The Incredible Falling Dollar

The buck keeps sliding, even as the U.S. economy revs up. That's a plus for business-but there are risks ahead

With all the great news on the economy, you'd think the dollar would be soaring. U.S. economic growth clocked in at an astounding 8.2% in the third quarter. Corporate profits are taking off. And stock prices are climbing, with the Dow Jones industrial average flirting with the 10,000 milestone. Yet the once-mighty buck is crumbling. Although it bounced a bit on Dec. 10 thanks to heavy buying by the Bank of Japan, the greenback is still trading near a record low vs. the euro and multiyear lows vs. the yen, Swiss franc, pound sterling, and Australian dollar.

So why is the dollar losing altitude just when the economy is taking off? In large part, it's Washington's doing. Thanks to the Federal Reserve's easy monetary policy -- and its promise, repeated on Dec. 9, that money will flow freely "for a considerable period" -- faster economic growth isn't driving the higher interest rates that would tempt global investors to hold more dollars. The Bush Administration's laissez-faire currency policy, which accepts a deeper dollar decline to help hard-pressed manufacturers, is another reason investors are wary of owning too many greenbacks. And the Administration's protectionist forays, along with its cut-tax-and-spend budget policy, provide added reasons for caution.

FREE LUNCH

Behind the dollar's weakness is the gaping U.S. trade deficit and America's increasing difficulty in attracting foreign money to finance it. The composition of the capital that is coming to the U.S. and who's providing it has changed, putting downward pressure on the dollar. Rather than huge corporate investments such as Daimler Benz combining with Chrysler, now the U.S. is dependent on more fickle financial flows into stocks and bonds from foreign investors and support from Asian central banks.

So far, the greenback's decline has been a welcome development for U.S. companies. In fact, says Marc Chandler, chief currency strategist of HSBC Holdings PLC in New York, it's as close to a free lunch as things can get. "Obviously, our exports benefit from the weaker dollar," says Nathan J. Jones, chief financial officer at farm equipment maker Deere & Co. (DE ). U.S. exports rose to their highest level in more than two years in September. The falling dollar also pads the profits that U.S. multinationals earn on their operations abroad.

At the same time, the declining dollar hasn't pushed up inflation. Non-oil import prices were up just 0.7% in the year to October. Nor have the buck's travails hurt U.S. financial markets. While bond yields rose on Dec. 9 after the Fed showed less concern about a fall in inflation, they're low by historical standards.

There are risks, of course. Currency moves tend to affect inflation with a long lag, so there's a danger the U.S. is storing up trouble down the road. The weaker dollar is already pushing up prices of many commodities, including gold. And OPEC cited the weak greenback on Dec. 3 as a reason why it's keeping oil prices up.

The uneven nature of the dollar's decline is also a concern. The dollar has fallen much more against the euro -- which is up 46% vs. the greenback since October, 2002 -- than against Asian currencies, including the yen, which is up less than half that. One especially controversial exchange rate -- the yuan-dollar rate, pegged by China to prevent fluctuations -- hasn't changed at all. If Europe continues to feel the brunt of the dollar drop, its fledgling export-led economic recovery could grind to a halt, hurting the global economy.

SHIFTING OUT OF STOCKS

In the roaring '90s, the rising U.S. current account deficit didn't matter much for the dollar. At a quarter of a billion dollars in 1999, the gap between imports and exports was roughly half of what it is today at a time when investors saw the U.S. stock market as the best game in town. But now, the deficit is pushing a record 5% of gross domestic product -- a level that Fed research suggests can't be sustained. And global investors are chock-full of dollars after a buying binge that pushed the U.S. currency's share of their stock and bond portfolios up to 50% from 30% in the early '90s, says former Fed official Catherine L. Mann. With the trade deficit continuing to mount, investors need to add to the proportion of dollars they hold to prevent the currency from falling. But there's no sign they're willing to do that, especially since the U.S. is using the foreign capital to finance a ballooning budget deficit.

As the deficit has swelled, there has been a shift in foreign buying away from equity purchases, which tend to be driven by differences in economic growth rates between countries, to bond purchases, where interest-rate differentials are what counts. That has been the case particularly for European investors, who pulled back sharply from the U.S. stock market after the bubble burst in 2000 and show no sign of returning. What's more, risk-averse investors in the U.S. Treasury market are more prone to hedge their exposure to the dollar by selling greenbacks. Data culled by State Street Corp. (STT ) from its institutional investor clients worldwide suggest such hedging has picked up sharply.

With foreign private investors less willing to hold dollars, Asian central banks are taking up the slack, says consultant David Gilmore of Foreign Exchange Analytics. To avoid appreciation of their currencies that would hurt exports, central banks in China, Japan, and other Asian countries are buying up dollars to invest them in U.S. Treasury debt. Foreign central banks now own more than $1 trillion of U.S. securities.

U.S. investors, too, including Warren E. Buffett and George Soros, are moving money out of dollars. Through the first nine months of this year, U.S. investors bought $57.9 billion of foreign equities; in the same period last year, they sold $8.3 billion. Much of that has gone to Japan and other markets in Asia.

While a short term dollar bounce is possible, many experts think the buck has a lot further to fall before the current account deficit reaches a more manageable level. But as long as the drop continues to be gradual -- and not the crash landing that some fear -- it should be a plus for the U.S. and world economy.

By Rich Miller in Washington, with Michael Arndt in Chicago, Kerry Capell in London, and David Fairlamb in Frankfurt

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