Waning Days Of The Dollar.(Global Investor)

The U.S. dollar took another big hit last week, not only because of more news around subprime mortgage losses, but also thanks to comments from a Chinese official that the country has a "very clear plan" to diversify its currency reserves. Most economists believe that further weakness lies ahead, and one of the big questions is how this will affect consumers and investors around the world.

The dollar's decline is part of a much larger and more consequential rebalancing in the global economy, the impact of which will differ significantly from country to country. With the United States continuing to run a large trade deficit, the depreciation of the dollar is largely unavoidable over the medium term. Moreover, investment flows into dollar-denominated bonds are likely to slow as the Federal Reserve continues to cut interest rates and, more generally, the U.S. financial system works through the damage from the subprime debacle.

So far, the dollar has fallen by about 40 percent since its peak around five years ago. This is warranted not only by the payment imbalances, but also because the dollar has started from such a position of overwhelming dominance in the portfolio allocation of large institutional investors around the globe, including many central banks (most notably Japan, China and oil producers in the Middle East). This makes it vulnerable to a process of portfolio diversification that will accelerate as these investors seek to mitigate their concentrated currency risk.

The impact of the fall will vary widely. At the moment, it is most acutely felt in Europe, where the euro has surged to record levels against the dollar. No wonder European exporters complain of competitive pressures while European tourists are flooding the United States.

The phenomenon is less pronounced in Asia. There, the basket of 10 Asian emerging currencies has appreciated just 16 percent against the dollar in the last five years. The resulting depreciation of Asian currencies versus the euro has bolstered already-robust Asian exports.

How will a weaker dollar affect Americans? The most immediate impact of the dollar's fall is being felt through the related surge in oil prices and other raw materials. As these higher costs make their way through the production chain, they will result in declining profit margins, price inflation and greater pressure on wages. This will further complicate the job of the Federal Reserve, accentuating the trade-off between containing inflation and avoiding a sharp economic slowdown.

What explains these striking ...