Far-reaching impact of dollar's slide

Posted: Friday, November 19, 2004

The dollar has been struggling for almost two years, but in recent weeks its slump has been exaggerated, dropping against most major currencies and tumbling to a record low against the euro.

Should it stay on such a course, the implication extends a lot further than just bumping up the costs of vacations in Europe. And while the weak dollar is already helping U.S. exporters and companies doing business abroad, it could mean higher borrowing and mortgage costs and make everything from imported cars to toys more expensive.

The dollar hit a new low against the euro last week when it cost about $1.30 to buy one euro, the common currency used by 12 European nations. The greenback has also lost 10 percent of its value against the currencies of the United States' major trading partners since mid-May.

There are many reasons for that decline. Most recently, pressures are coming from investors' nervousness that President Bush and his administration would do little to stem the dollar's slide. U.S. Treasury Secretary John Snow on Monday said the United States would like the dollar to strengthen, but he repeated his position that international currency markets should be left to set its value.

Also weighing on the dollar are the huge U.S. trade and budget deficits.

The recent sell-off comes despite some favorable news that at other times should have helped strengthen the dollar. For one, new data on the job market shows improving employment growth, which supports the view that the economy is gaining traction.

In addition, the Federal Reserve raised interest rates last Wednesday for the fourth time in five months. The federal funds rate, the interest that banks charge each other, now sits at 2 percent, double the 46-year low of 1 percent that it was at in June.

With this weakness in the dollar, there is concern over how foreign investors will react particularly Asian central banks, which in recent years purchased dollars to hold down the value of their currencies and then used those dollars to buy U.S. Treasurys.

There are indications that foreigners are starting to pull back their investments, which is worrisome given that they own about 48 percent of Treasurys and 24 percent of U.S. corporate debt, according to The Bond Market Association.

In August, the most recent data available, net foreign purchases of government bonds fell 34 percent to an 10-month low of $14.7 billion. Meanwhile, foreigners sold $2 billion in stocks, down sharply from the $9.8 billion gain the month before, according to the Treasury Department.

''Their portfolios are saturated with U.S. dollars, and they need to consider what is the risk to buying additional dollars,'' said Bernard Baumohl, who heads The Economic Outlook Group in Princeton, N.J., and is the author of a new book ''The Secrets of Economic Indicators: Hidden Clues to Future Economic Trends and Investment Opportunities.''

The problem with all this is that we need that foreign money to cover shortfalls in the U.S. trade and budget deficits. And it is hard to drum up that missing cash inflow from other sources.

Consider that foreign private investors would have to increase their accumulation of U.S. stocks and bonds by six times this year from what they spent last year should the foreign central banks curb their dollar-buying, according to a recent report issued by the Federal Reserve Bank of New York.

Thus, a continual dollar decline could set off a vicious cycle of events.

It could prompt the Fed to hike interest rates to attract foreign capital, which would likely lead to a drop in bond prices. That would trickle over into higher mortgage and borrowing costs, which then could pinch corporate earnings as well as consumer spending. A weak dollar could also lead to higher inflation, which historically has been bad for stock prices.

Former U.S. Treasury Secretary Robert Rubin suggested in a speech last week that unless politicians in Washington get serious about reducing the federal deficit, an acceleration of the dollar's decline could be far reaching.

''If markets begin to fear long-term fiscal disarray and if foreign providers of the capital inflows upon which we have now become so enormously dependent share this fear and also develop a concern about our currency, then the markets may begin to demand sharply higher interest rates on long-term debt and possibly even create conditions of serious disruptions in our financial markets, with all the problems that that can lead to for our economy,'' he said.

Even with all those negative factors potentially at work, there is no chance that foreigners would dump their dollar-backed holdings entirely. That would drive up the value of their currencies and cause big portfolio losses.

And there are plenty of economists who believe the sinking dollar is good news. One is Stephen Roach of Morgan Stanley, who thinks that the declining dollar will provide ''long overdue restraint to interest-rate sensitive and asset-driven spending of American consumers and businesses.''

That, in turn, will rebuild national savings, which will thereby reduce the large current account and trade deficits.

It sounds good. That is, if it works.

Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org

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