For months now political capitals have been roiled by the prospect of regime change as the Bush administration pursues its campaign to remove Saddam Hussein from power in Iraq. But much of the accompanying turbulence in financial markets reflects fears of a different kind of regime change -- the decline of the dollar as the world's most valued currency.
The greenback has fallen significantly over the past year, particularly against the euro, as the plunge in U.S. equity prices and the sputtering American economic recovery have dulled the attractions of investing in the U.S. The slashing of U.S. interest rates to a 50-year low of 1.25 percent has aggravated the dollar's weakness versus the euro because investors are earning a yield premium for holding the single currency. Analysts and investors increasingly regard the slide not as a temporary bout of weakness but as the beginning of a long-term decline fueled by big U.S. budget and current-account deficits, similar to the weak-dollar period of the late 1980s and early 1990s.
"We're seeing a genuine structural shift in the way people are viewing the dollar, and it's still relatively new news," says David Puth, global head of currency trading at J.P. Morgan Chase & Co. in New York. Adam Seitchik, global chief strategist at Deutsche Asset Management in London, concurs. "We're in for a multiyear period of dollar weakness," he says. "The markets are telling the world that the U.S. can't be the engine of global growth. The source of global growth has got to come from elsewhere."
Since hitting a high of a little more than E1.16 and nearly ¥135 in February 2002, the dollar has fallen by just over 20 percent against the euro and by 11 percent against the yen. That's a substantial decline for a given year, to be sure, but it's relatively modest compared with the big swings that have taken place since the Nixon administration pulled the plug on the Bretton Woods system of fixed exchange rates in the early 1970s. The dollar soared 89 percent against the deutsche mark from its 1979 low to its 1985 peak, and then plunged by 61 percent over the following decade before surging again by nearly 75 percent from its 1995 trough to its peak in October 2000.
For dollar bears it's particularly telling that the currency's weakness accelerated at the end of 2002 and at the start of 2003, just as tensions over Iraq were escalating. That suggests that the dollar has lost its status as a haven for investors in times of crisis, says Avinash Persaud, global head of research at State Street Global Markets in London. "We're now on the edge of a dollar crisis," he says. "Dollar decline is looking more and more like a certainty."
A long-term dollar decline would have major consequences for financial markets and the global economy. At best a gradual decline could act as a kind of global reflation mechanism, spurring U.S. growth and trimming its current-account deficit while prodding Europe and Japan to stimulate their own internal demand rather than relying on exports. James O'Neill, head of global economic research at Goldman, Sachs & Co., estimates that a further 10 percent decline in the dollar's trade-weighted value, combined with stimulative policies elsewhere, would boost global growth by at least half a percentage point.
It's that sort of reasoning that leads many analysts to conclude that the Bush administration, despite its rhetorical support for a strong dollar, would actually welcome some more depreciation. The new Treasury secretary, John Snow, made a telling remark in a recent interview. Asked if he was concerned about the current-account deficit, Snow replied: "No, I'm not. If the rest of the world economy gets stronger, they'll be buying more from us." If the administration is counting on overseas growth, it may be tempted to use a weaker dollar to encourage stimulative policies in its trading partners. David Hale of Hale Advisors, a Chicago-based consulting firm, predicts a new era of "competitive monetary reflation" as a weak dollar forces Europe and Japan to ease monetary policy aggressively.
Too large or rapid a fall could undermine the confidence essential for growth, however. In the first official sign of concern, Ernst Welteke, president of the Deutsche Bundesbank, warned last month that the speed of the dollar's decline risked stifling growth in Germany. Given those risks, it's worrying to many analysts that the Bush administration and its counterparts in Europe and Japan show little sign of working together to foster growth. Indeed, the angry dispute between the administration and Paris and Berlin over Iraq is likely to make cooperation on economic policy issues even more difficult. "Generally, when political relations deteriorate, it's harder to develop the kind of closer economic coordination you need to deal with these problems," says Robert Hormats, vice chairman of Goldman Sachs (International) and a former senior official in the Carter and Reagan administrations.
The foreign exchange market is a notoriously volatile beast, of course. Many analysts and investors believe a dollar rebound is likely in the short term, particularly if the situation in Iraq is resolved quickly. Trying to pinpoint the reasons why a currency should rise or fall over the longer run is never easy in a market where volume averages a cool $1.5 trillion a day. As Daniel Szor, head of the European office of currency overlay adviser FX Concepts in Paris, puts it: "Fundamentals are a great way of explaining currency moves. They're a lousy way of predicting them."
And it's not as if the dollar is alone in its problems. The euro zone remains more sluggish than the U.S. economy, with Germany bordering on a double-dip recession, and policymakers from the European Central Bank to the finance ministries of the 12 countries that use the euro appear impotent when it comes to reviving growth. Japan remains the global economy's black hole, with output contracting again and deflation continuing unabated. In short, dollar bearishness doesn't translate into enthusiasm for the euro or the yen. That represents a sea change from the late 1980s, when Germany and Japan were booming. When it comes to the major currencies, "at the moment it's the three ugly sisters," says Sushil Wadhwani, a former member of the Bank of England's Monetary Policy Committee who is launching a macro strategy hedge fund to take advantage of currency shifts. But with investors focusing on the dollar's negatives more than on those of its rivals, the U.S. currency can continue to decline.
The signs for the dollar are distinctly negative. The constellation of factors that propelled the currency higher from 1995 to 2001 -- a booming equity market that pulled in portfolio investment, a record-breaking surge in acquisitions by foreign companies seeking to establish a foothold in the giant American market and an abiding faith in the ability of U.S. monetary and fiscal policymakers to restore vigorous growth -- have faded. Last year, for the first time, there was more foreign direct investment in China, $52.7 billion, than in the U.S., which received $21.9 billion in the first three quarters.
Instead of those positive drivers, investors today are turning their attention to that bogey of the late '80s, the twin deficits. The U.S. budget has swung from surplus to deficit at a breathtaking pace, and President George Bush's latest budget proposal forecasts the deficit rising to $307 billion in fiscal 2004 and remaining high for years to come. Federal Reserve Board Chairman Alan Greenspan, who gave a crucial endorsement to the Bush administration's 2001 tax cuts, last month called the new projections "sobering" and told Congress that "there should be little disagreement about the need to reestablish budget discipline." The U.S. current-account deficit, the widest measure of trade in goods and services, is likely to expand from an estimated $500 billion in 2002 to some $600 billion this year, or 5.6 percent of GDP, estimates Goldman's O'Neill. The trade deficit alone surged 21.5 percent last year, to a record $435.2 billion.
Financing the current-account deficit was no problem during the late '90s boom, when foreign asset managers and corporate executives were scrambling to invest in the U.S. But financing a burgeoning deficit at a time when U.S. stock markets and growth are weak, yields on dollar bonds are at historic lows and uncertainty about a possible war in Iraq is prompting risk-averse investors to stay at home is an awfully tall order. "If you have a deficit that needs to be financed on the order of $1.5 billion a day, you need people to feel willing to move capital overseas," says J.P. Morgan Chase's Puth.
Global investors haven't been so willing lately. As a consequence, most forecasters expect the dollar to continue to weaken this year, albeit along a choppy path. Lara Rhame, currency analyst at Brown Brothers Harriman and a former economist at the Federal Reserve, predicts the dollar will end the year at about $1.15 to the euro, but sees a risk of $1.25 if the slide gathers momentum. Jonathan Davis, currency strategist at UBS Asset Management in London, believes that the dollar will head toward an equilibrium level against the euro, which he estimates at $1.18. But as with many previous swings in the foreign exchange market, "it is quite likely to overshoot," he says. Goldman's O'Neill notes that it took a 30 percent fall in the dollar from 1987 to 1990 to trim the current-account deficit by 2 percent of GDP, but Japan and Germany were growing strongly at the time and were able to absorb more U.S. exports.
Dollar bulls -- and there are still a few -- dismiss such bleak scenarios. They believe the U.S. economy will reassert its dynamism after the Iraq crisis is resolved and pull the dollar back up. "We still believe the States is going to offer better investment opportunities over the medium to long term than Japan or Europe," says Steven Englander, a currency analyst at Schroder Sal-omon Smith Barney in London. He sees the dollar at parity against the euro by the end of the year, assuming that U.S. growth recovers to a strong 4 percent rate. "If the U.S. looks like it's falling back into the pack in terms of growth, then the dollar will have problems," he concedes.
The dollar's weakness also has been a relative thing so far. The currency may have fallen by just over 20 percent against the euro since February 2002, and by 11 percent against the yen, but on a trade-weighted basis, it is down only 5 percent. "The dollar is still reasonably strong," says Paul Chertkow, a currency strategist at Bank of TokyoMitsubishi in London.
Whichever forecast proves correct, the dollar today is a source of volatility that financial markets had largely forgotten about in recent years. Sure, investors have had to endure plenty of market turmoil lately. The collapse in stock prices has wiped more than $13 trillion off the value of equity markets worldwide since the technology bubble burst three years ago. But the striking thing about the collapse in equities is that it has been relatively consistent across major markets, reflecting a common problem of overvaluation in almost all major equity markets during the boom and the synchronous nature of the current economic slowdown.
The dollar's decline, by contrast, reflects fundamental concerns about the U.S. economy and its imbalances with the rest of the world. For William Gross, chief investment officer of Pimco, the big U.S. bond fund group, it's impossible to understate the change. "Three years of stock market declines, a 20 percent devaluation of the dollar over ten months and an inability to serve as the global economy's locomotive despite massive monetary and fiscal stimulation suggests America's shining city on a hill may have lost some of its sheen of late," he wrote in his February commentary. "Economically, we may have begun a process of hegemonic decay."
This new and growing concern about U.S. economic potential is the main reason currency traders have refocused their attention on the current-account deficit. That deficit, after all, has been large and growing for years but was easily financed as long as foreign investors regarded the U.S. as the most productive place to put their money. Former U.S. Treasury secretary Paul O'Neill was so confident the funds would continue to flow that he blithely told an audience of financiers and policymakers at the annual IMFWorld Bank meeting in September that the current-account deficit was an irrelevance.
Such unbridled optimism is nowhere to be found today. As a result, it's the defensive bond market rather than the equity market that drives international capital flows today. And with Treasury yields near historic lows, new supply burgeoning with the deficit and the prospect of further Fed easing limited, the U.S. fixed-income market is not the magnet that Wall Street was three years ago. Low yields and increased currency risk have prompted Lombard Odier Darier Hensch Group to underweight dollar bonds by 30 percent in its model portfolios and overweight euro-denominated bonds by 30 percent, says Patrizio Merciai, global strategist at the Geneva-based private bank.
"Ever since the equity bubble burst, we've been in a very different environment in terms of capital flows," says State Street's Persaud. "Now cross-border capital flows are very much bond flows. Investors are looking for value. The U.S. fares very poorly in terms of bond valuation."
Asian investors have been among the biggest buyers of U.S. Treasuries and corporate bonds recently, but their appetite could well diminish. The fact that foreign funds are increasingly financing the U.S. budget deficit rather than business investment is a big negative for the dollar, Zhu Min, general manager and economic adviser to the president of the Bank of China, told business leaders at the recent World Economic Forum in Davos, Switzerland. "Asia has been exporting to the U.S. and buying U.S. Treasury bills, and so far everybody has been happy. But I don't think it is sustainable," he warned. "Dependence on Asian capital flows to sustain the deficit is not healthy."
Geopolitical tensions merely add to investor concerns about the twin deficits. Although a quick, decisive war might give the dollar a fillip, many investors believe that the U.S. will face a long and costly involvement in Iraq after any invasion. Former White House economic adviser Lawrence Lindsay estimated the costs of an Iraq war at $100 billion to $200 billion, and researchers at the Brookings Institute in Washington have come up with similar estimates. "One way or another the U.S. is going to be in the region longer than we realize," says John Llewellyn, global chief economist at Lehman Brothers. "That will signal a prolonged bout of U.S. budget deficits and dollar weakness. You may be looking at weakness for a number of years."
A weak dollar would not necessarily be bad news for the U.S. Indeed, at a time when the Fed has used up much of its monetary ammunition by reducing rates to 1.25 percent and the federal budget deficit has ballooned, a depreciating currency might be the best tool the Bush administration has for stimulating the economy. Suspicion that the administration would gladly accept a weaker dollar is a significant factor behind the bearish sentiment toward the currency. Treasury Secretary Snow made the ritual expression of support for a strong dollar in his recent congressional testimony, but most analysts and investors detect less commitment to the strong-dollar policy today than under his Democratic predecessors, Robert Rubin and Lawrence Summers. "I think they would not mind the dollar weakening, but they won't say it explicitly," says Goldman's Hormats. "If it looks as if the U.S. is using the dollar as an instrument, there's a risk it will go down more than they want."
The dollar's decline, and the consequent rise in the euro, presents trickier problems for Europe. It threatens to curb demand for exports at a time when growth is already slowing, particularly in Germany. Lehman Brothers' Llewellyn calculates that the drag on growth from the rise in the euro has effectively offset the stimulus of the European Central Bank's half-point interest rate cut in December. German industrial production fell by 2.6 percent that month, and unemployment soared by 398,000 in January, to 4.6 million, or 11.1 percent of the workforce. The ECB is likely to reduce its already modest 1.6 percent growth forecast for the euro zone this year, said Matti Vanhala, the Finnish member of the bank's governing council.
But a weaker dollar will reduce import prices and contribute to decreased inflation in the euro zone, creating leeway for lower interest rates. ECB President Wim Duisenberg said last month that inflation was likely to fall below the bank's 2 percent target ceiling later this year, compared with the current level of 2.2 percent. The key question is whether the ECB will take advantage of this opportunity to ease monetary policy and go for growth. "If the ECB responds by becoming more aggressive with interest rate cuts, this will be good for Europe," says State Street's Persaud.
But the ECB's initial instincts were cautious. The bank refrained from cutting rates in early February, in part because it worried that the impact of any reduction would drown in a sea of economic uncertainty over Iraq, Duisenberg said. "If I had full confidence that the ECB would lean against the wind and counteract the euro's rise, I wouldn't worry,"says Anders Schelde, who helps manage E100 billion at Nordea Asset Management & Life in Copenhagen. "But everybody has a feeling that the ECB is probably not going to neutralize this completely."
In Japan, by contrast, the government has been trying to encourage a weaker yen to stimulate the moribund economy, but the sheer force of deflation, which pulls Japan's massive savings into the booming government bond market, has frustrated policymakers. "Life insurance companies have given up their previous role of recycling the trade surplus" with the U.S., says Marshall Gittler, the currency analyst at Deutsche Bank in Tokyo. "They aren't buying as many foreign bonds, and when they do, they're hedging the currency exposure."
Where Japanese institutions have been active, they have tended to favor the euro. The country's institutional investors, which during the 1990s devoted almost all of their overseas bond allocations to the U.S., now have about 30 percent of those funds invested in euros, estimates Bank of TokyoMitsubishi's Chertkow. That shift is one of the reasons why the yen has declined by more than 5 percent against the euro over the past year. Private investors also have been eagerly snapping up Australian dollar bonds, attracted by the currency's relatively high interest rates.
The decision of Prime Minister Junichiro Koizumi to appoint Toshihiko Fukui as the next governor of the Bank of Japan, rather than the reflation candidate, Shin Nakahara, suggests a continuation of the status quo. Fukui, a former deputy governor, opposes the idea of trying to end deflation by setting a formal inflation target and increasing the money supply by having the central bank purchase government bonds aggressively. That's not good news for the Japanese economy, but with the risk of inflation apparently receding, "bonds now come with a BoJ put," says Deutsche Bank's Gittler. "This means the authorities are likely to have to continue to intervene, or see the yen appreciate further" against the dollar.
For the U.S. currency, having "ugly sisters," as Wadhwani puts it, may be little consolation.