The Dollar Is Soggy, and Still Sliding

The greenback is weighed down by the trade deficit, low interest rates, and terror jitters

America, accustomed to being the world's economic powerhouse, isn't laughing about a feeble euro anymore. The European currency, which fell to 87 cents in March, is back above a buck; at yearend, it hit nearly $1.05--a 17% loss of value for the dollar. Since late November alone, the greenback has slipped 6% against its European rival and now is at a three-year low. "America certainly doesn't have the attraction [for investors] it did in the second half of the 1990s," says Volker Dosch, head of U.S. equities at DWS Investment, a unit of Deutsche Bank and Germany's largest fund manager.

A one-time jolt due to global jitters over the fallout from a war with Iraq? Hardly. An array of other pressures ranging from the huge trade deficit and low U.S. interest rates to the narrowing advantage in economic growth are also weighing on the greenback. Many currency traders figure the slide against Europe's common currency could be just the start of a broad decline. "The dollar needs to correct lower," says Ashraf Laidi, chief currency analyst at MG Financial Group in New York. Many believe that the euro could rise to $1.07 in coming months. Moreover, the dollar, which has lost 5% against the yen since early December, could sink below 115 Japanese yen from its current 118.

A modest further drop in the dollar probably would be good for the faltering U.S. economy on the whole. It clearly would benefit domestic manufacturers who export or who compete with imports; the combination of a high dollar and tough competition from countries with low-cost production has cost the manufacturing sector 2 million jobs since 2000. By lowering the prices of their goods in terms of euros, yen, and other foreign currencies, a lower dollar would let producers regain market share and maybe even raise prices a bit. "We are gratified to see that the dollar has been easing down. We think it has further to go before it reaches what we think is a fair level," says Hank Cox, assistant vice-president of the National Association of Manufacturers.

But a decline in the dollar has domestic downsides as well. It hurts U.S. consumers by raising the price of imports. It also could bump up interest rates if foreign investors demand higher returns because they risk currency losses when they switch back into their home currencies. That may be why the Bush Administration hasn't come out in favor of a lower dollar. "It's too risky because you just never know how your actions are going to be interpreted," says Thomas D. Gallagher, senior managing director in Washington for Wall Street consulting firm ISI Group.

For America's trading partners, a much weaker dollar would be a big negative that could smash fragile recoveries. America's tireless consumers have been the heroes of the world economy, and if higher prices lead them to buy fewer imports, growth abroad will be hit. Stronger foreign currencies would hold down overseas inflation rates--but inflation is the least of the problems in countries like Japan and China that are battling outright deflation.

It's unlikely, though possible, that the decline of the dollar will start to feed on itself and accelerate, much like a crash in the stock market. That would force the U.S. to jack up interest rates to keep foreign investors from bailing out entirely. The U.S. trade deficit would shrink, but in the worst possible way: A deep recession would slash consumers' buying power, while the dollar's devaluation would make imported goods impossibly expensive.

Although a dollar disaster is unlikely, the forces arrayed against the greenback likely will keep it falling for at least a while. The immediate cause of weakness seems to be the market's fears that a conflict with Iraq could be costly, damage U.S. interests in the Middle East, and prompt more terror attacks against American targets. Each step toward war has jolted the dollar a bit lower against currencies that are more removed from the conflict.

Indeed, while the dollar typically has served as a refuge during international crisis, it has behaved more like a risky asset lately, according to an analysis by Boston's State Street Bank. In 2001, the dollar tended to do well whenever investors seemed risk-averse. But since last January the dollar has begun to move in sync with State Street's Risk Appetite Index. That means investors have been buying dollars when their appetite for risk grows and selling when they get cold feet--making it the opposite of a safe-haven play. "The U.S. has become a prominent component of current geopolitical concerns," says Laidi.

Beyond war and terrorism jitters, the dollar's recent slide comes against the backdrop of a growing deficit in the U.S. current account. America is importing way more than it exports, while the income it gets from foreign investments is less than what it pays out to foreigners on their investments in the U.S. Of course, the U.S. has run a current-account deficit for years. But the gap has been growing, and at an annualized rate of $500 billion, the deficit is now close to 5% of gross domestic product. That's a level at which smaller, less creditworthy nations often see a run on their currencies.

Rather than exchanging goods for goods, the U.S. is paying much of its import bill with paper--that is, claims on U.S. assets such as stocks and bonds. Dollar bulls say it will be easy to get foreigners to keep accepting American IOUs on the grounds that, for all its problems, it remains the world's best place to invest. But already there are signs that the U.S. is having a harder time attracting the kind of long-term, patient capital that makes for a stable currency, notes Michael Metcalfe, a senior strategist in London for State Street Bank. The U.S. attracted $130 billion of foreign direct investment in factories, real estate, and corporate acquisitions in 2001, but only $24 billion worth through the first three quarters of 2002. Meanwhile, purchases of U.S. securities other than Treasuries fell from $407 billion in 2001 to an annual rate of $300 billion through the first three quarters of 2002. "It will be increasingly difficult for the U.S. to draw enough capital to compensate [for the trade deficit]," says Dosch, the German fund manager.

Another reason for foreigners' diffidence is that America's growth advantage is likely to shrink in 2003. While it is growing faster than most industrialized nations, economists expect its growth rate to increase by only 0.4 percentage point this year. Improvement elsewhere will be stronger: Britain and Europe expect to see 1 percentage-point gains, while Japan could rack up a 1.5 percentage-point gain in 2003, according to a survey by newsletter Blue Chip Economic Indicators.

Nor is the dollar getting any help from U.S. interest rates. To stimulate the economy, the Federal Reserve has lowered the federal funds rate to a 42-year low of 1.25% over the past two years while it has been pumping up the money supply. After subtracting inflation, the real return on two-year U.S. Treasury notes is just 1.7%. That's below the returns available on the two-year notes of Britain and the euro zone. Even Japan, with its famously low interest rates, does better. Although the nominal yield on Japan's notes is just 0.9%, consumer prices in Japan are falling 0.9% a year, so the effective return on the notes for yen-based investors is 1.8%.

Of course, the bears could be wrong. The dollar has weakened before only to spring back. While its decline against the euro is pronounced, the greenback has held up well against most other currencies. In the long run, though, it's almost inevitable that the dollar will lose altitude--there's a limit to how long the rest of the world will keep extending credit to the American consumer. The healthiest outcome would be for the dollar to sink gradually in response to accelerating growth abroad. A planet as big as this one needs more than a single engine of growth.

By Peter Coy in New York, with Jack Ewing in Frankfurt, and Laura Cohn in Washington

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