The dollar is all but fated to weaken as long as the US current account deficit remains wide, analysts say, but the question that worries traders and policymakers is how fast that decline will be. The dollar has weakened steadily in recent months even as the US economy improves and interest rates rise, bringing its losses since early 2002 to 15 percent against a basket of currencies and more than 30 percent against the euro.
Analysts blame the widening US current account deficit.
As the deficit widens, more dollars must flow into the country in the form of portfolio inflows. If inflows are not large enough to offset the dollars going offshore to buy foreign goods, the dollar will decline.
"The problem with the current account gap is that its financing depends on the whims of others. And that has a high price that must be paid either with a lower dollar or with higher interest rates to attract investors," said Alan Ruskin, research director at 4Cast in New York.
A lower dollar helps exporters but hurts consumers and businesses that import inputs. It also erodes the foreign-currency value of US assets, depressing foreign investment.
For many years, foreign investors and central banks have been willing to finance the gap through purchases of US assets like stocks and bonds.
For many central banks, particularly in Asia, buying US assets has had the bonus of keeping their currencies depressed against the dollar, spurring exports.
But central banks won't pick up the slack forever.
"The Bank of Japan and other Asian countries don't have to keep their currencies artificially weak to the extent that they have been doing in the last year and a half because growth prospects are improving," said Bob Lynch, currency strategist at BNP Paribas in New York.
With the need to prop up their currencies diminishing, the central banks would be more eager to pursue diversification of their portfolios, especially in an environment where a weakening dollar lowers the value of US holdings.
"If everyone thinks the dollar is going to weaken and you have 60 to 90 percent of your reserves held in dollars, maybe you want to shift that reserve balance," said Lynch.
Michael Englund, chief economist at Action Economics, said there were already signs that Japan, a major holder of US securities, was becoming a less willing buyer.
China, meanwhile, was expected to cut dollar holdings as it inches toward a more flexible currency regime than its current policy of pegging its yuan to the dollar.
"If the Chinese and Japanese authorities are willing to accept a weaker dollar, it is unlikely that other central banks will be willing to completely fill the capital account void," said Englund.
The US current account deficit, the broadest measure of US trade because it includes investment flows, was running at a $664 billion annual rate in the second quarter, or nearly 6 percent of gross domestic product.
TOO MUCH, TOO FAST: While the US Treasury has staunchly maintained its strong dollar policy, many international policymakers - as well as some members of the Federal Reserve - have acknowledged that a weak dollar is necessary to right global imbalances.
The worry is that the dollar will fall too fast.
"The concern is that the dollar decline gets so rapid that it becomes a one-way street and undermines the faith in US assets," said Sean Callow, currency strategist at IDEAGlobal in New York.
The composition of the decline also matters.
Up to now, the euro has borne the brunt of the dollar's fall, partly because the currencies of a number of the United State's main trading partners, notably China, are pegged to the dollar or closely managed, a development that has started to trouble European leaders.
"Europe doesn't want a 15 percent trade-weighted decline in the dollar to be a 35 percent decline in the euro and no change in the Chinese yuan," said Callow.
The United States has been pressuring China to liberalise its currency regime.
Slower US growth or faster, domestic-demand led growth among its trade partners would also help cut the US trade gap. But Ruskin of 4Cast said don't count on this.
"If you are looking at the same dollar rate and the same relative growth rates, the US is heading for current account deficits of 7 to 8 percent of GDP. A lot of central bankers have also done this arithmetic, and that's why they have been fairly tolerant of dollar weakness," he said.