Foreign Investors and a Dollar Plunge

Foreign central banks worry about U.S. debt load after a bailout. The greenback could suffer
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Could the dollar get hammered if the $700 billion bailout goes through?

For years the connection between the dollar and the size of the U.S. government debt has inspired one of the scariest scenarios in international finance. The U.S. depends on foreign investors to finance its budget shortfalls: 47% of Treasury bonds are held abroad. When foreigners buy this debt they support the greenback, since they need dollars to buy T-bills and other U.S. government debt. But if foreigners get spooked by the deterioration of the U.S. budget deficit, they might demand higher interest rates or even dump the U.S. paper in favor of bonds denominated in yen or euros or yuan. If the great dumping occurs, the foreign investors don't need or want as many dollars anymore—and the greenback takes a hit.

The scenario hasn't played out yet: The dollar has declined but not crashed. The patience of foreign investors, however, has started to wear thin. Foreign central banks already showed their concern by urging the U.S. to take over Fannie Mae (FNM) and Freddie Mac (FNM). Now if foreign holders of U.S. equities and bonds don't like the way the bailout or the economy is headed, Hank Paulson and Ben Bernanke could have a dollar run on their hands. "There's no question but that investors are starting to worry about [the dollar]," says Kenneth S. Rogoff, former chief economist for the International Monetary Fund and now an economics professor at Harvard. "We will see a reassessment of the size of the flows people are willing to put into the U.S."

Investors and policymakers alike got a rude taste of that possibility on Sept. 22. While markets had rallied on news of the Treasury's plan the previous Friday, the dollar plunged 2.5% against the euro as investors tallied up the huge price tag and realized the bailout wouldn't bring a quick recovery. That was the biggest one-day drop since 2001.

More scares are likely as the deficit explodes. Though the shortfall hit $163 billion for the fiscal year closing on Sept. 30, the Congressional Budget Office had already projected that lower tax receipts and higher spending would stretch the deficit to nearly $500 billion by fiscal 2009. Now that half a trillion looks like chump change: Factor in the various rescues the government is arranging and the continued drain on tax revenues as the economy slows, and Merrill Lynch (MER) estimates the deficit could hit $900 billion in fiscal 2009. That estimate doesn't account for the big fiscal stimulus the next President will probably seek to kick-start the economy. "No one really knows" how big [the deficit] could get, adds Merrill analyst Alex Patelis.

There's still plenty of room to expand the deficit, which at around 3.5% of gross domestic product is well below historic levels: A $900 billion deficit would be around 6% of projected GDP. But piling on more debt is not good for the dollar. "Traders look at a couple of things in valuing currencies, and the debt load is one of them," says one well-placed Washington analyst. "Whatever the number, they see that we will be printing more money." Raising interest rates to entice more foreign buyers into Treasuries is not a good option given the economy's weakness.

This leaves the U.S. very exposed. "There is a structural risk we could exhaust our credit line," says Brad W. Setser, a former Treasury official now with the Council on Foreign Relations. "We're asking foreigners to keep lending to us when U.S. assets aren't looking good."

Setser argues that many private foreign buyers have already started to beat a broad retreat from dollar-denominated assets. Central banks, sovereign wealth funds, and other official bodies, he figures, have held steady in their purchases of U.S. debt and equities over the last four quarters. Private investors, on the other hand, slashed net holdings of Fannie Mae, Freddie Mac, and other U.S. agency debt by $37 billion. They also cut net purchases of U.S. corporate bonds to $70 billion—well down from the $660 billion bought the previous four quarters.

As much as faith in the dollar, those continued central bank purchases reflect economic policy in China and other Asian countries that peg their currencies to it. Such strategies won't change anytime soon, although Merrill's Patelis argues that many central banks are reassessing where to invest their accumulated reserves. "That's happening for many reasons," he says, "but the fact that U.S. government paper is not as secure as people thought adds one more."

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