Dollar Free-Fall: Do We Have a Winner? Commenting on the hands-off attitude of G8 political leaders toward the plummeting dollar, Desmond Lachman from the American Enterprise Institute warned, “It would be better to let markets gradually rediscover that the emperor has no clothes rather than to have the emperor himself publicly declare his preference for strutting about in the nude.” However, the heads of the G8 gave little indication that the fall of the dollar mattered to them. American policymakers seem to have good reasons to let the dollar go. There are at least three potential benefits from a weak dollar. First, a weak dollar would help the United States narrow the current account gap by reducing imports and boosting exports. Second, increased demand for exports would act as a catalyst, reviving output and investment and pushing the economy toward recovery. Third, higher import prices would have a countervailing impact on the looming deflationary threat in the U.S. economy. But it is highly uncertain whether the United States can reap these benefits or not. The dollar has mostly depreciated against the euro. While a significant part of trade between the United States and euro zone countries is capital and intermediate goods, the demand for these goods is usually rigid and an increase in costs will most likely be passed onto consumers. U.S. trade within the North American Free Trade Agreement (NAFTA) is not expected to be significantly affected, and Asian currencies’ appreciations against the dollar were not large enough to have any notable impact on their exports to the United States. However, higher import prices could dampen the domestic consumer demand of the United States, offsetting the output growth originating from export increases. Furthermore, a weak dollar would damage the confidence of foreign investors, resulting in capital outflow or higher interest rates, which would deal a heavy blow to the still struggling economic growth. For the recession-haunted European and Japanese economies, dollar depreciation is the last thing they want to see. Germany and Italy recently posted contractions in real output for the first quarter; the French economy has been stagnant over the last two quarters. In Japan, the economy will teeter back toward contraction if foreign demand does not pick up within the next six months. Dollar depreciation is also bad news for fragile Latin economies. The weakening of the dollar’s impact on China’s economy is more complicated. As China’s RMB pegs the dollar in a de facto way, dollar depreciation at first sight could lower export prices of Chinese goods, thus making them more competitive in the international market. Would that make China a winner? Some claim it would, but the truth is that it highly depends. The U.S. market is by far the largest export market for China’s goods, while dollar-pegging means that the price level of China’s exports to the United States remains unchanged, even when the dollar depreciates significantly against other major currencies. Exports to other countries and areas would apparently become more price-competitive, but it depends on the assumption that the dollar depreciation would not damage the growth of the world economy, and China’s major trade partners, like the EU and Japan, could somehow secure their economic recovery. This scenario is difficult to realize; China’s exports will continue to grow in 2003, but the main engine will likely not be the exchange rate. Dollar depreciation would have a significant negative impact on China’s huge official foreign exchange reserves. China has not officially released any documents regarding the currency composition of its foreign exchange reserves to the public, but analysts guess that the U.S. dollar occupies a rather large share. According to the U.S. treasury, China had become the world’s second largest U.S. treasury bond holder by mid-2002, worth a total of $80.9 billion. This figure would be $122.9 billion if Hong Kong was included. Dollar depreciation could bring another potential problem for China, the RMB exchange rate. As China’s exports of manufactured goods grow, appeals for RMB appreciation have increased. Japanese economic officials have been openly pressuring for this over the past two years, some U.S. scholars and politicians have also repeatedly expressed their dissatisfaction toward China’s so-called “artificially low price for manufactured goods.” With extraordinarily strong economic growth and export performance, huge foreign exchange reserves and trade surplus, the RMB pegging system could become an easy target for the United States and its other trade partners if the world economy enters another recession. For the moment, expectation for stronger RMB does exist. But when talking about the exchange rate of the RMB, what needs to be concerned is not only its value related to foreign economic issues(I’m actually referring to the international price of RMB here). Some Chinese experts pointed out that China has both outward(export-oriented seems to be better?) sectors with rising competitiveness and inward(originally highly protected?) sectors with typical features of a transitional economy. So, certain vulnerable sectors constitute a potential threat to the stability of the RMB exchange rate, for example, the attention-drawing non-performing assets of state-owned banks. In addition, adjustments of the RMB exchange rate are closely connected with reforms in China’s foreign exchange and financial systems. Given this, now is not the right time to make a big adjustment of the RMB exchange rate. Moreover, the appreciation of the RMB alone would not be able to (do much good in helping the US and Japan to)handle trade and economic problems of (themselves)the United States and Japan. But that is not to say that the RMB would remain indifferent toward dollar depreciation and the pressure to be revalued. The foreign exchange control system that China is carrying out allows most foreign exchange reserves to remain in the Central Bank in the form of currency, which at the same time forces the Central Bank to shoulder the most exchange rate risks. In fact, considering the present situation, it is discussable whether it is still rational to keep strict control on the foreign exchange quota for private and business uses. In addition, the public should keep in mind that the RMB would eventually become a totally convertible currency and its exchange rate would eventually conform to the equilibrium rate of exchange in the market. In this sense, it is an acceptable alternative to moderately adjust the fluctuation margin of the RMB exchange rate at an appropriate time. A weak dollar would not be able to bridge the huge gap between savings and investment in the United States, and it won’t do any good to its trade partners. The world economic recovery may survive if dollar depreciation occurs in an “orderly way,” but a dollar free-fall would surely throw everybody in the same boat into the water.