updated 10/7/2010 4:56:10 PM ET 2010-10-07T20:56:10

Fears of a full-blown currency war flared Thursday as the dollar fell to an eight-month low against the euro and the U.S. stepped up pressure on China to let its currency rise.

The escalating tension threatened to dominate a three-day conference of the International Monetary Fund and the World Bank. Leaders from both groups warned Thursday that a currency war could destabilize global financial markets at a fragile moment.

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The flare-up comes as investors are anticipating the Federal Reserve will pump billions more dollars into the U.S. economy. That is weakening the value of the dollar against the euro, which has been surging.

A falling dollar can hit U.S. consumers, investors and businesses in various ways. Travel to Europe becomes more expensive for Americans. Exports from U.S. businesses become more affordable for European buyers. U.S. Treasurys become less attractive to investors.

A different scenario has been playing out with China. An undervalued Chinese yuan has weakened U.S. exports while making Chinese goods attractive to U.S. consumers. The imbalance has weakened U.S. economic growth. And it threatens U.S. manufacturing jobs at a time when the American economy is struggling with 9.6 percent unemployment.

At the same time, China's economy is soaring.

World Bank President Robert Zoellick said Thursday that the tensions over currencies could undermine investor confidence at a time when the world needs the private sector to bolster growth.

"If ever there were a time that we should not turn our backs on international cooperation, it is now," Zoellick said at a news conference ahead of three days of high-level talks on global finance in Washington.

Economists said they don't expect major breakthroughs coming out of the weekend meetings. Countries are feeling so much pressure to produce jobs by boosting exports. One way to do that is by lowering the value of the country's currency.

China is hardly alone in trying to gain a competitive advantage. The United States is contributing to a weaker dollar by pressuring Beijing and by having the Fed flood the markets with U.S. dollars.

The Japanese government intervened in currency markets for the first time in years on Sept. 15. It sold yen and bought dollars to push the yen's value lower. And this week, the Japanese central bank announced that it would pursue a policy similar to the Fed's: Buy assets to lower Japanese interest rates, another way to lower the yen's value.

Brazil and South Korea have also taken recent actions to weaken their currencies as a way to protect their exporters.

"The global economy is struggling right now after a very deep recession. Everybody wants to grow through increasing their exports," said Sung Won Sohn, an economics professor at the Martin Smith School of Business at California State University. "I think we will see more currency tensions and trade tensions."

High unemployment in the United States and many other nations could pressure leaders to establish trade embargoes that could further strain the global economy.

Already, the U.S. House has approved legislation that would allow for economic sanctions on China and other countries found to be manipulating their currencies to gain trade advantages.

The legislation is not expected to pass the Senate this year. Still, the Obama administration has responded by increasing pressure on Beijing in the weeks leading to congressional midterm elections. Those elections are shaping up to be a referendum on Democrats' handling of the economy.

American manufacturers would like to see the dollar fall by as much as 40 percent against the yuan. The administration is hoping this change will give a boost to U.S. manufacturing jobs.

The U.S. plans to make currency values a dominant topic at the IMF-World Bank meetings this weekend. It will also raise the issue during sideline discussions among the Group of 20 major economies. That group of rich nations and major developing countries includes China.

Chinese officials have reacted strongly to the stepped up U.S. pressure. Prime Minister Wen Jiabao said Wednesday that "if the yuan is not stable, it will bring disaster to China and the world."

IMF Managing Director Dominique Strauss-Kahn and Zoellick said a compromise solution to the currency dispute would reassure financial markets.

Strauss-Kahn suggested China needs to move faster to address concerns about its undervalued currency if it wants more influence at the IMF. He echoed comments Wednesday by Treasury Secretary Timothy Geithner.

"If you want to have more say, more weight in the IMF, then you need to take more responsibility in the stability of the system," Strauss-Kahn said when asked about Geithner's speech Wednesday at The Brookings Institution.

The Associated Press and Reuters contributed to this report.


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