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The Greenback Isn't a Goner

The dollar may well continue to decline, but that doesn't signal a long-term collapse of the currency. This downdraft is cyclical, not structural

Currency traders have every reason to be down on the dollar: The U.S. economy is struggling, while other economies are holding up. The Federal Reserve is slashing interest rates, yet other central banks haven't even started to cut. The U.S. has heavy international debts to repay, and sentiment toward the currency is increasingly negative. Some oil-exporting nations complain that their dollar-based revenues don't stretch as far in the global marketplace as they used to, and everyone from supermodels to rappers have made news by dissing the dollar. Has the greenback fallen into serious trouble?

Not really. The U.S. currency will not soon lose its preeminence in the global economy. A long-term collapse would require a complete loss of faith in the future of the U.S. economy and the policies that guide it, such that America would become an unattractive place to invest. Abu Dhabi's $7.5 billion infusion into capital-challenged Citigroup (C) on Nov. 26 is a reminder that there is still lots of foreign savings sloshing around seeking good investments. That deal is an endorsement of the dollar's long-run worth.

Right now the greenback is doing just what economists would predict. Economic growth and interest rates favor investments in other currencies, and the dollar must be low enough to attract enough foreigners to supply America's huge funding needs.

All this means there is more decline to come, but keep the drop in perspective. On a broad, trade-weighted basis, the greenback's 24% swoon since early 2002 has been from an unusually high, overvalued level. The U.S. currency rose 72% from 1992 to 2002, and it is still 42% above the 1985 peak when it earned the name superdollar.

One fundamental is turning in the right direction. The U.S.'s need for foreign capital, reflected in the current-account deficit, is easing. That gap, fueled mainly by the trade deficit, has shrunk from a peak of 6.8% of gross domestic product in the fourth quarter of 2005 to an estimated 5.3% last quarter, and it will shrink further in 2008, as the trade gap narrows.

Still, the U.S. has a huge need for foreign funds that must be satisfied at a bad time for the economy and the financial markets. The current-account deficit needs some $60 billion per month in overseas money. That's why the sharp slowdown in foreign inflows in August and September bears watching. Net foreign purchases of U.S. stocks and bonds rose only $26.4 billion in September, after a steep $70.6 billion plunge in August, as market turmoil reduced the appetite for U.S. securities. Purchases had averaged $80.4 billion per month from January to July.

The September rebound partly reflects foreigners' confidence in the Federal Reserve's actions to restore market calm. However, slower inflows will place added downward pressure on the dollar. The biggest concern is foreign buying of U.S. corporate debt, which has counter-balanced a large portion of the current-account deficit. The credit-market troubles, stemming from the uncertain value of mortgage-related asset-backed securities, has temporarily damaged foreign confidence in corporate debt, and markets remain under heavy stress. By Nov. 23, yield spreads between corporate bonds and no-risk Treasuries had soared well past their August-crisis highs, partly reflecting companies' yearend funding needs. The U.S. will be challenged to make up that loss of financing elsewhere, since equity markets remain volatile.

Clearly, there are risks: The dollar's fall could become too rapid, which would rattle other markets. The drop could also push up U.S. inflation. It could even harm growth in other exporting economies, as stronger currencies abroad make foreign-made products more expensive in the U.S. amid sagging U.S. demand.

Even so, the current dollar downdraft is cyclical, not structural. After the greenback works it way through this soft patch in the business cycle, there is every reason to expect it to strengthen again.

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