase the
bonds, which leads to bubbles in U.S. treasury bond
transactions. If the bubble bursts, China will suffer
serious losses.

Moreover, since the Chinese trading regime requires
its foreign trade enterprises to convert their foreign
currencies into yuan, the more foreign exchange
reserves China accumulates, the more yuan the
Chinese authorities will need to put in the market.
This will exert more pressure on the already serious
inflation situation, making it harder for the central
authorities to conduct macro-economic regulation.

Besides, investing most of its foreign exchange
reserves in U.S. treasury bonds also holds great
political risks.

To ward off foreign exchange risks, China needs to
readjust the current structure, increasing the
proportion of the euro in its foreign exchange
reserves.

Considering the improving Sino-Japanese trade
relations, more Japanese yen may also become
an option. During the January-June period this
year, the proportion of China's trade volume with
the United States, Japan. and Europe to its total
trade volume was 36.5 percent, 28.6 percent and
37.4 percent, respectively.

Obviously, seen from the perspective of foreign
trade relations, the U.S. dollar makes up too large
a proportion of China's foreign exchange reserves.

China could also encourage its enterprises to"go
global" to weaken its dependence on U.S. treasury
bonds.

And using U.S. assets to increase the strategic
resource reserves, such as oil reserves, could be
another alternative.

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The author is director of the Department of
International Economics of China Foreign Affairs
University.