The US dollar has weakened dramatically since 2007, with the Nominal Major Currencies Dollar Index dropped to 71.1053 in early November, marking a year-to-date decline of 12.7% or a year-on-year decline of 10%. Such drastic fall of the USD has aroused concerns among global investors. The current downtrend of the dollar can be traced back to March 2002¹. Despite a mild rebound in 2005(details as shown in the following tables), the USD index fell to 73.2693 at the end of 2007, the fresh low after the U.S. government decided to suspend gold convertibility in 1971. Over the past six years, the index has declined 34%, and specifically the dollar has slipped 39% against the euro, 27% against the British bound, 14% against the Japanese yen and 12% against the RMB.

There are several reasons for the downtrend of the USD:

1. Attractiveness of USD denominated assets has been greatly reduced following the burst of the dot-com bubble in 2000, curbing capital inflow to high growth but high P/E valuation stocks listed on the NASDAQ. The USD had rallied 41% against the major currencies on the back of the economic boom during 1995-2002. Cyclical factors have contributed to depress the value of USD.
 
2. Adoption of loose monetary policy. Central bankers in the U.S. are compelled to adopt loose monetary policy to stimulate the stagnant domestic consumption. The Fed fund rate was lowered from 6.5% in 2001 to 1% at mid-2003, making USD denominated assets less attractive. Subsequent tightening of monetary policy since mid 2004 has not been sufficient to rebuild the dollar's strength.

3. Adoption of expansionary fiscal policy. The budget situation has deteriorated rapidly under the Bush Administration. The tax cuts endorsed by the Congress were not matched by comparable spending cuts. The budget deficit was entrenched under the shadow of skyrocketed military expenditure. The cumulative fiscal deficits reached USD 1.5146 billion during 2002-2006, while the fiscal deficit/GDP ratio raced up to 3.6% in 2004. Such a growing fiscal deficit had to be financed by more government or foreign debts, or fresh money creation.

4. Widening trade deficit. The U.S. current account deficit touched the historical high of USD 811.5 billion in 2006. The cumulative current account deficit hit USD 3.99 trillion during 2000-2006. The current account deficit/GDP ratio surged to 6.2% in 2006 from 3.8% in 2001, exceeding the conventionally recognized sustainable threshold. Appeal of dollar-denominated assets was diminished because of the sheer size of current account deficit.

5. The Euro emerged as a hard currency. In January 1999, at the time of its birth, the euro-dollar rate was 1.18. After plunging to the low of 0.8228 on 26 October 2000, the euro crawled back to its upward channel since 2002 and hit 1.4603 against dollar by the end of 2007, gained 78% over the record low registered in 2000. Solid performance of the euro in recent years has boosted the currency as a rival to the dollar as the dominant reserve currency and unit of account. The euro has surpassed the dollar as a major currency in international debt denomination.

6. Subprime meltdown has intensified the bearishness of the dollar. USD denominated assets have been sold off sharply last year, on concerns the subprime woes would cripple through the broader economy and hurt the investors' confidence toward the U.S. credit rating system. Uncertainties about the economy and financial markets give the Federal Reserve more reasons to lower interest rates as a measure to prevent the economy from sliding into full-fledged recession, in spite of the alarming inflation risk. The Fed has slashed the benchmark interest rate by 100 bp to 4.25% during the second half of 2007, narrowing its rate advantage over euro to 100 bp.

Dollar's downward spiral is unlikely to be reversed

Indeed, depreciation of the USD could bring profound impacts on global markets. Oil producing countries, China, Japan and other countries, which hold enormous amount of U.S. dollar reserves, are suffering from growing currency risk stemmed from the weakening USD. At the same time, countries having adopted the dollar-pegged exchange rate regime like Hong Kong and several oil exporting countries in Middle East are under pressure of imported price inflation. Kuwait dropped the dollar peg in response to rising import inflation and switched to link to a basket of currencies last year. Gulf states' dollar peg has come under threat.

After all, the dollar's downward spiral is unlikely to be reversed in view of the current note-issue mechanism, gloomy economic outlook in the U.S., persistent fiscal and trade deficits, exchange rate policy bias and less attractive investment value of USD denominated assets.

1. The right of the U.S. to issue paper money, without any promise of redemption in either gold or silver, is blamed as the root cause of the USD's downward spiral. The Bretton Woods Agreement, set up in 1944, established a dollar based "dual peg system", the U.S. dollar was pegged to gold at $35 an ounce, whilst other currencies were pegged to the dollar. Under this regime, U.S. dollar supply was constrained by official gold reserves, in order to honor the commitment to sell gold to foreign central banks, and this provided a solid support for the USD exchange rate. However, the U.S. gold reserves to money ratio dropped remarkably in late 1960s as Washington fire up the printing press to cope with staggering military expenditure in Vietnam War. As American gold reserves were no longer enough to meet the demand from foreign official agents, U.S. President Richard Nixon ended trading of gold at the fixed price of $35/ounce at 1971. The US government declared to adopt an inconvertible paper or fiat money, backed only by the credit and fiscal discipline of the government. FX reserves built up under the Bretton Woods Agreement were regarded as the cure-all for the staggering U.S. trade and fiscal deficits. U.S. dollars can be supplied as many as it wishes at essentially no cost. The greenback weakened further as a result of a flood of dollar in the markets. The Nominal Major Currencies Dollar Index dropped to 73 by the end of 2007, which was only a third of the value of dollar at the time when the U.S. decided to suspend the gold convertibility. The dollar fell 69% against the yen, from 360 to 111.7 yen during the same period of time. It shed 19% against the euro since its inception at 1999. The dollar dropped 44% against the euro, if compared with the euro's low at 0.8228 recorded on 26 October 2000.

USD faced hefty selling pressure and caused severe disruptions in the FX market after the Nixon Administration closed the gold window in 1971. John Connally, then US Treasury Secretary under Nixon Administration, once told his European counterparts, "It may be our currency, but it's your problem". The statement had shocked the world², and actually summarized the relationship among different interest parties involved in the collapse of the Bretton Woods. Connally's statement continues to hold true. The fiat monetary system has set the stage for the protracted dollar downtrend.

2. For the U.S., coexistence of a weak dollar and low economic growth trapped central bankers in a dilemma. Should the Fed lift its rate to restore investors' confidence toward USD denominated assets by widening its rate advantage against other major currencies, economic activities would be dampened and the subprime woes could intensify. Another choice for the FOMC is to vote for a rate cut to help avert the subprime crisis and foster economic growth, but let the dollar depreciate further. The U.S. policymakers tend to choose the latter, as evidenced by the bold 100 bp rate-cut last year.

3. The euro's solid performance has strengthened its role as a major reserve currency, rivaling the predominated position of the dollar in FX market. According to IMF's data, the proportion of USD in global central bank reserves has tumbled to 64.8% in 2007 from 71% in 1999. On the contrary, the proportion of euro has shot up from 19.7% in 2002 to 25.6% in 2007. Joseph Stiglitz, a Nobel laureate in Economics, said³ that the change in mindset about the use of the dollar in reserves and the movement of the dollar out of reserves will continue, and exert downward pressure on the US dollar. We estimate at least 1 trillion worth of USD reserves will switch to other major currencies in the next five years. The proportions of dollar and euro in global central bank reserves are expected to adjust to around 60% and 30% respectively.

4. Oil producing countries call for removing U.S. dollar as major oil trading currency. Gulf Co-Operation Council has explicitly expressed their willingness to replace the U.S. dollar by other major hard currencies in oil trading, in response to the devaluation of the U.S. dollar. Iran dropped dollar as the standard for pricing petroleum and asked its customers to pay in euro. Venezuela may has the political incentive for such a move. Once the proportion of euro in global central bank reserves reaches a critical mass, demand for the dollar may reduce significantly without its oil backing.

5. Forces of further RMB appreciation. The Sino-American trade deficit has been a perennial irritant in Washington. U.S. Congressmen are clamoring for an appreciation of the RMB to reduce its huge trade deficit. The RMB has gained 14% against the dollar since China commenced its exchange rate reform in July 2005. Still, the Chinese currency is under great pressure from the U.S for further appreciation. Also, E.U. policymakers have taken a hawkish stance on the issue of RMB appreciation at the E.U.-China Summit 2007. Joint forces from the U.S. and EU governments would probably bring additional pressure for RMB appreciation in face of the ever-growing trade deficit in the western countries.

In 1985, finance ministers from the world's five biggest economies announced the Plaza Accord to intervene in currency markets so as to get the yen up. The yen appreciated 203% against the USD in a decade after the Plaza Accord, from 240 yen to 79 yen per dollar at April 1995. Massive yen appreciation led the Japan's export-dependent economy into recession and eventually brought about financial bubble. If history is any guide, the US government would like to see the RMB trend higher in a more aggressive fashion.

Brutal dollar depreciation could unsettle the different economies across the world

Nonetheless, there have been sharp changes in global economic and financial environment in the last two decades. Sino-American trade relationship is much different from the U.S.-Japan relationship twenty years ago. Seemingly, even the white house is not reluctant to let dollar maintain its downtrend, in particular with regard to further softening against the RMB, as evidenced by rare FX intervention to prop up the dollar in recent years. The task would be more complicated if Washington should face the threat of a dollar crisis. We believe the status of the dollar would remain intact in view of the following reasons:

1. The emergence of the euro posed a serious challenge to the pre-eminence of the dollar as reserve and settlement currency. For long-term benefit, U.S. policymakers are almost obliged to restore fiscal discipline to stabilize the purchasing power of the dollar, in order to regain investors' confidence toward USD denominated assets and consolidate its status as the dominant reserve currency.

2. Should the nominee of the Democratic Party win the presidency election of 2008, Americans would likely to see a return to conservative budget as seen in the Clinton presidency. Conservative fiscal practices will help stabilize the greenback in the FX markets. Actually, the swing in the federal budget from deficit to surplus has boosted the US dollar index up 14% during Clinton's presidency (1992-1999), marking its longest winning streak since the breakdown of Bretton Woods system⁴.

3. While China, Japan and other Asian countries hold enormous amount of USD denominated assets, brutal depreciation would hurt the value of their existing reserve holdings. This suggests that those central banks have effectively been diversifying their reserves do not necessarily need to rush to sell USD assets. And for Japan, China and other export giants, continued depreciation of the greenback has been curtailing their export competitiveness. They would like to see a stable FX market.

4. Fears about Europe's export-led recovery will be derailed are looming as the euro has gained nearly 80% against dollar since 2000. Moreover, dollar financial market has edges over the euro market in terms of liquidity and settlement system. Euro is not yet in a position to replace the dollar as the dominant trading and settlement currency.

5. The federal fiscal deficit was improving. U.S. fiscal deficit/GDP ratio declined to 1.9% in 2006 from 3.6% in 2004, marking the lowest amount of red ink in the past few years. Fiscal deficit is expected to shrink further in 2007. Trade deficit/GDP is expected to shed 0.4 percentage point to 5.8%, underpinned by robust growth of capital goods export.

Looking ahead, the downward spiral of the dollar is unlikely to be reversed in the short term. Yet, the decline of the dollar during the past few years has already been significant. Major economies including Europe, Japan and China are reluctant to see brutal depreciation of the greenback. Washington is obligated to maintain the role of the US dollar as a global reserve currency in long-term benefit. Overall, we believe the risk of a full-blown dollar crisis is yet to be significant in the coming year. The dollar is expected to remain weak against the euro, British bound and Japanese yen, but short-term rebound may occur occasionally. On the other hand, the structural downtrend against the RMB would be protracted. One must aware that the RMB/USD exchange rate issue has crucial strategic implications for overall Sino-U.S. economic relationship, and hence does not simply mirror the difference of economic fundamentals.

Summary Table of Twin Deficits and Public Debt in U.S.

Source：Bureau of Economic Analysis, Congressional Budget Office

Tse Kwok Leung
Senior Economist