The Dollar: What Goes Up...


By Rich Miller Finance ministers and central bankers from the Group of Seven (G-7) industrial nations could barely hide their glee when they gathered in Washington on Apr. 24, on the fringes of the International Monetary Fund's (IMF) spring meeting. At their previous powwow in Florida, back in February, some of the monetary mandarins fretted that the dollar was heading into a free fall that could wreck the world economy. Since then, the greenback has rallied, alleviating fears of a crash. In fact, G-7 officials said they barely discussed currencies at their latest get-together.

Treasury Secretary John W. Snow, Federal Reserve Chairman Alan Greenspan, and their fellow G-7 policymakers shouldn't get too comfortable, however. The dollar's recent recovery (it has risen 7.6% against the euro and 5.5% against the yen from its recent lows) is probably a temporary reprieve. With world trading patterns so lopsided -- the U.S. ran a record $542 billion current-account deficit in 2003 -- the greenback is likely to drop again after a quarter or two of strength.

LESS HEDGING. The two forces behind the dollar's bounce -- faster economic growth and rising interest rates in the U.S. -- will serve only to worsen global imbalances by pumping up American imports and increasing what Washington must pay its foreign creditors. Foreigners are likely to demand a steep markdown in U.S. assets via a further drop in the American currency. "The dollar will reach new lows in the next 12 months," says David Gilmore, a partner at consultants Foreign Exchange Analytics. That could complicate an already complex market dynamic for investors.

For the moment, though, the G-7 is basking in its success in halting the dollar's slide. At the Boca Raton (Fla.) meeting, the U.S. signaled that it was no longer eager for a dollar decline by joining its partners in warning speculators against "excess volatility" in exchange rates. The shift came in response to pleas from Europe that its economy was getting killed by the euro's relentless rise. Japan then hammered the message home to speculators with a buying spree, snatching up $20 billion-plus in bucks.

The dollar revival gathered force in April. A spate of favorable U.S. economic indicators sent interest rates surging as expectations mounted of tighter credit from the Fed. At the same time, Europe's economy faltered, increasing pressure on the European Central Bank to cut rates. The result: a shift in long-term interest rates in favor of the dollar, with the 10-year Treasury note now yielding more than its German counterpart and holding more allure for international investors.

PADDING THE DEFICIT. The rise in U.S. rates has also dampened dollar sales by investors and multinational companies. When rates were low, these players would hedge their international investments against a dollar drop by selling dollars forward -- a persistent downward push on the greenback. But higher U.S. rates have raised the cost of that strategy, so this dollar hedging has fallen off. Data culled by State Street (STT) from its institutional investors found that forward-dollar sales have sharply declined in 2004.

While the combination of growth speeding up in the U.S. and slowing in Europe is helping the dollar now, it will probably hurt the buck later. Fed research suggests that U.S. imports rise 1.8% for every 1% increase in U.S. spending, while U.S. exports shrink 0.8% for every 1% slowdown in foreign economic growth. The result: a bigger U.S. trade and current-account deficit.

Rising U.S. interest rates will also tend to pad the current-account deficit, notes former Fed official Edwin M. Truman. According to hedge fund Bridgewater Associates, foreigners own more than 45% of U.S. Treasury securities, more than 30% of U.S. agency debt issued by firms such as Fannie Mae (FNM), and 20% of U.S. corporate bonds. Thus, as rates rise, so does America's debt service.

DANGEROUS LEVEL. The dollar's 10% drop since early 2002 should soon show up in a smaller current-account deficit, boosting U.S. exports and dampening American imports. And if China and other Asian nations allow their controlled currencies to appreciate against the greenback -- as some experts believe is increasingly likely -- that should help shrink the deficit, too.

Still, it probably won't be enough, and the implications for financial markets are worrisome. The IMF predicted on Apr. 21 that the U.S. current-account deficit will fall from 4.9% of gross domestic product (GDP) last year to 4.1% in 2005. Yet even at that level, America's foreign indebtedness would grow from 25% of GDP now to a more dangerous 40% or so by the end of the decade. To head off that scary scenario, the dollar still needs to come down -- sooner or later. With Dexter Roberts in Beijing, Moon Ihlwan in Seoul, and David Fairlamb in Frankfurt

Miller covers the Federal Reserve for BusinessWeek in Washington, D.C.


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