Dollar in focus as world leaders meet

LONDON — Investors will be keeping a close eye on how far world leaders will go in expressing support for a strong dollar at the Group of Eight summit in Italy, amid talk that the dollar’s status as the world’s reserve currency will be on the agenda.

China, Russia and India have indicated that they want to see long-term changes in the international monetary system in the wake of the financial crisis that has pushed the world economy into its first synchronized downturn since the Second World War.

But they have been careful to not push their desire for change too far — in case the dollar slumps and the value of their large dollar-denominated investments plummet.

“The bottom line is that a weaker dollar is in nobody’s interest,” said Neil Mackinnon, chief economist at ECU Group, a currency hedge fund management firm in London.

The short-term result may be statements to support the dollar, while developing countries think long-term about ways to diversify their holdings away from it. China and the biggest developing countries have limited participation at the G-8, which are Britain, Canada, France, Germany, Italy, Japan, Russia, and the U.S.

A sliding dollar would have massive repercussions for the world economy as it looks to emerge from one of the most savage recessions in generations, which has seen global trade collapse by up to 20 percent.

It would be bad for global growth as it introduces uncertainty into the financial markets as well as reining in the purchasing power of U.S. consumers given that a weaker dollar increases the value of imported goods. It would also raise the value of commodity prices, such as oil, that are priced in dollars, and make it far more difficult for the U.S. to fund its deficits as investors would be wary of buying up U.S. Treasury debt.

Moreover, a falling dollar would hit big holders of dollars, such as China and Russia. In recent weeks, China, which holds around $2 trillion worth of reserves, mainly in dollars, has been particularly wary of undermining the U.S. currency by any loose talk about diversifying its reserves.

“They have a strong interest in avoiding any action that would undermine the dollar’s value,” said Stephen Lewis, economist at Monument Securities.

Partly as a result, the dollar has held up well in the foreign exchange markets over the last few weeks, with the euro trading in a narrow range around $1.40 and the pound dropping back from recent highs. However, the yen has garnered some support over recent weeks as the stock market rally came to an end — the Japanese currency is widely considered a barometer of risk appetite in the markets in general.

Investors will be particularly interested to see what the world’s leaders say about the dollar both in Friday’s communique that follows the three-day meeting in L’Alquila and in the ensuing press conferences.

In particular they will be looking to see whether the language goes beyond the generally banal insistence that G8 leaders want to avoid “excessive volatility” and “disorderly price action.”

Though the communique may not have any specific mention about the dollar’s future as the leading reserve currency, talk of reform of the international monetary system is unlikely to go away.

In fact, there’s likely be some important chats in the earthquake-ravaged town of L’Aquila about the need for addressing the huge trade imbalance between the U.S., the world’s biggest economy and consumer of goods, and China, the world’s fastest growing major economy.

“Whether China’s leaders really want to see the end of global imbalances that benefit their producers is probably a consideration prompting them to proceed cautiously in pressing for currency reform,” said Lewis.

Thursday could be the most important date for currency markets, as working sessions take place throughout the day between the G8 and several developing countries.

Geoffrey Yu, an analyst at UBS, said he expects Russia to align itself with the world’s major reserve holders in these meetings and that markets will be interested in whether the BRIC nations (Brazil, Russia, India and China) put forward any concrete proposals for reforming the international reserve system.

“It is unlikely the matter will end up in the final communique,” said Yu. “China is the main player in the debate and has pledged to be a stabilizing force since well before the April G20 summit in London.”

At their meeting last month, the BRIC countries surprisingly did not include any reference to reserve currencies, stoking speculation that the leaders could not find common ground beyond recognizing the need for reform.

China has at least made some noises about what a future viable alternative would be — the International Monetary Fund’s special drawing rights, or SDRs, should be developed as a unit of value that could be used in settling international balances.

SDRs are an IMF-backed money equivalent that can be exchanged for hard currency, and their expansion at the G20 meeting of world leaders in London in April allowed IMF member states greater access to liquidity.