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Falling Dollar Squeezes U.S. Trade Partners
By JOANNA SLATER
Wall Street Journal
September 21, 2007; Page C1
The dollar's sharp weakening is creating a predicament for many U.S. trading partners,
few more so than oil-rich Saudi Arabia.
Like several other Persian Gulf nations, the Saudis have pegged their currency to the
dollar for many years. Now the peg is under pressure, because the weak dollar could
stoke inflation in an oil-rich economy that is already growing at gangbuster rates.
The dollar declined broadly yesterday, falling against the euro, the Canadian dollar, the
Japanese yen and the British pound. The Canadian currency briefly touched parity with
the U.S. dollar for the first time in more than 30 years. Like Saudi Arabia, Canada is
resource-rich and benefiting from the boom in global commodities. Meantime, the euro
pushed past the $1.40 mark for the first time to set a new record, with one euro buying
$1.4066 late yesterday in New York.
The potentially imperiled link between the dollar and the Saudi riyal was one factor
weighing on investors. Saudi Arabia's currency has been pegged to the dollar since 1986.
The link to the U.S. is especially problematic now, because the Federal Reserve just
lowered interest rates.
Normally, countries that link their currencies to the dollar follow moves in U.S. interest
rates. Wednesday, however, Saudi Arabia said it would hold rates firm despite the recent
0.5% cut by the Federal Reserve. If the Saudis cut rates, that would only stoke growing
inflationary pressures. In July, inflation in the kingdom rose to nearly 4% over a year
earlier, up from just 0.3% in 2003.
The Saudis might get rising prices anyway. By not lowering interest rates in concert with
the U.S., the country could see large inflows of capital seeking to take advantage of the
difference in interest rates. The money flowing into the country could also spur growth,
and consequently push domestic consumer prices up.
In May, Kuwait decoupled its currency, the dinar, from the dollar, in response to similar
concerns about an overheating economy. Saudi Arabian officials say they haven't any
plans to abandon the peg to the dollar.
Still, some economists believe others may eventually follow Kuwait's lead. "We'll
probably begin to see more countries maintaining a peg against a basket of currencies and
not just against the dollar," says Richard Clarida, global strategic adviser at Pacific
Investment Management Co. and an economics professor at Columbia University.
Currency pegs in the Persian Gulf "are facing a perfect storm," said Steve Brice, an
economist at Standard Chartered Bank in Dubai. Moving to lower interest rates when
there is "strong growth and soaring inflation is fundamentally inappropriate."
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A move away from dollar pegs could add further downward pressure to the U.S.
currency. That wouldn't necessarily be a bad development for the U.S., since a weaker
currency makes U.S. exports less costly abroad, which helps to close the country's large
trade deficit.That is a reason the Bush Administration has pushed China -- another critical
trading partner with a pegged currency -- to allow its currency to appreciate.
An enfeebled dollar raises the risk that countries like Saudi Arabia and China, with huge
foreign-exchange reserves, would be less inclined to invest in Treasury bonds and other
dollar assets, pushing U.S. interest rates higher.
In general, countries can adopt several different approaches to exchange rates. Some, like
China, stick to a regime of fixed exchange rates, either against one currency or a basket
of currencies, and allow only very narrow fluctuations.
A second group, including India, adopts a policy of managed exchange rates, where
governments intervene in the currency markets. Others let their currencies float more or
less freely.
China and countries in the Persian Gulf have seen an unprecedented flow of dollars into
their coffers. While linking a currency to the dollar can reduce volatility, it also means
central banks have very little room to maneuver in fighting inflation.
The advantages and drawbacks of a dollar peg have become a matter of intense
discussion in the Persian Gulf, because of the windfall from higher energy prices. Among
oil exporters in the Middle East, inflation has jumped from an average of 4.5% last year
to 6.5% so far this year, according to Morgan Stanley.
Qatar, Oman, Bahrain and the United Arab Emirates all tie their currencies to the dollar.
In the past, there have been brief periods when Saudi Arabia hasn't followed movements
in U.S. interest rates, says Caroline Grady, an economist at Deutsche Bank in London.
However, the largest difference between the key policy rates in Saudi Arabia and the U.S.
was 1%, and that lasted for just three months, from December 2001 to February 2002.
Currently the difference stands at 0.75%. That could widen if the Fed moves to lower
interest rates again, as many economists expect.
China is on the horns of a similar dilemma. "I don't know what day they're going to do it,
but they've got to let the currency appreciate further, and perhaps faster," says Jim
O'Neill, head of global economic research at Goldman Sachs.