Dollar's drop a long-term trend

By Phil Smith

LONDON (Reuter): The dollar's decline over the past 18 months has undoubtedly been dramatic, but looking back it is little more than a continuation of a trend that has been in place since the 1980s and even before.

The dollar's problem stems from the United States' twin budget and trade deficits and there seems little likelihood of an improvement in the foreseeable future, analysts say.

"I think the long-term trend of the dollar is one of weakening and that hasn't really been reversed by recent events," said Standard Chartered chief economist Chris Tinker.

"Really what you are looking at is relatively fast modernizing economies, which Germany and Japan have effectively been since the Second World War, seeing an appreciation of their currencies," Tinker said.

The deficit problem raised its head as far back as the early 1970s when the U.S. need to fund the Vietnam War broke apart the Bretton Woods fixed exchange rates system.

The Bretton Woods system was created in 1944 and in the first 10 years there was a shortage of the dollars that were badly needed for post-war reconstruction.

But during the 1960s the shortage turned into a surplus linked to an outflow of gold from U.S. reserves, and when the Vietnam War came along in the late 1960s the U.S. balance of payments was pushed into deficit and was flooding the global economy with dollars.

Things do not seem to have changed much with the U.S. still struggling to fund its huge budget and current account shortfalls.

"The big problem is that the U.S. is supplying dollars onto the financial markets at a massive rate and there just aren't the holders for those dollars," said David Coleman, chief economist at CIBC Wood Gundy. "It's simple supply and demand."

Bretton Woods finally broke down in 1973 due largely to the lack of U.S. monetary restraint because of the need to fund the Vietnam War.

The dollar has pretty much been in decline ever since, apart from the Ronald Reagan-inspired surge in the 1980s.

The former U.S. president embarked on a series of expansionist policies such as tax cuts and increased defense spending and it was this combination of loose fiscal and tight monetary policy which pushed the dollar almost back to levels seen in the early 1970s.

In 1971 before what is known as the Smithsonian devaluation the dollar was at 3.53 deutsche marks and 355 yen and has since lost well over half its value versus the mark and around three- quarters of its value against the yen.

Analysts said its 20 percent decline since the beginning of 1994 represented an acceleration of the downtrend and a correction is due. But with the fundamentals basically unchanged the dollar's decline in the medium to longer term is set to remain in place.

"If the U.S. could come up with a credible package to reduce government borrowing over the next 10 to 15 years things could well change," said Stephen King, international economist at James Capel. But grand plans to tighten fiscal policy usually founder on a downturn in the business cycle.

Given that fact, King said unless there is a significant increase in the rate of return -- i.e. much higher interest rates -- the dollar will continue to head downwards.

"From the point of view that much higher interest rates look extremely unlikely it is very difficult to see the dollar making significant gains against either the yen or the mark over a five or 10-year period," he said.

All that said there must come a time when the dollar will get so cheap it will stop falling and it would be wrong to draw a straight line down and say - "It can only go to one."

"The dollar won't continue down forever," said CIBC's Coleman. "Eventually there will come a crisis point when the U.S. will realize that the big problem is not competitiveness or trade, it's simply spending too much money."