A dollar of dangerous strength:
The US currency is creating policy problems around the world
Financial Times; Apr 5, 2001
By Alan Beattie and Christopher Swann

For years, most economists assumed that when US share prices fell, the dollar would come down with them. But though the dollar's main prop is being chipped away week by week, the currency has taken on a life of its own. Its continuing strength could not only make global economic imbalances worse but also mean any eventual correction is sharper and more damaging.

The US last year needed a net inflow of more than Dollars 400bn - equal to 4.4 per cent of gross domestic product - to fund its current account deficit. Such giant flows of capital, it was almost universally believed, would continue only if equity markets continued to rise and US bonds offered greater returns than assets elsewhere. Without capital flows propping it up, the dollar would surely slide.

But for the moment, the currency is defying gravity. The S&P 500 has fallen 16 per cent since the beginning of the year, compared with a 13 per cent fall in the FTSE Eurotop 300 and a small rise in Japanese stocks. Meanwhile the difference between yields on US and euro-zone two-year bonds - US yields were more than 1 percentage point bigger late last year - has disappeared.

By contrast, other currencies with yawning current accounts to support, such as the Australian and New Zealand dollars, have fallen sharply.

The US dollar's recent rise against the yen is understandable, given the Bank of Japan's commitment to monetary easing. But convincing explanations for its strength against other currencies, especially the euro, are becoming harder to find.

The three explanations often given - safe-haven flows, longer-term confidence in the US and structural factors - seem unlikely to survive a prolonged bear market in US equities.

The idea of a flight to safety is hard to argue: the financial turmoil largely emanates from the US, making the dollar an unlikely refuge. More persuasive is the second explanation, that investors believe falls in US markets will be short-lived.

"Looking forward 18 to 24 months, earnings expectations for the US remain at very lofty levels, significantly above those for European companies," says Avinash Persaud of State Street, the Boston-based investment bank. "Optimism that the market will rebound quickly, though probably misplaced, is the cornerstone of the dollar's strength."

Non-US investors purchased a net Dollars 23.9bn of US equities in January, the latest month for which data exist. Meanwhile, in four of the six months to January, US investors were net sellers of overseas shares.

Part of this trend may be one-off transactions as US investors liquidated European shares they received during the recent merger and acquisition boom. In the past three years US investors have received Dollars 303bn worth of European shares in payment for US companies. "US investors never chose to buy these shares," says Paul Meggyesi, director of foreign exchange at Deutsche Bank in London. "Even though US shares may be falling slightly faster, US investors may be disposing of 'involuntary' holdings first."

Sales of European equities may also reflect frustration at the refusal of the European Central Bank to cut interest rates. "There is a belief that the US slowdown has been globalised by the policy intransigence of Europe and Japan," Mr Persaud argues.

The final explanation is a structural demand for US equities irrespective of market movements. As restrictions are lifted on where European pension funds can invest, the argument runs, demand for overseas equities will rise - and investors will turn first to the US.

But these motives are unlikely to put a floor under the dollar for much longer unless US growth starts to recover. Even if structural demand for US equities has increased, investors are unlikely to keep buying heavily into falling markets.

Strategists are almost unanimous that the dollar is overvalued. Consensus Economics, an economic pollster, says the average prediction is for the euro to rise towards 1:1 parity with the dollar by the summer.

Without such a correction, the dollar's strength is creating policy problems and exacerbating imbalances around the world. At home, it means the weakness of domestic demand is compounded by US exports becoming less competitive, threatening continued large trade deficits and further falls in business confidence.

In Japan, business leaders - in spite of the benefits of a stronger dollar for their exports - are warning that a further sharp drop in the yen could cause a sell-off in Japanese assets, whose yields are low, damaging confidence. Hiroshi Okuda, chairman of Toyota and head of the national federation of employers' associations, said yesterday: "Yen weakness to beyond Y130 (against the dollar) should draw caution. We need to be careful if the yen's current weakness results from a move to sell Japan."

His caution is echoed by east Asian emerging market countries such as Korea and Taiwan, which have been forced to let their currencies follow the yen lower against the dollar rather than lose competitiveness.

In Europe, to which most of the world is looking to take over from the US as importer of last resort, Giles Keating at Credit Suisse First Boston warns: "The weak euro is acting as a drag on the ECB's ability to cut interest rates and that is not helpful." And for countries such as China and Argentina, which maintain pegs against the US currency, dollar strength means a continued struggle to export to the rest of the world.

Most economists agree that the best route for the dollar would be a gentle depreciation that allowed investors steadily to reposition themselves and the trade imbalance between the US and the rest of the world to adjust smoothly.

Extreme and rapid moves in currencies, such as the sharp dollar-yen swings during the Asian crisis, contribute to a drying up of financial markets and uncertainty among companies, investors and consumers. But the longer the dollar goes on defying gravity, the greater the imbalances become and the further and faster the currency may have to fall.

Mr Keating, one of the more optimistic on this front, says that with alternative investment opportunities such as Japan unattractive, the dollar has a window of opportunity to effect a soft landing that may last for the rest of the year.

But the window will not be open for ever. And as Paul Donovan, international economist at UBS Warburg, says: "A 10 per cent decline in the dollar over the next six months would be advantageous. A 10 per cent drop in the next 24 hours would be a crisis."