Weak Dollar Feels New Stress

A rising tide of inflation pressure around the globe is putting more stress on the beleaguered U.S. dollar, as central banks from China to Chile fight rising prices by letting their currencies strengthen.

China's yuan has already appreciated nearly 3% against the dollar this year, putting it on pace to strengthen at more than double last year's rate. Last week, Vietnam relaxed strict controls on its currency, the dong, allowing it to rise more rapidly against the U.S. currency.

In the Persian Gulf, news agency Zawya Dow Jones reported yesterday that the United Arab Emirates is re-examining its currency's peg to the dollar, largely because having a stronger currency would help in its struggle against inflation.

One big source of inflation worries: soaring prices for raw materials. Yesterday, oil closed at a new high of $107.90 a barrel on the New York Mercantile Exchange, jumping $2.75, or 2.6% as more investors piled into the hottest commodity around. Oil's rise is fueling gasoline prices: The average U.S. retail price of a gallon of regular gas rose 6.3 cents to a new high of $3.225 this week, the U.S. Energy Information Administration said yesterday.

Yesterday's surge in oil prices was "fast money chasing faster money," said Dean Hazelcorn, a trader with Coquest Inc. in Dallas.

The weak dollar has played a role in the latest surge in commodity prices. Yesterday, it held relatively steady, though it was languishing near an all-time low it hit last week against the euro. This year, it has weakened 4.9% against the European common currency and 8.7% against the Japanese yen.

When the dollar weakens, commodities priced in dollars effectively become cheaper for buyers holding other currencies, spurring demand. At the same time, the producers of these commodities have an incentive to boost prices, since they are getting paid in less-valuable dollars.

A broader shift could also bring the dollar under renewed pressure. Since the U.S. currency's slide began in 2002, the lion's share of its weakness has been felt against free-floating currencies in developed markets, such as the euro and the Canadian dollar. Now it may be the turn of currencies in developing markets, especially in Asia and the Middle East, to strengthen against the dollar. Mounting inflation is speeding up the shift. A more robust local currency would make imports cheaper, helping to blunt the impact of rising prices.

In the past, many developing countries, in particular, have been reluctant to allow their currencies to strengthen because it makes their exports more expensive in global markets. But in the past year or so, as investors have flooded into these countries, the upward pressures on their currencies have grown -- raising the costs of government efforts to hold them down.

Outside the Comfort Zone

Lawrence Goodman, a currency strategist at the Bank of America, says that inflation is increasingly outside the comfort zone of central banks in emerging markets. A year ago, in a group of 24 large developing nations, three-quarters were either meeting or staying below their inflation targets. Now that figure has fallen to about one-fifth.

Late last year, faced with rising inflation, China began allowing the yuan to strengthen at a faster pace against the dollar. China's central bank governor recently noted that a stronger currency "helps to rein in inflation" -- which hit a 12-year high of 7.1% there in January -- but added it wasn't the government's primary strategy to combat rising prices.

Vietnam loosened controls on its currency after inflation touched 15.7% in February, the highest rate in 12 years. As part of several measures aimed at controlling price pressures, the central bank widened the band within which Vietnam's currency can trade against the dollar.

Investors say that Asian currencies are poised to strengthen in the current environment. "There are not many currencies that I don't like in the region right now," says Edwin Gutierrez, an emerging-market bond manager at Aberdeen Asset Managers in London.

He says that for the past two quarters he has made profitable bets that the Chinese yuan would strengthen. He also foresees further strength for the Malaysian ringgit, the Singapore dollar, the Philippine peso, the Indonesian rupiah, and the Thai baht.

Not all countries in the emerging world are confronting these problems from a similar starting point. Nations like Hungary, Turkey, and South Africa -- which run large deficits -- may see their currencies weaken as such gaps become more difficult to finance.

More Flexibility

In late February, Hungary abolished a regime linking its currency, the forint, to the euro, to give its central bank more flexibility to tackle a growing inflation problem. The desired result would be a stronger currency, but Hungary's economic fundamentals are deteriorating. Its central bank "wants the currency to do part of the job, but I don't think it will work," says Claire Dissaux of Millennium Global Investments, a London asset manager specializing in currencies.

Magic Bullet

Allowing a currency to strengthen isn't a magic bullet against inflation. Some countries have already allowed their currencies to appreciate considerably, but they are still struggling to tamp down prices. In Chile, for instance, inflation just touched its highest level in 12 years, and the country's peso is at its strongest point against the dollar in a decade. Exporters have begun to complain vociferously that their products are becoming less competitive, raising the prospect that the government could move to slow the currency's rise.

The inflation dilemma is at its most stark in countries that peg their currencies directly to the U.S. dollar, such as Saudi Arabia and other Persian Gulf nations. These countries are struggling with galloping inflation brought on by an oil boom and resulting investment binge.

In Qatar, a natural-gas-rich emirate jutting into the Gulf, inflation hit 12% last year, the highest in the region, according to the International Monetary Fund. In the U.A.E., the IMF pegged overall inflation at 8% last year. According to a survey by a consumer-rights group, food prices there rose 27%.

Letting Persian Gulf currencies strengthen would ease some of the pressure. But that would also involve abandoning their longstanding peg to the dollar, which has served as a stabilizing force in the past.

Task Force

Officials in the U.A.E., which has been considering whether to abandon its currency's link to the dollar -- are establishing a task force to examine the issue more closely. It seems unlikely to deliver its conclusions until the end of the year.

Last May, Kuwait became the first of the Persian Gulf countries with currencies linked to the dollar to abandon its pegs, partly due to rising inflation concerns. Rather than binding its currency, the dinar, solely to the dollar, Kuwait now ties it to a basket of currencies in which the dollar plays a major role. Since Kuwait abandoned the peg last year, its currency has gained nearly 7% against the dollar.