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Dollar's drop is more than a passing trend

The risk of a global currency war occupied a serious chunk of finance officials' face time at the annual IMF gathering in Washington over the weekend.

It seems that a handful of countries intent on exporting their way out of the economic slump have concluded that this will only work if they can knock the pins out from under their own currencies. Just because it's usually a bad idea that tends to trigger dangerous trade friction is no deterrent to a desperate government.

So what started as long-simmering American anger over an undervalued Chinese yuan has spread to other currency concerns in Japan and Europe, as well as a raft of emerging countries eager to keep their impressive growth rates on track and hot money out of their financial systems.

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But while they may be upset at Chinese manipulation or direct intervention by the Japanese and the Swiss, what really keeps the finance bureaucrats awake at night is the prospect of prolonged U.S. dollar weakness.

Since the U.S. Federal Reserve began musing six weeks ago about making its easy money policies even easier, the greenback has fallen about 7 per cent against a basket of other major currencies and much more against such relatively strong currencies as the Brazilian real. The euro is sitting at an eight-month high against the dollar; the yen hasn't been this lofty since 1995; and the loonie climbed again Friday, closing in on parity, despite more downbeat Canadian housing and jobs stats.

Well, here's a news flash. Short of global action to stabilize currency markets or a dramatic reversal of government policies, the greenback is going to stay on its downward trajectory while the previously embattled euro heads the other way. Both moves stem from the divergent paths being charted by monetary policy makers.

The European Central Bank may bemoan the fact that the recently feeble euro is gaining remarkable strength despite increasingly sluggish euro-zone economies. But the bank adamantly resists any further monetary stimulus. The Fed, on the other hand, is set to launch the next big round of quantitative easing, dubbed in finance circles as QE2, even though policy planners harbour serious doubts it will have any beneficial economic effect beyond dampening the dollar.

"Assuming the Fed does this and the ECB does nothing, what happens to the exchange rate?" Michala Marcussen, London-based head of global economics with Société Générale, asked the other day while on a visit to Toronto and other Canadian locales. "Our answer is you push the euro/dollar [rate]to 1.65."

That would be a stunning jump of nearly 20 per cent over the recent close and a record high.

Ms. Marcussen stresses that this is not an official forecast, because other factors play into currency rates. But the trend is plain. "If we continue down that trajectory, then clearly we are seeing much, much more dollar weakness."

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Despite the economic risks, Ms. Marcussen firmly supports the ECB's monetary stance, as well as what she calls "the German diet" of tough austerity measures being imposed by essentially insolvent governments in the region.

Looking at such fiscally challenged countries as Ireland, Greece and Portugal, the prospect of exceedingly slow or no economic growth will make it hard to rein in deficits. "You could find yourself in the nasty situation that you do the German diet and you're still putting on weight on your public finances," Ms. Marcussen acknowledged.

But she added: "I don't think we'll be given an alternative. ... We're in a situation where as a region we need fiscal austerity."

Needless to say, that is not the direction U.S. monetary policy appears to be taking.

Dallas Fed chief Richard Fisher insists the internal debate over QE2 is not yet resolved. But the market is already assuming the next round of Fed fiddling will begin in earnest in November. Over the next year, about $1-trillion (U.S.) worth of Treasury bonds are likely to be added to the Fed's balance sheet, Ms. Marcussen says.

Some analysts argue it should be at least double that level to have any economic impact. Others, like Ms. Marcussen, doubt it can work as an economic stimulant, especially if divorced from fiscal policy. It's hard, she says, to see how "pumping more money into the system and having it come back and sit on your balance sheet in the form of reserves really does all that much."

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But one desired result is sure to be achieved: a weaker U.S. currency in a more volatile foreign exchange market. Last week's strengthening of other key currencies against the greenback merely foreshadows a longer-term pattern.

*Editor's note: This article has been changed to correct a typo. The Chinese yuan is considered to be undervalued.

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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