Why The Dollar Is Giving Way

The problem: America's yawning deficits -- and foreign investors' waning interest in financing them

What's going on with the dollar? After falling steadily for the better part of two years, the greenback showed signs of stabilizing in the spring and summer. Massive dollar purchases by Japan and other Asian central banks, hopes that the U.S. trade deficit was peaking, and expectations that the Federal Reserve would hike interest rates rapidly all combined to put a floor under the U.S. currency.

But in the last few weeks that floor has suddenly given way. The dollar is once again on the decline, dropping to a record low vs. the euro, a four-year low vs. the yen, and a seven-year low against the South Korean won. Behind the latest downdraft: a stubborn U.S. trade deficit that refuses to stop climbing and growing hints from Japan, China, and other Asian nations that they might be willing to countenance an appreciation of their currencies to help narrow the shortfall. Moreover, Washington's lack of concern about the plunge has added fuel to the fire. Treasury Secretary John W. Snow has all but ruled out action to stop the dollar's decline, while Federal Reserve Chairman Alan Greenspan suggested on Nov. 19 that a fall is inevitable. Put it all together, concludes Robert D. Hormats, vice-chairman of Goldman Sachs International (GS ), and "it's an invitation to sell the dollar."

So far the drop has been largely benign. Despite the dollar's 5% slide against major currencies in the last month and a 25% fall since its peak in early 2002, the global economy has continued to grow, and stock and bond markets have been steady. But history suggests that caution is in order. Currency markets are prone to excess -- and an uncontrolled fall of the dollar would be good for no one. It would disrupt financial markets worldwide and undercut global growth. "You could have a couple of rough patches," says ex-Fed official Edwin M. Truman.

The renewed drop already has led to heightened transatlantic tensions. European Central Bank President Jean-Claude Trichet, worried that the strengthening euro could undercut the region's fragile recovery, has called the currency's rise against the dollar "brutal." German Chancellor Gerhard Schröder agrees. "The euro-dollar rates are a cause for concern," he told reporters in Berlin on Nov. 20 before an address to Snow and other economic policymakers from the Group of 20 nations. "The cause is clear," he added. "It can be found in the double deficit in the U.S. -- the deficit in the federal budget and the current account."

Snow disagrees. He pins much of the blame for the gaping U.S. trade shortfall on what he calls a "growth deficit" in the rest of the world, especially in Europe. In the third quarter, growth slowed to a virtual standstill in Germany and France. He wants Europe to reform its product and labor markets and boost its economies so it can buy more imports from the U.S. and elsewhere.

At the heart of the dollar's difficulties is the ballooning U.S. current account deficit and the growing wariness on the part of foreign investors and central banks to finance it. Thanks in part to sky-high oil prices, the U.S. deficit looks on course to hit a record $600 billion this year. At close to 6% of America's gross domestic product, that's up from $496.5 billion last year and $421.7 billion in 2002. Economists Nouriel Roubini of New York University's Stern School of Business and Brad Setser of Oxford University reckon that the deficit could rise to well over $650 billion next year.


Foreign investors and central banks are already showing signs of fatigue in funding that ever-rising U.S. shortfall. According to Treasury Dept. data, foreign investors bought a net $158 billion worth of long-term U.S. securities -- both stock and bonds -- in the third quarter, while foreign central banks purchased $42.4 billion. That's down sharply from the $176.3 billion and $91.3 billion they bought, respectively, in the first quarter.

In a speech in Frankfurt on Nov. 19, Greenspan predicted that foreign investors would eventually get their fill of dollar assets and that a lower greenback and higher U.S. interest rates would be needed to keep them investing. That may be what's happening now. According to Catherine L. Mann of think tank the Institute for International Economics in Washington, 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 nearly 50%, from 30% in the early '90s.

Even foreign central banks are diversifying their portfolios. "They have made a strategic decision that the dollar is vulnerable," says David Gilmore of consultant Foreign Exchange Analytics. First Deputy Chairman Alexei Ulyukayev of Russia's central bank rocked currency markets on Nov. 23 when he suggested that the bank might sell off some of its dollars for euros. "Most of our reserves are in dollars, and that's a cause for concern," he told reporters in Moscow. "Looking at the dynamics of the euro-dollar rate, we are discussing the possibility of changing the reserve structure."

Russia is hardly alone. Signs are growing that Asian central banks might be willing to cut back on their dollar purchases and allow their currencies to appreciate against the dollar. Japan so far has allowed the greenback to fall toward 100 yen without stepping into the market to stop it. That's in sharp contrast to earlier this year, when it bought a massive $140 billion in the first quarter alone to push the dollar above 110 yen. Behind the apparent shift in strategy: a growing confidence in the durability of Japan's recovery. South Korea, too, has let its currency appreciate, by some 7% over the last month, though it has since stepped into the market to stabilize the won.


Still, the big kahuna is China. Faced with a $160 billion trade deficit with China alone, the U.S. has been pressing Beijing to loosen its hold on its currency, which has been pegged at 8.3 to the dollar since 1994. At the Group of 20 meeting in Berlin, Central Bank of China Governor Zhou Xiaochuan said Beijing is "reviewing its old foreign-exchange control systems." What's most likely, experts say, is that China will accept a small appreciation of its currency sometime in the next six months by widening the range in which the yuan trades.

In anticipation that a Chinese move will lead to a regionwide currency revaluation, hedge funds and other speculators have sold U.S. dollars short and loaded up on South Korean won, Taiwan dollars, and Japanese yen. According to data from the Chicago Board of Trade, speculators were short the dollar on nearly 275 million futures contracts on Nov. 16, compared with 90 million on September 28. The selling began in late September as China's attendance at its first meeting of the Group of Seven industrial nations fanned speculation that Beijing would make a move on its currency. It accelerated after President George W. Bush's reelection on Nov. 2 as speculators bet that the Bush Administration would not stand in the way of a further dollar decline and also would do little to bring down the U.S. budget deficit.

The sheer size of the speculative selling means the dollar might be susceptible to a short-term snapback as hot-money traders close out their bets and take profits. But short-term gyrations aside, most experts believe the dollar's long-term direction is downward. "The dollar has a lot further to fall -- especially against Asian currencies," says Brian Garvey, senior strategist at State Street Corp.'s (STT ) State Street Global Markets.

Provided the dollar's fall is gradual, it should prove manageable for the world economy. But that doesn't mean there won't be some dislocations. The higher inflation and interest rates brought on by the weaker dollar will mean that U.S. consumers will have less money in their pockets to spend. And U.S. companies will find it harder to make acquisitions overseas. "Many of us will feel a little bit poorer," says Kenneth S. Rogoff, former International Monetary Fund chief economist and now a professor at Harvard University. But Japan and Europe could be hit harder unless they take action to boost domestic demand to offset the loss of their exports.

Of course all bets would be off if the dollar suddenly nose-dived, dragging U.S. stock and bond prices down with it. That would raise the risk of a global recession. After all, it was a currency clash between the U.S. and Germany in 1987 that helped trigger the crash that pulled down stock prices by nearly 25% in a single day. Policymakers take note: When it comes to currencies, it pays to be careful.

By Rich Miller in Washington, with Jack Ewing in Frankfurt, William Boston in Berlin, Dexter Roberts in Beijing, and bureau reports

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