The initial reaction of the stock market was favourable. For the first time since May 2002, the Dow Jones industrial average rose above 10000 . But soon the initial enthusiasm disappeared and at the close of the day, the index fell by 0.42 per cent. Next day it again went over 10000 points. If the reaction of the stock market was not consistent, the news created a havoc in the foreign exchange market. The euro hit a new high of 1.23 against the US dollar (more than 44 per cent rise since the euro was launched). The sterling reached its highest level against the dollar in eleven years and the yen also reached its highest level in three years and gold prices shot up to $407 per ounce.

Now one may well ask, why are we making all this fuss over the exchange rate problem of one single currency? What is so earth-shattering about the news of the plunging dollar? Why is it so important to monitor the movement of dollar in the foreign exchange market? The importance of the exchange rate of the dollar against other currencies is due to three factors : that dollar is the currency of the world's number one economy and that since the end of World War II the US dollar has become the only major currency in which most of world's financial transactions are made and the economic data stated. The other important point about the US currency is that most of the foreign exchange reserves of central banks are in dollars. According to the IMF, at the end of September 2003, the central banks held $2.9 trillion of foreign-exchange reserves of which approximately 67 per cent was in dollars. No wonder, " the strength of dollar affects trade balances, capital flows, growth rates, profits, share prices, inflation rates, interest rates and even the relative size of economies" of the world (The Economist).

Actually the price of a foreign currency is largely determined by the forces of supply and demand, hence the importance of having a surplus or a deficit on the current account. Persistent current account deficit of a country creates pressure on its currency. The current account deficit of the United States now stands at 5 per cent of GDP, which can be considered as high by any standard and it is financed by borrowing from the rest of the world. (The US needs $50 billion dollars a month in capital inflows.) Now the question is : If the dollar is plunging and the interest rate is so low why does the world lend money to the United States? In simple terms it can be described as a confidence trick. First of all, the sheer size of its economy inspires confidence. And second , since the United States has become the only remaining super-power of the world and in its external relations it behaves as such, the lenders believe that it will somehow manage to get out of its financial difficulties and will not default. However, if the United States continues to have huge federal budget (created by Bush's reckless tax-cut policy) and current-account deficits, its debt burden will grow, which in turn will erode the confidence of the market . As a consequence the dollar will keep falling in the foreign exchange market and interest rates will rise in the United States.

On the other hand , a weak dollar makes American products cheaper. Therefore, it should benefit its export market, which would give a much-needed boost to the American economy. This eventually would create jobs. (According to some sources, during Bush's presidency American economy has lost several million jobs.) Since it would make imports from other countries more expensive, it should also help its balance of payments on current account by putting a brake on profligate consumerism of its people. (Yet, this profligate spending habit of the Americans has to a great extent been responsible for the export-led economic growth in many parts of the world among which South and East Asia figure prominently, where foreign investments are pouring in, employment is rising and technology is advancing.)

What is the current situation of the American economy? According to government sources, GDP grew by 8.3 per cent in the third quarter and company profits rose dramatically. Can we trust these figures? Has the GDP been manipulated ? Have the profit figures been massaged ? Given the Bush administration's reputation as spin masters, the doubts seem reasonable. As mentioned in the Economist of November 22nd 2003, "a few economists argue that America's growth is also partly phantom, because of the way inflation is measured". Last year's accounting debacles and this year's stock exchange scandals do not help matters. According to the University of Michigan, consumer confidence dropped to 89.6 per cent in December from November's 93.7 per cent. Inflation remains under control. Although the employment situation improved slightly, experts agree that since most of the productivity growth is technology-driven, American economy is not in a position to create millions of jobs in the near future.

While the export-led economies of East Asia are booming (their central banks have been buying dollars to slow down the appreciation of their currencies against the dollar, the currency of their prime export market) and although overstated, the American economy is also growing, the EU is fighting to hold off recession. Experts have been forecasting a modest annual growth in 2003. Exports rose by 2.2 per cent in the third quarter. The European Commission forecasted a further growth in exports. But now the rise of euro against dollar will make it very difficult to achieve this goal. The EU central bank may be forced to cut its benchmark interest rate. As far as the foreign exchange reserves of central banks are concerned, because of the uncertainty about the recovery of the American economy in the near future and also because of the falling value of dollar, they have already started moving away from dollar to euro . While at the end of 1999 only 12.7 per cent of the reserves was in euro, at the end of 2002 the figure went up to 18.7 per cent. In 2003, there has been a further shift to the euro. It is difficult to imagine the disastrous consequences (first, for the American economy) of a sudden decision of the Asian central banks to shed a large chunk of their enormous dollar reserves.

Even if, in a year or two, the US can manage to correct its current account deficit by exporting more and controlling its citizens' spending spree and even if, in the same period of time, it can manage to reduce its budget deficit by increasing taxes and pruning government expenditure, for the sake of long-term stability of the world economy, the central banks and the investors should restructure their currency reserves and portfolios by concentrating less on dollar and more on diversification.