Currency Whiplash Ahead?

The prospect of wild swings in global exchange rates is worrying the financial and economic honchos at the World Economic Forum in Davos

After two years of plunging equity markets and economic turmoil, the world could be headed for a prolonged period of dramatic currency gyrations. That's a big fear of many policymakers, investors, and business executives who are gathering in Davos, Switzerland, for this year's World Economic Forum. Volatile exchange rates hurt companies by making it difficult to set prices, control costs, and predict revenues. They alarm investors because they can quickly wipe out the value of their international portfolios. And they're a nightmare for monetary policymakers because they can undermine the impact of interest rate adjustments.

"The strong rise in the euro over the past two months has already neutralized the [50 basis point] interest rate cut the European Central Bank made on Dec. 5," says Jürgen von Hagen, economics professor at the Center for European Integration Studies at the University of Bonn in Germany.


  Sudden currency swings can also hurt entire economies by making exports uncompetitive or imports more expensive. Take the unexpected 17% rise in the euro's value since January last year. European businesses complain that it's making their goods more expensive abroad, sapping their revenues, and curbing already anemic growth. They dread the single currency strengthening even further against the dollar.

It wouldn't be so bad if it were possible to predict precisely where currency markets are heading over the medium and longer terms. But even the experts disagree. Gail Fosler, chief economist of CEO group The Conference Board, forecasts that the greenback could soon regain all the ground it has lost over the past year -- and then some. "We could see it at higher levels than ever before," she predicts. Fosler says a speedy and victorious war in Iraq, followed by a reduction in oil prices, stronger U.S. consumer confidence and a rekindling of economic growth would all be good for the dollar.

She adds that the continuing love affair of Asian countries -- especially Japan and China -- with the greenback will sustain it over the longer term. "The Far East is basically a dollar zone," she says. "The dollar is the main medium for trade and investment there, so demand for it will remain strong."


  Not all analysts see it this way, however. Stephen S. Roach, Morgan Stanley's chief economist, says it's hard to envision a strong economic recovery stateside in the near future, even with the huge tax cuts proposed by President George W. Bush.

And Chinese officials say their appetite for the dollar could wane. Zhu Min, general manager and economic adviser to the Bank of China's president, says the mainland is less dependent on the U.S. as a market than it once was. As the world's most populous country and fastest-growing economy diversifies its trade relationships, its interest in the euro is growing. "I can't confirm the view that Chinese businesses will continue to help underpin the dollar's value," he cautions.

Asian investors' enthusiasm for dollar-denominated assets could also cool, taking away some support for the greenback. In the 1980s, Japanese and other Asian investors snapped up American securities while the U.S. ran up huge budget deficits and a widening trade gap with the rest of the world. But today, these foreign investors aren't as enamored with Treasury bills as they once were, and they might steer clear if the U.S. starts running up the red ink again.


  However, if the Iraqi impasse drags on or the U.S. gets bogged down in a long war, all bets about the greenback are off. "The dollar could plunge suddenly -- and erratically," worries the CFO of one large euro-zone bank. "I've not seen the currency markets this uncertain since the mid 1970s, when the Bretton Woods system collapsed."

The prospect of a roller-coaster ride in currency markets is unnerving to many businessfolk, especially those with large foreign operations. While they can partially protect themselves against short-term currency swings by hedging their foreign-exchange exposure, it's nearly impossible for them to protect themselves in the longer term, especially if currency movements do become very erratic. Besides, all the financial wizardry in the world can't stop a business or country from losing its competitive edge if the national currency suddenly goes through the roof.

And the most worrying possibility: Currency volatility could undermine weak global economic growth and increase the likelihood of a double-dip recession -- especially in Europe. Indeed, German growth has already slipped back into negative territory, and the rest of the euro zone could soon follow suit.

Roach thinks U.S. growth could also stall this quarter partly because of currency jitters. "Things are bad enough already," says the bank CFO. "These currency concerns can only make them worse." Small wonder for the anxiety in the Alps as Davos gets under way.

By David Fairlamb at the World Economic Forum

Edited by Douglas Harbrecht

Before it's here, it's on the Bloomberg Terminal.