Nobody thinks central bank diversification out of dollar is over, trader says

Section:

David Uren and Roy Eccleston
The Australian, Sydney
Friday, February 25, 2005

http://www.theaustralian.news.com.au/common/story_page/0,5744,1236420
2%255E601,00.html

Treasurer Peter Costello's closest adviser fears the US is heading
for a devastating financial crash that could ravage Australia's
economic growth.

As the Reserve Bank considers raising interest rates at its board
meeting next Tuesday, Treasury Secretary Ken Henry likened the flood
of money pouring into the US to support its budget and current
account deficits to the stockmarket's dotcom bubble of the late
1990s.

Were it suddenly to stop, there would be shockwaves felt throughout
the world's economies.

The financial crash feared by Dr Henry would involve a sharp fall in
the US dollar and a bond market selloff, which would push up US and
world interest rates.

This would hit US economic growth and, as a result, cut Chinese
exports of manufactured products to the American market. In turn,
this would threaten the boom in Australian mineral exports to China.

Fears that the world economy is in grave danger are growing in the
major financial capitals.

The International Monetary Fund, which is responsible for stability
of the world economy, also warned yesterday of a sudden collapse.

IMF managing director Rodrigo de Rato said urgent combined
international action was required to head off the dangers.

The main cause of concern is the fact the US is running a trade
deficit of about $US600 billion (AU$760 billion) and a budget
deficit of about $US430 billion for 2005.

US imports are almost 50 percent greater than the country's
exports, with the deficit being financed by international central
banks and funds managers.

Despite signs that the deficit is getting bigger, money is pouring
into the US from Asia and Europe at such a rate that the US has been
able to keep its long-term interest rates steady at 4.2 percent
since the middle of last year.

Dr Henry said the flood of money was "worryingly reminiscent of
Federal Reserve chairman Alan Greenspan's warning in 1996 of
irrational exuberance in US stocks."

He said that, as with the dotcom bubble in the 1990s, one could not
tell how long it would keep going, but it would burst eventually.

Dr Henry's comments, made to a meeting of Asian treasurers in Sydney
yesterday, reveal that Treasury is much more worried about the
health of the world economy than is the Reserve Bank.

Reserve Bank governor Ian Macfarlane said last week that he did not
think the US current account deficit was a serious threat.

"I suspect the rest of the world will continue to finance the US
current account deficit," he said. But if it did not, all that would
happen would be a fall in the US dollar, which would not have
serious consequences.

The Reserve Bank expects world economic growth to slow only slightly
from last year, when it recorded the fastest growth in almost 30
years.

The different views about the economic risks may be aired at the
Reserve Bank meeting on Tuesday. Dr Henry sits on the Reserve Bank
board.

The bank does think there are risks of financial collapse in the US,
but believes it would be caused by the complexity of new financial
products.

The IMF also thinks economic growth will remain firm over the year
ahead, but Mr de Rato says there are "serious threats and challenges
ahead".

Mr de Rato warned that it was highly unlikely that the US would
continue to have access to "easy credit," based on its present
economic policies.

Mr de Rato said the fall in the value of the dollar should act as
a "timely wake-up" to policy makers around the world to tackle the
imbalances in the world economy.

Mr de Rato said these included not only the US's deficits, but also
resistance to economic reforms in Europe and Japan, as well as
China's fixed exchange rate.

Dr Henry said the problems went beyond the American deficits, which
he said were mirrored by excessive surpluses in Asia.

He said Asian countries were not allowing their domestic economies
to grow fast enough, and were relying too much on exports. This put
them at risk in any world economic downturn.

The boom in investment in American financial markets could be
brought to a halt by a number of developments, Dr Henry said.

A slowdown in American growth could lead international private
investors to pull out of the country.

Foreign central banks, which have been buying long-term American
government bonds, are already facing big losses as a result of the
fall in the value of the greenback.

"What if they change their mind?" Dr Henry asked.

He said it was imperative that the Americans take action to reduce
their budget deficit, while they should allow the value of the US
dollar to fall further.

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