Crisis looms due to weak dollar

Jiang Ruiping China Daily Asia News Network Beijing

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 towards 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 $459 billion deficit, which accounts for 3.8 percent of the U.S. gross domestic product (GDP).

By the 2004 fiscal year, the U.S. Government's outstanding debt stood at $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 $189.9 billion. In 2002 and 2003, however, the figure soared to $473.9 billion and $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 $174.4 billion, $283.4 billion and $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 ($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 $165.6 billion. By the end of 2002, it rocketed to $286.4 billion before it soared to $403.3 billion by the end of 2003. By the end of June this year, the reserve was registered at a staggering $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 $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.

The writer is director of the Department of International Economic under China Foreign Affairs University.