Dollar's Wobbly Foundation Becomes Apparent: Caroline Baum
By Caroline Baum
New York, May 29 (Bloomberg) -- The U.S. dollar has been defying the odds for some time now. As the current account deficit reached and breached 3.5 percent of gross domestic product in 1999 -- shortly after the introduction of Europe's common currency to wild acclaim -- reports of the dollar's demise were rampant.
Instead, the dollar went right on strengthening -- up until the early part of 2002. Hedge funds have battle scars to show from their various campaigns against the dollar -- short dollar/long euro positions -- during the past three years. Currency analysts have egg on their faces as well.
One reason the dollar refused to succumb, especially in the last year, to low real interest rates and negative stock market returns was that the alternatives were so lousy. Japan can't seem to do anything right 12 years after its asset bubble burst. Europe is still shackled by regulation and taxation.
So despite the fact that an investor wasn't getting paid to put money in the U.S., he seemed to have faith that the U.S. had the right stuff to produce higher returns in the future. Investors put a higher priority on the dynamic, to-be-delivered future of the U.S. than on current meager returns.
The Federal Reserve's trade-weighted dollar index hit a 15 1/2-year high in late January and has slipped 6.25 percent in the last four months. Not a big deal in the grand scheme of things: the trade-weighted dollar is still 28 percent above its 1995 low.
Capital Account Driver
The fact that the dollar was rising while the current account deficit was growing suggests foreigners were eager to send capital here.
``As long as investors prefer to hold dollar-denominated assets, a huge current account deficit doesn't necessarily have negative implications for the exchange rate,'' says Joe Carson, an economist at Alliance Capital Management. ``The expected returns on real and financial assets take center stage in determining the value of the dollar.''
When the capital account is driving the current account -- when the foreign inflow of dollars provides the grist for U.S. purchases of goods and services overseas -- there's no need for an adjustment in the exchange rate. The country on the receiving end experiences ``higher financial asset prices and lower interest rates'' than it would otherwise, Carson says.
When capital flows start to waiver, however, it manifests itself in a weaker exchange rate.
Contrarian Alert
Analysts are currently united in the view that the dollar is set to fall; the only question is how far and how fast. While such unanimity of opinion is generally a red flare for contrarians, the dollar does seem to have lost its supports. Or, more correctly, the foreign-exchange market collectively has just started to acknowledge the wobbly pegs.
``The last time the U.S. economy started a recovery with very low real interest rates and relatively high P/Es was in the early 1960s,'' Carson says.
Back in those days, the U.S. was a capital exporter, Carson says. Now the U.S. needs to attract more than $1 billion a day at a time when interest rates are low both in absolute terms and relative to those of our trading partners.
``You can earn 100 basis points more on a German two-year note and 160 basis points more on a UK two-year note than you can in a two-year U.S. Treasury note,'' he says.
Similarly, the price-earnings ratio on U.S. stocks is high both in an absolute sense and when compared with the P/Es of foreign stocks, Carson says.
Policy Tools
One way to ``fix'' the current account deficit, which totaled $417 billion last year, is by slowing domestic demand via fiscal and monetary policy.
``With the proper policy adjustments, the decline in the dollar would be orderly,'' Carson says. ``Without it, the risk is that it won't. Look what happened in Asia'' in 1997.
Alas, fiscal policy is in full expansion mode while the Federal Reserve isn't going to raise rates until it absolutely has to.
While the reduced demand for dollars is evident from the slowdown in foreign direct investment in the U.S. -- FDI slowed to $179 billion in 2001 from $288 billion in 2000 and $301 billion in 1999 -- the increased supply of dollars is starting to manifest itself as well. The Fed printed gobs of money last year and has shown no interest in removing even the post-9/11 emergency stimulus.
No Present Value
The 17 percent rise in gold prices since the trade-weighted dollar peaked suggests to Carson a shift in global preferences in favor of hard assets.
Not everyone is convinced the dollar's demise is at hand.
``Why now?'' asks Jim Glassman, senior U.S. economist at J.P. Morgan Chase. ``Why not last year? It's hard to find a region that will outperform the U.S.''
Carson says investors don't buy GDP or profits. ``They buy credit-market instruments, stocks and companies.''
The long-term growth dynamics may be stronger here than they are in Europe or the rest of the world. Still, a bright future doesn't negate the fact that ``capital inflows have driven asset values to levels not supported by fundamentals,'' he says.
The foreign-exchange market is coming to grips with that reality. |
