Letting Off Steam

The recent currency realignment has provided relief. But can it last?

If extraterrestrials can track the economic anxiety level of Planet Earth from the far reaches of space, they may have detected just a slight easing in recent days. They may have observed that the fall of the U.S. dollar has worked a bit like an emergency valve, releasing some of the dangerous pressure that has been building as emerging markets cratered and investors poured into the safety of the greenback and U.S. Treasuries.

But will the relief be lasting? The currency realignment, though driven largely by technical factors, does reflect something new about the relative economic strength of the U.S., Japan, and the European Union and the consequent expectations for lower global interest rates. Certainly, the remarkable U.S. expansion that propelled the dollar skyward is showing signs of fatigue, and the Fed is flirting with more cuts on top of the quarter-point reduction of Sept. 29. At the same time, the steady Continental economies, especially Germany, look like relatively safe havens. Europe, excluding Britain, is running a $100 billion current-account surplus, justifying strengthening of the mark, French franc, and Dutch guilder.

And maybe, just maybe, the yen will be able to hold on to some of the ground it has retaken--rising from as low as 147 to the dollar on Aug. 8 to as high as 111 on Oct. 8. Tokyo has finally floated a credible plan to fix its crippled banking sector. It also is lining up $84 billion in new public-works spending and tax cuts to ease the sting of its worst postwar recession. "For the first time, there are signs of hope" coming out of Japan, suggests Lawrence A. Bossidy, chairman and chief executive of AlliedSignal Inc.

CHINA FACTOR. Not that anything is settled. The currencies are still adjusting, seeking a new equilibrium. Many economists are looking for a yen-dollar rate of between 125 and 130. That would still be enough, they say, to take the pressure off other Asian currencies and avoid competitive devaluations, especially by China.

"What people are worried about is 145, a level that is considered unsustainable, especially if the global economy weakens further," says David Wyss, chief economist at Standard & Poor's DRI. "If it goes back to that level, we'll likely see China go, which would trigger a second round of devaluations through Asia." But if the yen holds at around 130, "no one will be unhappy," he concludes.

Certainly not the Treasury or the Federal Reserve, where officials call the greenback a major "transmission channel" for its attempts to ease and bolster a slowing economy. A cheaper dollar means cheaper exports, which could help restore growth in manufacturing.

In fact, Japan would be ecstatic if the dollar were to stabilize at a slightly weaker level than its current 119. As the yen strengthens, Japanese corporations lose profits. Toyota Motor Corp., for instance, had based its financial planning and earnings forecasts on an average yen-dollar rate of 125. At 119, Toyota has seen its theoretical profits decline from its forecast by 60 billion yen, or $504 million.

But the stronger yen is good news for the rest of Asia. Indeed, on Oct. 12, Pacific Rim markets rallied on bets that a stronger yen would boost Asian exports by taking the heat off other regional currencies, particularly the Chinese yuan and Hong Kong dollar. Hong Kong Financial Secretary Donald Tsang even said that if the yen-dollar relationship doesn't revert to earlier levels, "we are now running toward the end of [Asia's] economic crisis."

If. The yen could still fall back to where it was--or lower. One of the big reasons for the dollar's precipitous dive was a sudden need by hedge funds to get out of their leveraged short positions on the yen--forcing them to sell dollars and buy yen. But that phenomenon, says Michael Rosenburg, head of international fixed-income research at Merrill Lynch & Co., was a "one-off shock to the system." His prediction: "The dollar should come roaring back"--plunging the yen to around 160 by March 1999.

Yen bears have a compelling case. Despite the new, improved bank-rescue plan that would include $510 billion worth of government money, the outlook for the Japanese economy, corporate earnings, and the Nikkei is pretty dreadful. After contracting 0.7% last year, the economy is likely to tumble 2% this year, and government officials concede it could tank again in 1999.

Even now, it's far from clear Tokyo can avoid bank failures and perhaps a full-blown financial panic. Restoring banks to full health will take years--not months. Nor are the new spending and tax cuts likely to have impact until well into next year. Salomon Smith Barney figures they would add maybe 0.6 percentage point to 1999 gross domestic product but not enough to avoid recession. "I don't think there is one magic wand to cover all of our problems," concedes Ichizo Ohara, a top economic adviser to Prime Minister Keizo Obuchi.

The outlook for key European currencies--and the new euro--is even less clear. J.P. Morgan's chief global currency strategist, Avinash Persaud, thinks the dollar will be dragged lower vs. the European currencies as foreign money exits U.S. equity markets. The dollar, he adds, will also come under pressure from the U.S. trade deficit, likely to hit $234 billion this year. Officially, the new European Central Bank says the current level of the dollar "is not a cause for concern." But come January, when the ECB takes charge, the betting is that it will push down a newly converged interest rate for the 11 economies it oversees to just below the German benchmark rate of 3.3%. That would nudge the euro down against the dollar, and help European exporters.

Of course, the Fed has a lot more room than either the ECB--which is defending a new currency--or the Bank of Japan, which has already cut rates to 0.25%. If the Fed cuts again to avert a recession, the dollar will look a lot less attractive.

CLEAR DANGER. But such cuts might only be justified if a U.S. recession becomes a clear and present danger. And that would spell trouble for the global economy: If the U.S. slips into recession, global growth would dip below 2%--for the first time since 1982. In that scenario, there is little hope for recovery for Japan and the rest of East Asia. As it is, only two countries in Asia, China and Taiwan, will generate positive growth this year. Imagine what would happen next year if the U.S. could absorb only a trickle of East Asian imports? Even without a recession, a less robust dollar makes imports more costly. "Whatever joy these economies get from weaker currencies against the yen would be lost from a big contraction in global demand," says Lehman Brothers Inc. economist Russell Jones.

So maybe the best that can be hoped for now is a stretch of currency stability between the dollar, yen, and euro. That would give the efforts by the Group of Seven and the International Monetary Fund a chance to take root. And emerging nations would be far less tempted to manipulate trade flows and debt repayments by messing with their currencies. "To have plus or minus 10% changes makes it difficult for all concerned," says Douglas A. Warner III, J.P. Morgan's chairman and CEO. Or to put it another way: The last thing a frail global economy needs is another psychotic episode in the currency markets.

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