Market retreat will force shady deals 'out of the woodwork'

Section:

Plunging Dollar Will Set
World Markets Reeling

Heather Stewart
The Observer, London
Sunday, December 3, 2006

http://observer.guardian.co.uk/business/story/0,,1962449,00.html

The slowdown in the US economy, which has sent the dollar into freefall over the past fortnight, will have devastating knock-on effects in markets around the world, analysts warn.

As the US slows and consumers in the world's biggest economy feel the buying power of the dollar in their pocket declining, global growth will be hit hard, economists say. The greenback took yet another turn for the worse on Friday, after a survey of the US manufacturing sector showed output declining for the first time in more than three years.

Wall Street is now betting that Federal Reserve chairman Ben Bernanke will slash interest rates to stave off a recession. The dollar ended the week at $1.98 against the pound and $1.32 to the euro, but analysts say there is further weakness to come.

"I think the dollar's going to hell in a handbag," said David Bloom, currency strategist at HSBC. "The market is starting to think that the US is going from a soft landing to a hard landing."

Some analysts have argued that a more balanced global economy, with strong growth in Asia and Europe, means the impact of a US slowdown will be limited. But Stephen Roach, chief economist at Morgan Stanley, believes China -- and in turn the rest of Asia -- will follow.

"America is China's largest export market, accounting for 21 percent of its total exports over the past five years," he said, adding that economies such as Japan, Korea, and Taiwan, which export directly to the US but also sell components to China that are assembled before being sent on to the US, will be hit.

Eurozone finance ministers have expressed alarm at the strength of the euro against the dollar, fearing that their exporters will suffer; but the European Central Bank is expected to push up interest rates by another quarter-point on Thursday, as it frets about inflation.

Despite increasing signs of weakening demand in the world's biggest economy, ECB chairman Jean-Claude Trichet has insisted the 12-member single currency zone can shrug off a US slowdown.

"The ECB's in a complete state of denial," said Paul Mortimer-Lee, global head of market economics at BNP Paribas. "Quite a lot depends on how Trichet plays it at the ECB press conference next week. They're hankering after raising rates again next year."

Wall Street will also be watching Bernanke for signals of a change. The Fed has left rates on hold at 5.25 percent since the summer, after increasing them 17 times over the previous two years as the US economy recovered from the post-dot-com downturn. Bernanke sought to reassure the currency markets last week by stressing that the Fed is still concerned about inflation, but his words failed to stem the selloff. "It's as though the markets are saying, 'you central bankers are worrying about inflation, we're worrying about the reality of life,'" said Bloom.

Mortimer-Lee said the Fed would wait for definitive evidence before making a move. "At the end of the tightening cycle, you know you've got an inflation problem, and it's only when the evidence is overwhelming that you move." However, he believes that evidence will come soon: with investment in construction already falling as the housing boom turns to bust, BNP Paribas is predicting that a million jobs will be lost in the building industry alone over the coming 18 months.

Equity markets are already wobbling as investors weigh the cost of a US slowdown. Graham Turner of GFC Economics said a shake-out would raise questions about this year's merger frenzy.

"We have had an absolute monster year in terms of leveraged transactions," he said. "A lot of them looked quite dubious in terms of their economic value. Once the market starts to retreat, all the suspect things that went on come out of the woodwork."

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