First Mexico's peso plunged, international investors fled, and the country's debt-fueled economy started to unravel. Then the currencies of a host of high-debt economies from Canada to Thailand came under attack. Now, as Congress grapples with reining in federal deficits and President Clinton struggles to bail out his Mexican allies, it's America's turn to be taken to the woodshed by the market for its excesses of debt.
After several months of relative calm, the battered U.S. dollar is plummeting once more against the hard-money currencies of the world. In a market already badly shaken by the collapse of the venerable Barings PLC merchant bank, the dollar has skidded to all-time lows (charts, page 49) against the German mark, Swiss franc, and Japanese yen.
Welcome to the debt crisis of '95. It's one in which the trillions of dollars of portfolio money now coursing through the global economy call the shots. With trade going global and country after country reaching out to foreign investors to finance everything from trade imbalances to superhighways, a new creditor class composed of millions of faceless individuals and institutions has sprung up. These creditors are demanding their due from America, by far the largest borrower on earth. In short order, says Nicholas P. Sargen, chief global strategist at J.P. Morgan Securities Inc., the U.S. is learning that "the price of breaching market discipline is much more painful than anyone ever expected."
What the market wants is simple: less debt or higher interest rates. In fact, the dollar rout is raising fears of a round of global deflation if the Federal Reserve is forced to boost short-term U.S. interest rates to defend the currency. While Fed Chairman Alan Greenspan is giving no hints that he wants to push rates up, he is clearly upset by the dollar's weakness. Not only is it "unwelcome and overdone," he told Congress on Mar. 8, "it adds to potential inflation pressures in our economy." Treasury Secretary Robert E. Rubin maintains that a stronger dollar would be in "our national interest." To hammer that point home, he ordered the Fed earlier in the week to buy greenbacks to try to brake their decline.
But even amid this show of U.S. support, there's no guarantee global money managers will change their minds for long. Stuffed to the gills with dollars after decades of heavy American trade deficits and borrowings, fund managers no longer want to hear vague assurances about America's fiscal health.
"THE DEFICIT THING." They acknowledge that the U.S. economy is growing strongly and that the nation's technology and productivity are among the best in the world. Nonetheless, worried about the effect on their massive debt holdings of renewed U.S. inflation and a possibly open-ended American obligation to Mexico, they now are demanding immediate, firm action to shore up America's balance sheet. And fearing they won't see it any time soon, they're racing to dump greenbacks as fast as they can. "It's the deficit thing," says Madis Senner, manager of Van Eck Global Income Fund. "People are calling North America the `peso bloc.' This does not look pretty."
In fleeing from the dollar to stronger currencies, these investors may be finally bringing about a watershed in global finance that has been a long time in coming. Much as the British pound was forced to relinquish its role as the world's reserve currency as the U.S. economy grew in importance, now the pound's replacement--the dollar--is being forced to make room for the currencies of economies with comparable heft and tougher central banks.
In many ways, this dollar crisis is more troubling than the spell of weakness that plagued the U.S. currency when Jimmy Carter was President in the 1970s. Even now, the dollar makes up 60% of world foreign exchange reserves. But the latest shift out of greenbacks will probably be accelerated by the new structure of international financial markets. Increasingly dominated by American mutual- and hedge-fund investors controlling perhaps $2 trillion in assets, this investor class is far different from the patient banks and multilateral development agencies that once provided the globe's international capital supply.
Today's hot-money set is benefiting from changes in investment technology that have made huge sums available to companies and governments that never were able to garner much overseas portfolio investment before. Investors now can move money from Treasury bills to Mexican retail stocks to German government bond options just by picking up the phone. This is calling into question the whole notion of national currencies. "Ten years ago, if you thought investing in Mexico was a good idea, you'd have had no idea how to go about doing it," says Merrill Lynch & Co. economist William Sterling. "Now, it's as easy as dialing 1-800-mutual fund."
In this new market, money moves faster than ever, raising the possibility that billions can flow in or out of an economy in seconds. So powerful has this force of money become that some observers now see the hot-money set becoming a sort of shadow world government--one that is irretrievably eroding the concept of the sovereign powers of a nation-state.
This amorphous mass of investors can penalize countries such as the U.S. by denying them ready access to funds. Other countries that have slashed deficits, boosted savings, and reformed their finances--such as Chile and New Zealand--are rewarded with strong currencies and buoyant domestic markets. As cash has flowed around the world, "control of monetary and fiscal policy has devolved," says Morris W. Offit, chief executive of New York's Offitbank. "Countries don't control their own destiny. If they don't discipline themselves, the world market will do it for them." It is for that reason, perhaps, that the Fed and the Clinton Administration have not taken heroic measures to halt the dollar's slide.
OVERSHOOTING. Of course, the Administration might soon persuade its Group of Seven allies to mount a dollar-rescue operation, much as it did when the currency collapsed in 1987. Bundesbank President Hans Tietmeyer even concedes he might sanction "a small rate cut." But Fed Chairman Greenspan believes the weak dollar must focus attention on the point that America's low savings rate and trade and budget imbalances have to be addressed. "The only solution [for the U.S.] is either to raise interest rates or cut the deficit," notes investment banker Felix G. Rohatyn of Lazard Frres & Co. But because higher interest rates "will create a straitjacket for the economy," Rohatyn says, Washington may have little choice. Without new Japanese financing of U.S. deficits--something that's not likely--the market may force upon the U.S. what the Republicans failed to achieve in Congress. "The collapse of our currency," Rohatyn warns, "will force us to balance our budget."
With more than $1 trillion a day sloshing around the currency market, there may be few other ways to hold the dollar up for long. And letting the market work might be all for the best. In a world of totally free capital movements, money should be able to go where it earns the best returns. The outflow of U.S. portfolio cash has fueled privatizations, pumped up stock and bond markets, created jobs, and eased the way for political and economic reforms, especially in the Third World.
But the easy flow of cash can give an illusory impression of stability. When it reaches a torrent, as it did in 1993 and '94, when more than $150 billion poured into emerging-market countries alone, prices of stocks and bonds can become inflated way beyond their fundamental values. It was much the same story with financial assets of numerous other high-debt countries, where high valuations brought on by sudden cash inflows bred complacency among investors and policymakers alike. Says E. Gerald Corrigan, senior adviser at Goldman, Sachs & Co.: "One of the curses of these current financial markets is that they overshoot--repeatedly and substantially."
Indeed, when U.S. interest rates were low in the early 1990s, American investors searching for high returns pumped $300 billion into international stocks, bonds, and mutual funds. It was an accomplishment all the more amazing because the U.S. was racking up a $400 billion current-account deficit during the period. When $225 billion in direct foreign investment is factored in, the U.S. outflow represented nearly 3% of the nation's gross domestic product by its 1993 peak, estimates Sterling. In terms of gross domestic product, that is a full percentage point more than the resources America shipped to Europe in the 1940s under the Marshall Plan.
America managed this herculean investment feat by borrowing heavily from the central banks of Japan and other surplus nations to cover its chronic trade deficits. That freed domestic savings to go overseas. But when the Fed raised rates last year to counter inflation and slow a strong economy, the rules of the game changed in an instant. With higher yields at home, the allure of overseas assets suddenly began to wane. In fact, economist Sterling estimates that American investors may buy as little as $30 billion in overseas stocks and bonds in 1995, less than half 1994's total.
UNEASE. The slowdown in investment flows gave the dollar a temporary lift. But it wasn't enough to overcome the greenback's fundamental weaknesses. In fact, as Mexicans have discovered in recent months, the money managers who plunged into Mexico City's Bolsa de Valores when times were heady are anything but patient.
Now, Washington and Wall Street are finding how that process works as investors flee the U.S. With the federal government planning to sell an estimated $1.4 trillion in new debt by the end of the century--and with 20% of U.S. government debt now in foreigners' hands--it has taken only a few weeks of financial jitters to knock the dollar off its perch. "There's a flight to quality," says Alan E. Royle, treasurer of S.C. Johnson & Son Inc. "People think the Germans know what they are doing."
The dollar's troubles began as the Mexican bailout bogged down. As the peso sank from 3.5 to the dollar to 7, investors started worrying that Washington was, in effect, putting Mexico's debts on its own balance sheet. If the Administration's huge bailout effort doesn't work, many asked, what then? Says CS First Boston Chairman David C. Mulford: "You can argue that Mexico's devaluation has tainted the safe-haven status of the dollar."
Adding to that sense of unease was the narrow defeat in the Senate of the Balanced Budget Amendment. Now, investors are worrying that talk of tax cuts will continue despite the amendment's failure. "The optimism that something would be done on the long-standing U.S. budget deficit problem has disappeared," argues Jonathan H. Francis, head of global strategy at Boston's Putnam Investments.
To many fund managers, Fed Chairman Greenspan provided the clincher. Greenspan's lobbying in favor of the Mexican rescue package angered some investors who thought the central bank should remain aloof from politics. Then Greenspan signaled that the economy may be slowing and the Fed might stop raising interest rates for a while. "This was a major shift," says Michael R. Rosenberg, manager of global fixed-income research at Merrill Lynch. But perhaps a premature one. Rosenberg notes that with U.S. bank loans and commercial-paper issuance expanding rapidly over the past three months, the economy may soon pick up again. "The foreign exchange market is telling us that inflationary expectations are still very high," he says. "We've got a credibility crisis."
Greenspan's comments could not have been timed worse for the dollar. They coincided with rising expectations that the Bundesbank would soon raise rates in the face of a strong German recovery. Adding to those worries, the decision on Mar. 7 by striking German metal workers to settle for an effective pay hike of 5.1% this year is unsettling investors. Despite Tietmeyer's holding out the possibility of a modest rate cut to help the dollar, wage pressures could still force the Buba to start pushing rates higher again before long. That would only increase the attractiveness of German debt to investors already looking at the U.S. with a gimlet eye.
Washington's debt situation looks pretty shabby. The federal government is expected to run a $192 billion budget deficit and a $175 billion trade gap this year. It thus will need to attract $200 billion in foreign investment in 1995 alone just to keep the dollar stable, estimates J. Paul Horne, Smith Barney Inc.'s Paris-based international economist. But the Japanese, who have financed the bulk of America's trade deficits over the years, now seem in no mood to continue.
Japan is burdened by as much as $400 billion in losses on previous U.S. investments. And the country faces huge spending needs at home as it repairs the damage of the Kobe earthquake and continues to restore the balance sheets of weakened banks. Now, "the sharp appreciation of the yen will have a bad influence on Japan's economy," says Shigeru Adachi, deputy general manager of research at Sakura Bank Ltd. "It could promote a further hollowing-out of manufacturing." Salomon Brothers Inc. economist Robert Alan Feldman believes Japan could see GDP growth slump to 1.5% next year--nearly two percentage points below his current forecast--if the yen remains at 90 to the dollar.
It thus is no surprise that manufacturers are pressuring the Bank of Japan to cut the discount rate from its current record-low 1.75%. But the bank is not budging yet. Such a reduction "is not under discussion," says Kengo Inoue, a deputy director-general at the central bank. "We won't change our monetary policy because of a temporary disruption in the market."
"WE'RE REALLY STUCK." Many European nations are also discovering the cost of currency turmoil. As the dollar crisis has spread to Europe, investors are laying waste to the European Union's plans for a currency union centered on Germany. As exchange rates sink in country after country around Germany's periphery, even the future of EU free trade may be in jeopardy, much as the Mexican crisis is calling into question the durability of the North American Free Trade Agreement.
Investor flight to the security and credibility of the Bundesbank has driven currencies in Britain, France, Sweden, Spain, Italy, and Portugal to record lows against the mark. But it is Europe's most profligate spenders that have been hardest hit. Since Europe's march to a single currency ran into its first crisis in 1992, the Spanish peseta has lost 25% of its value against the mark. The Italian lira has fallen by twice that amount. And there seems to be no end in sight.
Spain's emergency 7% devaluation of its peseta on Mar. 5 did little to reassure investors: They immediately pushed the yield on 10-year Spanish bonds to 12.5%--some five percentage points above those on comparable German debt. Deficit-ridden Italy, whose national debt equals 115% of GDP, soon may face even worse. Not only is the country experiencing capital flight, it is also seeing prices soar on goods imported from Germany. The price of stainless steel used by furniture maker Sawaya & Moroni, for example, has shot up 300% recently as the mark climbed and supplies tightened. Mourns Chairman Paolo Moroni: "We're really stuck."
Even France, a pillar of Europe's integration drive, is suspect. On Mar. 7, the franc hit an historic low against the mark as investors honed in on the runup to two rounds of presidential balloting that end May 7. The Banque de France raised rates by two percentage points in response. But whoever wins the presidency still will have to cope with 12.3% unemployment and soaring budget deficits, especially in health care and other social programs.
A public outcry could stall budget cutting. That would disappoint financial markets and might force France to abandon the franc fort, the strong-currency centerpiece of its economic policy. But the massive flight by investors into marks could also backfire for Germany. Peter Praet, chief economist at Brussels-based Generale de Banque, figures that a mark at 1.25 to the dollar would severely restrain exports and competitiveness, cutting Germany's current 3% annual GDP growth by a full percentage point.
The Bundesbank is willing to take that risk because it believes a strong currency says a lot about a country's fundamental strengths. The U.S. and many others have yet to come to that conclusion. Yet in the end, they may have no choice.
Faced with the new realities of the markets, governments will have to take the political heat and cut spending if they want to have access to global cash. As House Speaker Newt Gingrich notes: "If you were an international investor and watched this generation of politicians lack the courage to face up to a problem, and you said, `Where do I think my money's going to be stable?' I think you can understand why you would invest in Germany or Japan." It's that stark truth that is roiling currency markets right now. Unless the U.S. and other indebted nations catch on, even more trouble lies ahead.
What's Behind the World's Money Troubles
The peso's collapse in December sends Mexi-can debt and equity prices into a
tailspin that even a $53 billion,
U.S.-led bailout can't stop. The crisis spreads worldwide as global money managers slash the value of currencies, stocks, and bonds in nearly every economy with heavy foreign debt and weak national finances.
The dollar crashes against the mark and the yen as traders, already worried about the cost of the Mexican bailout, shift their anxiety to the Federal Reserve. They fear a lax Fed won't raise rates until late spring, allowing inflation to pick up.
Money from the world over floods into the mark as the Bundesbank signals displeasure with the scale of the Mexican rescue--and indicates German interest rates may head higher. Europe's deficit economies--Spain, Portugal, Greece, Sweden, and even Britain--take a beating at the hands of currency traders. Prospects for a European monetary union grow even more dim.
Faces the possibility of rising interest rates and a $200 billion repair bill in the wake of the Kobe earthquake. So Japan is slowing the recycling of its $146 billion annual trade surplus to conserve cash. That pushes the yen to record highs, raising questions about exporters' profits and the durability of an already sluggish recovery.