Dollar binds Asian economies to US

Dismissed as a distant dream even by its ardent advocates, Asian monetary union is in fact already up and running -- and helps explain the dollar's resilience in the face of bulging external deficits.
That at least is the view of economists who say Asia is in effect locked in a monetary embrace with the United States because its currencies are mostly pegged to the dollar -- either firmly, like China's, or loosely, like South Korea's.

As long as Asia preserves the link and is happy to be paid in dollars, the United States' deficit with Asia according to this line of thinking is as irrelevant for the US currency as the internal trade balances among the 50 states. Add in demand for dollars for global trade in everything from oil to financial assets and the result is a current account gap that is far less daunting than it looks, these economists say.
"Essentially, the fact that the dollar is the currency for the world implies that the US faces a much softer external financing constraint thanany other country," Morgan Stanley currency analyst Stephen Jen said.

In a note to clients Jen said that, far from being displaced by the euro, the dollar was increasingly in demand as a vehicle currency in interbank, trade and asset transactions. Some 80 % of South Korea's trade and two-thirds of Japan's is denominated in dollars, while Asian central banks hold large supplies of dollars because when investors flee the region they usually switch into US assets.
"The fact that Asia is effectively in an economic and monetary union with the US is hugely important for the dollar. The dollar cannot crash and will not need to adjust significantly as long as Asia elects to remain in this arrangement, which I believe will be the case for years to come," Jen wrote.

His conclusion? With global demand for the dollar as a transaction currency rising, the United States should be able to run a current account deficit of 3.5 to 4.0 % of GDP for several years. The US current account deficit in the first quarter widened to $ 145 bn, equal to 5.1 % of GDP, from $ 127 bn in the fourth quarter of 2003.
Others see things differently. Goldman Sachs, a long-time dollar bear, frets that a build-up in the United States' net foreign liabilities will balloon, entailing huge debt-servicing costs, if external deficits persist. The bank's economists advocate a 20 % drop in the dollar's trade-weighted value from its peak to reduce the current account deficit to a more manageable 3 % of GDP.

Yet why hasn't the dollar drowned in this sea of red ink?
The answer, says Jim Walker of brokers CLSA, is that more and more countries accept payment for goods and services in dollars. The list includes not only producers of oil and commodities priced in dollars but also countries with closed capital accounts and currencies fixed to the dollar, such as China.
Trade has traditionally been conducted in national currencies, but in China all dollars received by the central bank or held by exporters offshore ultimately find their way back into dollar-yielding US assets, Walker said in a recent report.

"In essence, US-China trade is no different from the exchange undertaken between an Arizona pencil manufacturer and an Arkansas calligraphy shop. Both transactions take place entirely in dollars."
In effect, under its current monetary and exchange rate regime, China is acting as the 51st state of the Union, the report says.