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Why The Dollar's Decline Isn't A Downer

A steep drop is unlikely, and there are advantages to a further slide

By James C. Cooper, BusinessWeek

Back in 2002, billionaire investor George Soros boldly warned that the U.S. dollar's value could plunge by a third over the next few years. He was pretty much on target. Since the greenback's peak in early 2002, it has dropped 35% against the euro, 28% vs. a trade-weighted basket of major currencies, and 18% vs. the currencies of all countries the U.S. does business with. What's interesting is, nothing bad happened--except maybe for those investors who didn't sell the dollar short, as Mr. Soros presumably did.

In fact, a lot of good things happened. U.S. companies became more competitive, and exports are now booming. Profits from overseas operations and returns on international investments are soaring as the gains are translated back into dollars. Long-term interest rates are still low, stock prices are setting records, and the economy continues to grow at a moderate clip.

But dollar worries are cropping up again. Through much of the fourth quarter, the greenback was undermined by perceptions in many areas of the foreign exchange markets that the U.S. economy is slowing down sharply enough to warrant the Federal Reserve to begin cutting interest rates sometime in 2007, and most analysts expect the dollar to continue to weaken at least gradually in the coming year.

The worst-case scenario would be a rapid decline that would disrupt global capital flows, damage foreign economies, push up U.S. inflation via higher import prices, and generally complicate the Fed's job of managing the economy and the financial markets. However, that seems unlikely. In fact, the potential pluses from a further downward drift in the greenback will most likely continue to outweigh any minuses--to the benefit of both investors and the economy.

THE DOLLAR WORRYWARTS point to the huge U.S. current account deficit. That gap, comprising mainly the U.S. trade deficit and some other financial transactions, has ballooned to an annual rate of just over $900 billion, or 6.8% of gross domestic product. At that level, the U.S. must attract some $75 billion in foreign financing each and every month to manage its global indebtedness, and the borrowing requirement is almost certain to rise further in the coming year.

The latest concern is that prospects for U.S. economic growth and interest rates relative to those in the rest of the world are fading, making dollar-denominated investments less appealing by comparison. The U.S. will continue to attract the foreign financing it needs. The question is: at what level of the dollar? Since the dollar is the equilibrator between the funds the U.S. needs and the amount foreigners are willing to lend, market pressure on the greenback has been generally downward.

The biggest danger in the coming year is a U.S. recession, but that still looks like a long shot. Currency markets began to fret at the end of last year that the housing recession would spill over to other areas of the economy, perhaps dragging down consumer spending. Worse-than-expected reports on home construction and weakness in manufacturing only fueled those concerns.

However, housing demand is firming up, and inventories of unsold homes are shrinking. Also, a broad effort by businesses to pare down top-heavy inventories of autos and home-related goods, which have sapped the strength of the factory sector, is already running its course. Industrial activity in December picked up, based on the month's rise in the Purchasing Managers Index, to 51.4%, as compiled by the Institute for Supply Management. Also, consumer spending in the fourth quarter is shaping up to grow at a healthy annual rate of about 4%. All this lessens the chances of any sharp or sustained economic weakness.

SO HOW MUCH MORE is the dollar likely to decline in 2007? Economists know short-term currency forecasting can be foolhardy in the rapid-fire world of financial globalization. But, while the dollar appears to be headed lower in coming months, it's important to note that it remains well supported by several forces that will limit the size and speed of the greenback's descent.

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