Can the embattled dollar reverse its long decline?

During the first three months of the year the beleaguered currency depreciated by about 7.5 per cent against the euro and 10 per cent against the yen.

It fell by about 6 per cent against the baht.

As the dollar's bear market stretches into its sixth year, one wonders if the currency can make a comeback this year as was the case in 2005.

The year 2008, however, does not seem to bode well for the greenback. There are many forces at work that suggest the dollar downdraft is likely to continue during the latter part of the year. Chief among these is the abrupt change in interest-rate differentials.

The Federal Reserve since September has lowered the federal fund rate, which banks charge each other for overnight loans, for the seventh time - from 5.25 per cent to 2 per cent. The latest cut of a quarter percentage point was made only last week. While a phalanx of prominent economists seem to agree that the Fed may take a break from interest-rate reductions in June, it may, however, not be finished cutting rates.

On the other hand, the European Central Bank, convinced that the economy of the 15-nation euro zone remains quite resilient in spite of the eight months of financial volatility that has rippled through the United States, is likely to maintain its main interest rates in the future in order to rein in mounting inflationary pressures caused largely by rising prices of crude oil and other commodities.

Likewise, the Bank of Japan is expected to leave its benchmark rate intact during the remainder of the year. This sudden change in the interest-rate gap will unequivocally weigh on the dollar for several months to come.

Changes in interest-rate differentials prompted by a dramatic decline in interest rates in the US have been the result of fear among policy-makers about the risk to the broader economy created by the financial market crisis and housing market downturn.

To be sure, the sub-prime implosion has now worked its way through the system with greater intensity. Given a deepening housing slump, the situation is set to deteriorate further. Of the huge increase in sub-prime mortgages that were issued in the last few years, most were set at an enticing low fixed interest rate for two or three years, after which a much higher variable rate would apply. That changeover is expected to peak this year, precipitating many payment defaults and foreclosures. Notwithstanding a series of aggressive rate cuts and recent fiscal stimulus measures, the sub-prime debacle will continue to drag the US economy into a recession, pulling the rest of the world with it.

In addition to a shift in interest-rate differentials, the dollar will be under pressure from the "carry trade" - the practice of borrowing in a currency with low interest rates and investing the proceeds in a higher-yielding currency or asset. With a drastic cut in interest rates in the US the dollar risks becoming a funding currency for this carry trade. The trade will create a downward drag on the dollar since the manoeuvre involves selling dollars to use the proceeds elsewhere. The last time the greenback was used for so-called carry trades was in 2004, when the Federal Reserve slashed its fed funds rate to 1 per cent.

While the Swiss franc, the yen and the Taiwanese dollar remain the vehicles of choice for financing purchases of high-yielding currencies such as New Zealand and Australian dollars, the greenback has increasingly become an attractive alternative for both investors and speculators. With the tendency for the dollar to fall further amid the prospect of a further decline in interest rates in the US, investors could profit from a combination of both the interest-rate differential and foreign-exchange gains.

The dollar also faces pressure from reserve diversification by major Asian central banks. The eight largest Asian central banks - China, Japan, India, Taiwan, South Korea, Singapore, Hong Kong and Malaysia - combined hold approximately US$4 trillion (Bt127 trillion) in foreign currency. These reserves are the product of accumulated current-account surpluses, foreign direct investment, and central bank interventions. As for China, they also represent large capital inflows that reflect speculative bets on a revaluation of the yuan. The motives to diversify are growing, especially a desire to achieve a better return on their reserves, which are mostly invested in highly liquid but relatively low-yielding Treasuries.

The notion that central banks would search for returns is a relatively new and somewhat controversial one. Central banks traditionally keep foreign reserves for rainy-day purposes, such as bolstering the currency in the event of an attack or supporting the local banks if there are sudden withdrawals. With reserves today at unusually high levels, central banks are increasingly under pressure to invest them in a more productive manner.

Not only are Asia's central banks diversifying out of their large holdings of US debt, other entities such as pension, insurance and mutual funds in the US are increasingly diversifying away from the dollar. So are central banks in the Middle East and certain oil-exporting countries, which have increasingly shifted a big chunk of their wealth from dollar-denominated investments.

While the recent narrowing of the US trade deficits and the surge in foreign direct investment from several sovereign wealth funds - particularly those from Asia and the Middle East that infused substantial amounts of cash into US financial institutions struggling with the fallout from the housing crisis - will help support the dollar, they pale in comparison with a host of other factors. Until the US economic downturn and housing slump show signs of bottoming out, the dollar will remain under pressure as further deterioration could prolong the interest-rate cutting cycle till the end of 2008 and beyond.