Capital flows vital

The capital account trends will remain important for the U.S. currency. The Homeland Investment Act (which temporarily removes the disincentive for U.S. businesses to keep offshore profits offshore for tax purposes) will continue to provide tax breaks for capital repatriation back to the U.S. until the end of 2005. The lower tax rate will encourage a flow of funds back to the U.S. during the fourth quarter and offer important balance of payments support.

There is, however, likely to be underlying reserve diversification away from the U.S. currency and, with direct investment flows still weak, the dollar will be more dependent on short-term capital inflows to avoid depreciation. The most recent capital flows data has been encouraging, with net inflows of $91.3 billion for August supported by strong flows into U.S. bonds. Inflows at this level would alleviate short term financing concerns and underpin the dollar. The overall risks are, however, likely to be asymmetrical given the wide current account deficit and likely drop in official inflows.