US Federal Reserve Board chairman Ben Bernanke on Tuesday broke with a long-held convention and discussed the Fed’s concerns over the declining US dollar (see also Dead dollar sketch, Asia Times Online, March 4, 2008).

Typically, only the US Treasury, now led by Hank Paulson, is supposed to talk about the dollar, but then again perhaps the Fed chairman was peeved with his counterpart’s lack of enthusiasm for pushing up the US currency. In any event, the scuttlebutt in Washington has been that Paulson is too busy interviewing for Wall Street jobs that may see him emerge as the head of a banking colossus early next year; with time running out on the Bush administration he doesn’t have long before facing the risk of joining the unemployment queue himself.

Going back to Bernanke’s verbal intervention on Tuesday morning, seeing as it was the Fed that was doing the talking up, the markets immediately responded by buying the US dollar and driving it up against Asian currencies such as the Japanese yen as well as against the euro over the day. Curiously, the stock market was falling through this period, led by financial stocks as concerns mounted that another investment bank – market speculation focuses on the smallest one, Lehman Brothers – had to borrow from the Fed (denied by the company) and would likely have to shore up its capital (not denied). On Tuesday alone, Lehman saw its share price fall almost 10%, pushing overall financial stocks down by 2% for the day.

Even bigger commercial banks such as Wachovia have fared poorly in the markets of late, highlighting the shift in market concerns from the over-leveraged investment banks to the wider financial system, as it confronts mounting defaults from mortgage borrowers, and increasingly on consumer finance products such as credit cards. All this bodes ill for the sector at large, suggesting that the time for them to go around hat in hand for more capital (yet again) is not that far away.

The combination of the Fed intervention and swooning financial stocks does not in my mind present a coincidence. It appears quite likely that the Fed is well aware of brewing problems at one or more investment banks, and seeing as these banks would need to raise capital once again in the next few weeks the central bank may well have seen the need to shore up confidence in the United States as represented by its benchmark, the dollar. Think about it like this: a falling dollar implies lower valuations for American stocks, but also higher investment risks for anyone considering investments in US financial companies.

Lastly, given rising inflation in the US, the Fed has limited ammunition to help its financial sector with further rate cuts. At the most, it could try to push through one more rate cut, but with most of the world’s large bond managers warning about the poor value of US Treasuries at current yields, such as a cut could have the perverse effect of increasing bond yields as markets show dissatisfaction with the central bank.

It is believed by some in the markets that various sovereign wealth funds contacted the US administration in recent weeks to ask about how serious problems in the financial system were likely to become, and more importantly about the outlook for the US currency.

In turn, the weakness of the currency has been the key driving force of oil prices that have had the deleterious effect on inflation across Asia, for example. To a large extent, the discussions may well have emanated from the constant US prodding for Asia to change its currency policies to allow greater appreciation against the US dollar.

Markets and inflation

This is where the story becomes a tad more complex, particularly for Asian central banks still living in the previous century. There is still talk in the region of “allowing” their currencies to appreciate, but most central bankers in the region have lost this window in the past few weeks. Inflation reports from across the region have been horribly high, with many countries showing double-digit year-on-year increases, even after all the “adjustments” on calculating inflation baskets. What you and I in plain terms would call lying.

On the other side of the coin, growth has been falling around the region as well. This combination of higher inflation and lower growth is what is known in economic circles as stagflation, and is clearly something you would want to avoid as part of any legacy. However, I would argue quite strenuously that Asians have missed the boat completely in terms of controlling the inflation problem.

Additionally, the flow of hot money into Asia has been slowing dramatically in the past few weeks, as shown in falling stock markets and rising interest rates in regional bond markets. This presents a headache for governments, as interest costs are rising alongside falling tax revenues, essentially pushing most towards larger fiscal deficits for the current year. Meanwhile, rising oil and commodity prices alongside falling export demand particularly from the US means that current accounts for most Asian countries are also likely to tip towards deficits by the third quarter of this year.

Vietnam represents a cautionary example for all Asian governments. The country attempted to fight market attempts to push the value of its currency, the dong, higher. This was “achieved” by strong-arm tactics, including the arrest of some bankers, and pushing through drastic limitations on foreign investors. Stuck with a number of their investments, foreign investors have pushed up Vietnam’s credit costs in external markets, by more than 100 basis points in the past two weeks alone, essentially rendering any recourse to such financing untenable for the country. Meanwhile, the loss of investor confidence has pushed stock markets into a downward spiral, with the benchmark index falling every day in May (absolutely unprecedented anywhere in the world).

This is the problem with traditional Asian responses to market forces, dictated as they are by communist ideology rather than rational understanding. The fallout from Vietnam is quite negative for smaller Asian economies, such as the Philippines, as it shows the limits of market patience with such government shenanigans. A rising US dollar would make matters worse for Asia in the short run, by creating greater inflation and sharper declines in household wealth, even as the concurrent benefits on exports fail to materialize thanks to a US recession.

In such a situation of rising budget deficits and falling current accounts, Asian governments will need to put their resources (and reserves) to better use, namely to buy essential commodities as well as to stockpile food. This would help to stabilize prices across Asia and ensure that there is no consumption bust in coming months. At that point, relative economic strength against the US can be used to argue for rising currency values, and therefore falling inflation for the region. This does depend on the first steps being successful, namely that inflation is brought under control.

The Fed would much rather that Asian central banks instead used their cash to buy stakes in US financial firms, even if (or more likely because) that guarantees billions in lost value over the next few years. Bernanke’s Fed pines for the near-distant past, when compliant Asians simply bought US financial paper that helped to generate economic growth in the country and also provided supplemental benefits for Asians in the form of rising exports. Unfortunately, those days are well behind us.