DOLLAR WEAKEN ON FEARS GULF WILL ABANDON

TEP - 15 November 2007

Pegs policy becoming untenable as oil-rich states face soaring property and food prices, writes Ambrose Evans-Pritchard

The dollar has slumped again on fears that the oil-rich Gulf states will ditch their US currency pegs, setting off a massive realignment of the global currency system and a flight from dollar assets across Asia.

Sultan Nasser al-Suweidi, the central bank governor of the United Arab Emirates, warned that Gulf states may have to defend themselves against imported US inflation.

"The dirham's peg to the US dollar has served the economy of the UAE very well in the past. However, we have reached a crossroads now with a further deterioration in the US dollar," he said.

The Gulf region has some $3,500bn (£1,690bn) in central bank coffers and wealth funds, so any shift in strategy could have a major impact. Kuwait has already ditched its peg, and Qatar's $50bn wealth fund has slashed its dollar share of its holdings from 98pc to 40pc.

Others have hung on to their pegs but the policy is becoming untenable amid rocketing real estate and food prices.

Inflation has reached 4.9pc in Saudi Arabia and 9.3pc in the UAE. Both have refused to follow the Federal Reserve in cutting interest rates, but this has drawn a flood of hot money into their economies.

Robert Mundell, a Nobel economist and currency expert, said the scare of a dollar collapse was overblown. "We may be close to the bottom," he said. "The dollar will remain the anchor of the world's currency system unless the US makes some catastrophic errors.

"The dollar has problems, but the euro also has problems, and these are structural. They are part of the euro's genetic make-up," he told Italy's Il Sole.

Prof Mundell, known as the "father" of the euro, said the single currency's relentless rise is splitting the eurozone in two.

"Germany has been able to cope with the dollar crisis through a strong export recovery. But the situation is becoming critical in France and Italy," he said.

For now, the markets seem determined to overlook the euro troubles and drive the dollar lower, betting that a series of Fed rate cuts will lead to a further exodus from the US.

"We're seeing the sort of total capitulation sell-off you have at the end of every bear market trend," said David Bloom, head of currency at HSBC.

The biggest worry now is that a flight to the yen could lead to an abrupt reversal of Japan's $1,200bn ''carry trade", draining liquidity from global asset markets.

The yen strengthened violently on Monday in moves that recalled the ructions of the Asian crisis in 1998.

It has appreciated from 124 yen to 110 yen against the dollar since July.

Japan's premier, Yasuo Fukuda, halted the moves yesterday with a loud warning to hedge funds. "Speculative movements need to be kept in check. What I am saying is: 'Be careful'," he said.

Hans Redeker, currency chief at BNP Paribas, said that the intervention threat had no bite without help from the EU and America, who both want the yen to strengthen.

In any case, a shift in the tectonic plates of Japanese investment world may now push the yen much higher.

Tokyo's insurance companies and pension funds tend to track the gap in yields between US three-month bills and 10-year Treasuries. This has reached 50 basis points and is growing fast.

As the yield curve "steepens", Japanese firms buy hedges that drive down the dollar. Although this complex pattern is little understood in the West, it can have powerful effect on global markets.

"This is the real reason why the yen is rising. It will reduce liquidity. We remain ultra-cautious on share markets," said Mr Redeker.