Dollar's weakness could burst bubble of US expansion
The recent launch of Europe's new currency, the euro, has overshadowed a more worrying currency upheaval - the faltering of the dollar
A weak dollar and a strong yen can only worsen Japan's economic plight
The biggest influence will be doubts about the US's ability to go on financing its deficit
BY DISPLAYING a big euro symbol carved out of ice in the foyer of its headquarters in Paris, Banque Nationale de Paris seemed, at the weekend, to be tempting fate. Fortunately, no unseemly meltdowns took place.
The birth of Europe's new currency, the euro, was remarkably easy. But as the bands played and the champagne flowed, another, more serious currency drama was unfolding: the slide in the dollar. If it continues to fall the consequences could be grim.
Although the dollar fell a bit against the euro in its first days of trading, it dropped by far more against the yen. In fact, the dollar has been looking decidedly rocky ever since last October's sudden plunge, when it lost one-eighth of its value against the yen in just three days. After a respite, the greenback is sliding again; at one point this week it fell to below ¥110, its lowest for 27 months and 25% below the high of last summer. So much for those pundits who had predicted a dollar climb to ¥180.
The surprise is that the US economy is still growing strongly, while Japan's continues to shrink. A stronger yen is hardly the medicine that such a sick economy requires. There are, however, several explanations for why this is happening. One has been a continuation of last October's unwinding of so-called "yen-carry trades", in which banks and hedge funds had borrowed cheap yen and invested the proceeds in higher-yielding dollar assets. Large losses over the past year, in these and other trades, have forced many investors to liquidate their carry trades by buying back yen and selling dollars.
Another explanation for the dollar's decline in recent months is the expectation that US interest rates will fall by more than rates elsewhere. Short-term rates in the euro area are already lower than in the US and, in any case, Europe's economy will probably be more robust than America's this year; euro interest rates are unlikely to fall much further. And although Japan's economy is still flat on its back, its short rates are as close to zero as makes no difference, so they cannot be cut much more.
Long-term rates are rising, largely because of worries about who will buy the bonds the government must issue to pay for its grand spending plans. The gap between US and Japanese 10-year bond yields has narrowed from 4.6 percentage points in November to 3.3 points.
But the biggest influence on exchange rates this year will be doubts about the US ability to go on financing its gaping external deficit. The US current-account deficit will probably hit $300-billion this year - a record. As a share of gross domestic product (about 3.5%), this will be as high as it was in 1987 - the biggest previous US deficit this century - a year when the dollar, ominously, went into free fall.
Bad enough, for sure: yet the situation is potentially even worse now than it was in the late 1980s. US net foreign liabilities then were tiny; today, they amount to about 15% of GDP. The US is now running an increasing deficit on its investment income, which will cause its current-account deficit to widen even if a weaker dollar stabilises the trade deficit. In contrast, Japan and Europe both have large and growing current-account surpluses (forecast by the International Monetary Fund to be 4% and 1.5% of GDP respectively this year). Creditor countries' currencies tend to strengthen.
Over the past few years, the dollar has been strong mainly because foreign investors have been happy to finance US external deficit, thanks to rapid economic growth and high returns. But investors may now prove less willing, which will mean either interest rates have to be raised, or, to make dollar assets more attractive, the dollar must fall.
The euro also now offers a new and viable alternative to the dollar as a global currency. The dollar's dominance is much bigger than US weight in the world economy seems to justify. The dollar accounts for over half of official reserves, more than twice the US share of global output. Extra demand for the dollar as the world's main reserve currency has made it even easier for the US to finance its current-account deficit.
The dollar's dominance has much to do with the unrivalled depth and liquidity of its financial markets. Unrivalled until the euro, that is: the new currency should go a long way to uniting Europe's hitherto fragmented capital markets. And given the overweighting of the dollar in their current portfolios, central banks and private investors alike seem likely to switch dollars to euros.
There is a further incentive for them to do so: returns on dollar assets are likely to be much lower than in recent years. Wall Street already looked overvalued before corporate profits started to fall. Yet investors in US stock markets still seem blissfully unconcerned by such niceties. The Dow goes from one record to another - on January 6 it closed above 9 500 for the first time - pulling consumer spending up with it. Currency traders appear less sanguine: the latest flurry of dollar selling was sparked by comments from Eisuke Sakakibara, the international voice of Japan's finance ministry - known as "Mr Yen" - suggesting the US economy looked "bubble-like".
An overvalued stock market, a credit-driven spending boom and a current-account deficit all point to the same conclusion: US expansion is unsustainable. The fates of the dollar and Wall Street are closely linked: soaring share prices have lured in foreign capital and so pushed up the dollar; if share prices tumble, so will the dollar. The reverse is also true: a sharp drop in the dollar could itself burst the stock market bubble, pushing the economy into recession.
Explicable it may all be. But a weak dollar and a strong yen can only worsen Japan's economic plight by putting still more downward pressure on prices and making exports - one of Japan's few sources of growth - less competitive.
Nor is it only Japan that will be concerned about a weak dollar. It could make for a tricky environment in which to nurture Europe's fledgling currency. If the euro rises further against the dollar, European businessmen will become gloomier, frictions between politicians and the European Central Bank more heated, and relations between the member countries of monetary union more strained. - © The Economist Newspaper, London, 1999.
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