`The Markets Smell Blood'

President Clinton was just getting ready for a relaxing summer on the home front. Economic growth was slowing to a sustainable level, inflation was at low ebb, job creation was picking up, and long-term interest rates were settling down. White House advisers were hoping financial markets would finally signal their approval of the President's economic stewardship.

Instead, foreign exchange markets responded with a stunning vote of no-confidence in the U.S. dollar and, by implication, Clinton's leadership. A flurry of selling that began June 17 put the greenback on the brink of free fall against the Japanese yen, the German mark, and other major currencies. On June 21, the dollar briefly dipped to 99.9 yen--its lowest point since the modern exchange-rate system was established at Bretton Woods a half-century ago.

Even though the dollar edged back above 100 yen on June 22, partly because Japan began buying dollars, traders were predicting the greenback eventually would plummet to 90 yen--and to 1.5 German marks from its current 1.6 level. The possibility of turmoil in the stock and bond markets loomed as well. "The markets right now smell blood," says Albert Soria, foreign exchange manager in New York for Kansallis-Osake-Pankki, a Finnish Bank. Even dollar bulls confident about the U.S. outlook started caving. "I don't think this should be happening," says Nicholas B. Sargen, managing director of Newark (N.J.)-based Global Advisers. "But I'm not going to fight the tape."

BENIGN NEGLECT. To be sure, the dollar's plunge was partly owing to factors the White House couldn't immediately control. With the U.S. economy cooling from its earlier heated pace and recoveries starting to take off in Europe and Japan, many investors began shifting funds from the U.S. to foreign markets. The U.S. current-account deficit, which widened to a five-year high of $32 billion in the first quarter, also depressed the dollar.

But some market pros say the fall in the U.S. currency reflects more than just economic fundamentals. They blame the Clintonites for a policy of benign neglect that tolerated a continual slide in the dollar. Indeed, the Administration initially resisted calls for it to fight for a stronger dollar by arranging a massive dollar purchase, as it did on May 4, by the Federal Reserve and other central banks. "The U.S. is going to have to go back into the markets to prevent a dollar crisis," predicts Robert D. Hormats, vice-chairman of Goldman Sachs International Ltd.

But Treasury Secretary Lloyd M. Bentsen gave no indication of imminent action. On June 22, he issued a tepid statement that expressed "concern" about the dropping dollar and promised that the U.S. and other major industrial nations--the Group of Seven--were poised for a rescue if needed. The same day, Federal Reserve Board Chairman Alan Greenspan ducked queries from Congress about whether he would hike rates to prop up the dollar.

Washington's response to the dollar mess failed to reassure traders, many of whom feel that even another massive campaign to buy dollars will prove futile. Says a trader for a big New York bank: "Intervention would just give me an opportunity to get out of my dollar positions."

INTENSE SCRUTINY. Why no quick response from the Clinton Administration? "We didn't want to draw a line in the sand that wouldn't hold," says one Treasury Dept. official, who fears that an intervention that failed to reverse the dollar's slide might precipitate a free fall. Nevertheless, the Administration's reluctance to act only reinforced views among market experts that it actually favors a weak dollar in order to reduce its trade deficit--even though Bentsen insists that's not true. "It's very hard, if not impossible, to reverse the perception in the markets that the U.S. is not going to support its currency," says David C. Mulford, a top Treasury Dept. official under Reagan and Bush.

The consequences of a cheaper dollar could reverberate across the globe. European governments, faced with high unemployment and weak consumer demand at home, have come to depend on exports to fuel the Continent's recovery. But higher Euro currencies could price European exports out of foreign markets and slow nascent economic recoveries on the Continent. For Americans, who could see exports boom with a cheaper dollar, the biggest danger is higher interest rates and rising prices for imports.

The threats posed by the dollar's slide have come under intense scrutiny at the White House. Indeed, some Clinton advisers now worry that a full-blown currency crisis could occur on the eve of the July 8-10 economic summit in Naples. The fear is that the summit's modest agenda--discussing a hike in Russian aid and how to boost global employment--might displease traders expecting strong economic coordination. Frets a Clinton adviser: "If the leaders have nothing to say that makes the financial markets happy, the dollar could fall more. Some of us are trying to point that out to the President."

But active support for the dollar carries certain risks. Intervention, which comes at a great price to other central banks around the globe, is beginning to wear thin with some U.S. allies. William P. Sterling, an international economist at Merrill Lynch & Co., estimates that by yearend, foreign central banks will have spent more than $150 billion in over two years to prop up the dollar--in effect, returning two-thirds of the U.S.'s $231 billion current-account deficit during that period.

By itself, moreover, intervention will do nothing to quell inflation fears that are growing in European markets. That may lead Germany and other countries to pressure the U.S. to raise its interest rates. Some experts believe the only thing that could bolster the dollar would be yet another hike in interest rates from the Federal Reserve Board. "The reason the dollar is so weak is because the Fed's policy is still accommodative," says former Reserve Board governor Wayne D. Angell, who has urged the central bank to raise its rates more aggressively.

FIXING A FLOOR. Although Greenspan is reluctant to tamper with rates at a time when the U.S. economy is growing at a moderate pace with little inflation, he may have no choice if the dollar continues its swoon. One solution: raise the discount rate--the Fed's lending rate for banks--from 3.5% to 4%. It would be a symbolic move that would reassure foreign markets but have no impact on the U.S. economy because banks rarely borrow directly from the Fed. But many traders think that only an increase in the federal funds rate--the rate banks charge each other for overnight loans--will cool the market's jitters and put a floor under the dollar. The Fed has already hiked the funds rate to 41/4%, but some traders would like to see it rise still another point or more.

European and U.S. officials believe that if they can ride out the present storm, currency markets will calm this fall. By then, the world's major economies should be in harmony, producing modest growth with low inflation--and more stable currencies. Meanwhile, though, it could be a long, hot summer for Bill Clinton.

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