The Greenback's Setback: Cause for Concern?

More weakness is likely, but a free fall isn't

The dollar has garnered a reputation as a Teflon currency, and for good reason. No matter how bad things looked for the U.S. economy in recent years, the greenback always emerged unscathed. First there was the March, 2000, collapse of the Nasdaq. Then the recession a year later. And, finally, the September 11 terrorist attacks. Through it all, nothing seemed to dent the dollar.

But now, some of the luster is starting to wear off. With U.S. growth slowing and the stock market looking erratic, foreign investors may have had their fill of dollars. The greenback dropped to a six-month low against the euro and a seven-week low against the yen on May 3, after news that the U.S. unemployment rate jumped to 6% in April. Although the dollar got a boost May 7 on news of an 8.6% annualized surge in productivity in the first quarter, on May 8 it remained off by roughly 5% against both the euro and yen over the past three months.

That has traders worrying that the dollar's decline could signal the beginning of a collapse. After all, traditional analyses comparing the cost of goods in various countries--so-called purchasing power--suggest the dollar may be overvalued by as much as 30%. At the same time, the U.S. trade deficit continues to grow, to $31.5 billion in February, its highest level in nearly a year. That means the U.S. is dependent on an ever-rising influx of foreign funds to pay for all the imported automobiles, TVs, and clothing that U.S. consumers crave.

Of course, for some, a weaker dollar would be good news. Hard-pressed manufacturing companies and farmers struggling to compete overseas have been complaining about the dollar's high level for months. But a dollar crash would be something else, disrupting financial markets and the economy. Fortunately, no one thinks that's imminent. Foreigners would have to flee the U.S. markets in a panic to trigger such a rout, and that's not happening. Foreign corporations and institutional investors are scaling back their purchases of dollars but remain in the game, says consultant David Gilmore of Foreign Exchange Analytics.

Yet even that small shift in sentiment could signify tough times ahead. "The recent weakness is a warning shot of what might be coming longer term," says Goldman, Sachs & Co. economist Jim O'Neill.

The biggest shift seems to be in foreigners' willingness to buy U.S. assets. In the late 1990s, the U.S. enjoyed a record inflow of direct foreign investment as companies from carmaker Daimler Benz to cell-phone giant Vodafone Group PLC sought a foothold in the booming market here. Now, that investment has slowed to a crawl: Foreign corporations announced a mere $600 million in cash-financed deals in the U.S. in April, far below the $11.2 billion monthly average during the last three years. "This represents a significant threat to the dollar," says Robert Sinche, Citigroup's head of global currency strategy.

Foreign pension funds and institutional investors may also have had it with U.S. financial assets. Catherine L. Mann, a former Federal Reserve official now with the Institute for International Economics, a Washington think tank, reckons U.S. stocks today account for nearly 60% of the equities held by global fund managers. That's roughly double the level in the mid-'90's. The U.S. share of international bond holdings has also doubled, to 30%. But that appetite appears to be decreasing as stock markets overseas have outperformed the U.S. Foreigners bought $26.7 billion of U.S. stocks and bonds in the first two months of this year, down sharply from the nearly $100 billion they snapped up in the same period last year, according to the latest U.S. government data. Anecdotal evidence suggests that the situation may have gotten worse since then. Nearly two-thirds of some 300 global fund managers polled by Merrill Lynch & Co. in April considered Wall Street the most overvalued of the world's top five stock markets.

Of course, the dollar continues to have plenty going for it. America's productivity remains the envy of the world. But with foreigners already heavily invested in the U.S. economic miracle, that's considered old news. Now the focus is on capital flows. And that's why the dollar's nonstick coating is showing scratches.

By Rich Miller in Washington, D.C., with David Fairlamb in Frankfurt

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