The plunge in the value of the Euro below 1.25 last week after almost breaching 1.29 last Monday, triggered forced liquidation from a market that was simply too long.

The dollar rallied sharply higher against most of the major currencies, forcing liquidation in long gold positions as well, which recently jumped to their highest levels since 1988.

The bloodletting started following a number of comments from the normally reticent European Central Bank expressing concerns over the Euro's recent rapid appreciation. Its president, Jean-Claude Trichet, went so far as to describe the Euro's jump in value as “brutal”, underscoring a growing concern that the strength in the currency could choke off growth in the nascent European economic recovery given that consumer demand there remains quite weak. The veiled threats of intervention and stronger than expected US economic data, triggered a wave of short covering that may precipitate further declines, perhaps to 1.20 in the case of the Euro, whose gains appear, for this quarter anyway, to be capped.

The down trend in the value of the dollar however remains intact, despite the Bush Administration's half-hearted attempts to reassert the nebulous “strong dollar policy”. The US currency, from practically any valuation tool one applies, remains over-valued, particularly from a trade-weighted basis. This means a further ten percent decline in its value this year still seems very likely and the dollar is not likely to find a bottom until 2005.

This view is rather more bearish than the consensus opinion, which calls for a modest decline in the value of the dollar, which is believed to be in the mature stages of this bear market cycle. The latest US trade figures indicate that the weaker dollar is having some of the desired effect the Administration was looking for.

A widening current account deficit, which requires a net foreign capital inflow of more than $1.5 billion a day merely to keep the dollar stable must surely keep policy makers up at night, mustn't it?

Well, yes and no. In a speech earlier in the week, Federal Reserve Chairman Alan Greenspan noted that despite the current account deficit widening significantly to 5.1 percent percent of GDP in the third quarter last year, there was “little evidence of stress in funding” it. He added that with the exception of the fall in the dollar, a widening of the deficit to record levels had been “seemingly uneventful”.

That is a little disingenuous, but it does suggest that looking at the current account deficit in terms of a funding issue for the dollar is flawed. This is because it overlooks the structural surpluses run in much of the rest of the world, particularly in the emerging economies like China. In other words, the dollar, remains to a large extent the predominant store of wealth. A look at the staggering increase in purchases of Treasury bonds by China over the last ten years drives that point home (see chart).

Chairman Greenspan did go on to say that history showed that the more flexible financial system brought by globalisation suggests that current imbalances could be “defused with little disruption”. The Bush Administration is keen to hurry that along. In a speech by Under Secretary of Treasury John B. Taylor, before the Subcommittee on Domestic and International Monetary Policy in October, the Administration again criticised the Chinese authorities' reluctance to allow more flexible exchange controls. The Yuan has been fixed to the dollar at a rate of 8.28 for the last decade or so, so while China's current account surplus with the rest of the world is not excessive, its frequent intervention in the currency markets has swelled its surplus to the US.

Since the end of 2001, the amount of dollars bought has been so great that the foreign reserves held by the Chinese government have risen from $153 billion to over $360 billion, in the process making it the second largest foreign purchaser of US Treasury bonds after Japan.

Obviously a weaker dollar would make US exports more attractive, but recent data from China suggests the economy there is going through a soft patch so any suggestion of a revaluation in the Yuan therefore seems unlikely in the short term.

So what about the appetite for US assets by other foreign investors? Overseas funds, attracted by the surge in profitability in US corporations, poured into the US financial markets according the latest report of capital flows by the US Treasury department.

But investors should take care not to weigh too much importance on this in terms of the value of the dollar this year. The real question in terms of the dollar and the sustainability of the current account deficit is what happens when the foreign accumulation of US assets by economies like China becomes too big.

At some point, and it looks like this may already be occurring, globalisation will mean that the US will have to compete for foreign funds that finance its spending short falls especially once growth picks up in these economies.

Because curing the imbalances in the economy is a tall order, these are issues that will not go away anytime soon. The sharp rise in gold prices indicates that the dollar's troubles are going to be an issue for some time yet.

@EDITRULE:

Kees van Beelen is a portfolio manager and a member of the Bankof Bermuda's Investment Policy Committee. The views expressed here are his and not necessarily the Bank's.