Expert View: Diversification from the East could send the dollar south

China has built up a huge store of dollar assets, lending the US the money to buy its own goods

The renewed weakness of the dollar last week may be the beginning of the end of a set of fundamentally unsustainable arrangements, which have nevertheless proved surprisingly durable because they have suited all the participants rather well. The weakness of the dollar is usually blamed on the US twin deficits, the budget deficit and the balance of payments deficit - especially the latter. That deficit did not matter too much as long as the rest of the world wanted to buy US assets. While Wall Street was rising they did. But the long period of sideways trading, following the dot-com crash, has reduced the world's appetite for US assets. As a result, the US basic balance (current account less net foreign investment flows) has deteriorated and the dollar has weakened.

The renewed weakness of the dollar last week may be the beginning of the end of a set of fundamentally unsustainable arrangements, which have nevertheless proved surprisingly durable because they have suited all the participants rather well. The weakness of the dollar is usually blamed on the US twin deficits, the budget deficit and the balance of payments deficit - especially the latter. That deficit did not matter too much as long as the rest of the world wanted to buy US assets. While Wall Street was rising they did. But the long period of sideways trading, following the dot-com crash, has reduced the world's appetite for US assets. As a result, the US basic balance (current account less net foreign investment flows) has deteriorated and the dollar has weakened.

But that is only half the story. Emerging Far East economies, notably China, have chosen to fix their exchange rates against the dollar. A substantial part of the US deficit is with China, but as long as the Chinese authorities hold down the renminbi against the dollar, one important price mechanism (a rising renminbi), which would help correct the US deficit, is blocked.

The Chinese policy is based on the desire to keep their exports competitive in the US, and as the dollar falls, improve their competitiveness around the world. They can follow this policy indefinitely because any country can keep its currency weak by printing and selling it. But the maintenance of competitiveness comes at a cost. Actually, what the Chinese authorities do is borrow from their own citizens, and use the proceeds to buy dollars, which go into their official reserves. This is already expensive because the interest received on the dollars is much lower than the interest paid on the borrowed renminbi.

But the more serious problem is that by following this policy over many years, the Chinese have built up a huge store of Western assets, in particular US dollar assets. In effect, the industrious Chinese have been lending the Americans the money to buy their own goods. The value of those US promises to pay, measured by the dollar's trade weighted index, has fallen by around 30 per cent from peak levels in early 2002 and there is no end in sight to this decline.

The Chinese thus face, in spades, the awful dilemma that confronts any large holder of an asset that is declining in value. They would like to diversify their reserves into other assets. To do so they have to sell dollars and buy (let us say) euros. But if they do that, they risk pushing the dollar over the cliff, causing a huge loss in value of their remaining dollar reserves.

It is not just the Chinese who face this dilemma. Many Far Eastern economies, including North Korea and Japan, are in a similar position. The signs last week were that some, though not Japan, are increasingly prepared to diversify, whatever it does to the value of their remaining reserves. It is thus hard to see an early end to dollar weakness.

Euroland is therefore entering a period in which steady capital inflows will drive up the exchange rate, putting downward pressure on inflation and on interest rates. The balance of payments will deteriorate, allowing Europeans to live high on the hog on borrowed money - just as the Americans have been doing all these years. If you think that doesn't sound too bad, you would be right. Consumers will benefit from cheaper imports. Trips abroad, especially to the States, will be remarkably good value. The strong euro will offset the rise in (the dollar value of) the oil price, also in the news last week. But European producers will be less happy, because less competitive. And, believe me, it is their voices we will hear, not those of the happy consumers.

Dr Bill Robinson is a director of economics at PricewaterhouseCoopers