How the mighty have fallen ( And taken us down under with them)

Taken from the Forbes Magazine

The Dollar's Double Whammy
Robyn Meredith, 12.02.04, 7:30 AM ET

BEIJING - When a Chinese leader rapped American economic policies, heads nodded in approval in capitals around the world. The United States should be like China in the late 1990s, and act responsibly for the good of its neighbors, lectured Chinese Prime Minister Wen Jiabao at a meeting in Laos.

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China avoided destabilizing world markets back then by holding its currency steady, even as most of its neighbors devalued in the face of the Asian Financial Crisis. This helped exports from hard-hit countries like Thailand and Korea compete, and helped those nations put their economic troubles behind them.

Since when does the world prefer Communist China's view of economic policy over that of America?

Since the dollar began its free fall this autumn.

The dollar has been dropping because the U.S. is running huge trade and budget deficits. The current account deficit hit a record $166.2 billion in the second quarter. The budget deficit would make a Democrat blush--$422 billion, or 3.6% of U.S. gross domestic product, as of September, according to the Congressional Budget Office--and such deficit spending tends to delay a belt-tightening that would normally occur.

While the Bush Administration officially proclaims that America's longtime strong-dollar policy is intact, currency traders, economists and finance ministers worldwide have concluded the opposite, and the dollar has recently hit record lows against both the euro and the yen. When the euro hit $1.33, European Central Bank President Jean-Claude Trichet said the falling dollar was "not welcome." With the dollar trading around 102.55 yen, Japanese Finance Minister Sadakazu Tanigaki warned that Japan stands ready to intervene in currency markets to keep the yen from rising further.

A falling dollar helps American businesses compete in the short term. When the dollar falls, goods imported into the U.S. become more expensive, while exports become more profitable for U.S. companies. Detroit is a big winner: Non-U.S. car companies that compete with American automakers bring home lower profits once the money they make in the States is exchanged to yen or euros, so General Motors (nyse: GM - news - people ), Ford Motor (nyse: F - news - people ) and the Chrysler unit of DaimlerChrysler (nyse: DCX - news - people ) are happy to see the dollar decline. Toyota Motor (nyse: TM - news - people ), Honda Motor (nyse: HMC - news - people ), Nissan Motor (nasdaq: NSANY - news - people ) and some European automakers will see their profits crimped.

But the weak dollar will have an outsized effect because China's currency, the renminbi (also called the yuan), is pegged to the dollar. Because this is the first time the dollar has weakened since China has become a big exporter, the falling dollar amounts to a double-dip problem for Japanese and European businesses. "The de facto depreciation of the renminbi makes a supercompetitive Chinese economy hypercompetitive," says Stephen Roach, chief economist and director of global economic analysis at Morgan Stanley.

This has Europe and Japan--both slow-growth economies struggling to regain momentum--in a panic. All their exports to the U.S. are becoming less competitive just as Chinese imports to their economies are becoming cheaper, squeezing European and Japanese industry at both ends. There is no China impact on American companies for the same reason: When the dollar falls, the Chinese yuan falls in lockstep. But most of the rest of the world faces a dollar-policy double whammy.

In Europe, both the U.S. dollar and the Chinese yuan have slid 10.8% against the euro since mid-May. In Japan, the dollar and yuan have fallen 7.9% against the yen since the end of July, and would have fallen further if the Japanese government hadn't spent more than $100 billion buying dollars to prop up the yen. Lehman Brothers says that the dollar has further to fall, and estimates that the euro will reach $1.40 and the yen will hit 90 to the dollar next year.

China doesn't want its currency weaker either. It is desperately trying to cool off an overheating economy, and the cheap currency in Europe and Japan gives more oomph to Chinese exports.

China is blaming America, and America is blaming China--the Bush Administration has called for China to allow its currency to "revalue," a code word for "strengthen." Europe and Japan will likely clamor for the same if they can't make the U.S. budge, which seems probable. "The longer the renminbi peg endures in a weakening dollar climate, the greater the risk that the world loses patience with China