Stephen King: Europe will be in the firing line of any fall in the dollar

If you think relations are already bad between the US and Old Europe, just wait until the going really gets tough. No, not war. This time, it's wallets and purses. The US economy is in a bad way but Europe's economy is even worse. And, to add fuel to the fire – possibly the wrong phrase to use given the complete absence of overheating anywhere – the dollar's decline since the middle of 2001 has simply shifted America's problems across to the other side of the Atlantic. Could it be that military warfare in Iraq is being augmented by economic warfare with Europe?

I don't think so. It's certainly the case that the US administration has become increasingly lukewarm about its once-cherished strong dollar policy. If, however, Europe is looking for someone to blame for the dollar's decline, it should simply look in a mirror. In one sense, the dollar's decline is all Europe's fault.

In the late 1990s, people just couldn't work out how the dollar seemingly defied gravity. America's bulging trade deficit didn't seem to matter. The reason? Europeans were more than happy to snap up US assets at what then appeared to be bargain prices. This seemed to make good sense. Old Europe couldn't offer decent returns but the New World had discovered the secret of everlasting profit. So long as Europeans believed this, they were happy to fund America's spending binge.

We now know, of course, that the US did not discover the elixir of stock market returns after all. And, once European investors worked this out, they were no longer prepared to buy what now appeared to be a bunch of crummy assets. Far better to keep the money at home, even if it was deposited in a boring bank account or invested in a dull government bond. As the money stayed put, so the dollar came down: the European lifeline that kept America's boom going had been cut (see left-hand chart).

So is the dollar now in danger of heading into free-fall? Well, it all depends. Against the euro, perhaps yes. But only because the dollar will not fall against other currencies. Ultimately, the dollar will only decline if other countries allow the dollar to drop. And there are an awful lot of countries around the world that have absolutely no intention of doing so.

Let's start with China. The renmimbi is pegged against the dollar. So, if the dollar goes down, so does the renmimbi. And, if the Chinese currency moves in line with the dollar, so will a lot of other Asian currencies. The basic point is that other Asian countries are terrified about competitive threat from China and they will work as hard as possible to prevent their own currencies from rising against the renmimbi. Thus, as the dollar falls, they will intervene in the foreign exchange markets, selling their own currencies and buying dollars.

The result of all this is a rapid rise in foreign exchange reserves for Asian central banks. Given their desire to avoid currency appreciation against the dollar and the renmimbi, they will have to invest these reserves in dollar assets. Central banks typically follow a safety-first policy so, unlike the Europeans of a few years ago, they won't be buying US companies or US equities: instead, they will be buying US government paper (see right-hand chart).

From a US perspective, this is rather good news. It may well be the case that Europeans have starved the US private sector of capital that was once bountiful but Asians have suddenly provided a way in which the US government can get access to funds on the cheap. Asian resistance to currency appreciation provides George Bush, John Snow and their friends with a steady stream of capital that will enable the US to expand not so much through the private sector but, rather, through the public sector. The US will be able to fund a rapid expansion in its budget deficit without having to worry too much about higher interest rates.

All this suggests that the US has found a neat way of funding its current account deficit. Of course, it implies that the source of American growth shifts from the private sector to the public sector – ironic given the Republican administration – and it may well be the case that the economy will not be able to repeat the extraordinary success of the late 1990s. Nevertheless, at least the US has got an alternative source of global capital to tap into without having to face significantly higher interest rates.

But is this enough for the US? Perhaps not. The low level of US interest rates still seems to imply that the dollar should be weakening against at least some currencies and it may well be the case that the US would be quite happy to allow the dollar to drop to more competitive levels. Yet, if the Asian currency bloc resists this process, there is only one obvious way in which the US can achieve a significant competitive gain: it has to come at the expense of Europe. At HSBC, we estimate that a 10 per cent drop in the dollar's overall exchange rate – weighted against a basket of important trading partners – would require a 30 per cent rise in the euro against the dollar. The plain fact is that, in the dollar depreciation game, it's the euro that has to take the strain.

For Europe, this would be disastrous. Europe would be directly in the firing line of any US attempt to kick-start its economy via the exchange rate. Accusations of "beggar-thy-neighbour" tactics would quickly fly across the Atlantic, reaching Washington in the bat of an eyelid. Yet, this result would not really be Washington's fault: it would simply reflect the currency regimes in place within the Asian region.

In essence, this story provides a mixed bag of global winners and losers. The Europeans end up badly off: they are incredibly exposed to any policy of dollar depreciation. The American public sector is a clear winner because it can take advantage of the implications associated with the Asian currency regimes. The American private sector, in contrast, is permanently starved of the European capital that contributed to the boom of the late-1990s. As for Asia, things there look rather more encouraging. Rapidly rising foreign exchange reserves will eventually lead to an expansion of domestic liquidity: if they're lucky, this may provide a source of insulation for Asian economies that would otherwise be rather too exposed to the weakness of demand in other parts of the world.

Overall, then, the US may have found an unexpected source of funding for its ever-growing current account deficit. But the fact that Asians are prepared to provide the necessary capital flows in no way prevents a scary appreciation of the euro. The quicker European policymakers recognise this unusual threat, the more likely it is that European interest rates will come down and the Growth and Stability Pact will be re-interpreted in an increasingly flexible fashion.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com