Dollar Faces Further Pressure

Drubbing Will Continue as Confidence Diminishes; Terrorism Worries Still Nag

By Michael R. Sesit

Wall Street Journal
January 2, 2004

Don't expect the dollar to experience a major reversal of fortune after the beating it took in 2003. Most currency strategists predict the currency will keep sliding. Even so, making money in the foreign-exchange market this year won't be the cakewalk it was during the past 12 months, as what many were expecting finally came to pass. Last year "was overdue and somewhat predictable, as a range of currencies returned to more normal equilibrium levels," says Dirk Morris, head of currency at Putnam Investments in Boston. "Most currency participants had a very good and profitable year."

But 2004 "will be a much tougher year to predict individual currency directions and make money," Mr. Morris says. That's because -- except for possibly China and several other Asian countries -- exchange rates are widely considered to be less out of kilter than they were a year ago. On Dec. 31, 2003, Europe's common currency was trading at $1.2579, up from $1.05 at year end 2002 and $1.1719 at its launch on Jan. 1, 1999. The dollar stood at 107.3653 yen on Dec. 31, compared with 118.76 yen at the start of 2003. Over the same period, the British pound rose to $1.7859 from $1.6097.

As it reached these year-end values, the dollar tumbled to its lowest level since late 1996 against the currencies of the 12 countries that use the euro. It also fell to 11-year lows against the British pound, its lowest point in a decade against the Canadian dollar, a seven-year low against the Swiss franc, six-year lows against the Australian dollar and a three-year nadir against the yen.

Moreover, worried about the dollar's eroding purchasing power, investors and speculators drove the price of gold futures to $416.10 an ounce, near an eight-year high. "The dollar is facing a long-term, slow-motion crisis of confidence," says Anne Parker Mills, a foreign-exchange economist at Brown Brothers Harriman & Co. in New York. "Or to put it less dramatically, a shift in investor preferences away from dollar-denominated assets."

Six months from now, she sees the U.S. currency trading at $1.30 to the euro and 90 yen; and by year end 2004, Ms. Mills says, the euro could be 15% higher than now, at $1.45, and the dollar still at 90 yen. Weighing on the dollar will be many of the same factors that have plagued it for much of the past year and a half. "The two key economic negatives are the twin deficits" in the U.S. federal budget and the U.S. current account, says Stephen Jen, chief currency economist at Morgan Stanley in London. A measure of trade in goods and services plus certain financial transfers, the current account is projected to be more than $500 billion in deficit in 2003, or more than 5% of U.S. gross domestic product. And because Americans don't save enough, the deficit requires foreign financing.

But with portfolios already chock-full of U.S. stocks and bonds, U.S. interest rates at four-decade lows and concerns that the U.S. economic recovery and current Wall Street rally might not be sustainable, foreign private investors are hesitant to keep purchasing American assets. Investors also are uneasy, because they suspect the Bush administration welcomes a weaker dollar to boost exports, increase jobs and thus enhance its re-election chances.

Another "important political negative [for the dollar] is the resurgence of protectionism," says Mr. Jen. "It would diminish what has historically been a key explanation of America's economic dynamism: the ability of companies to outsource and fully capitalize on their comparative advantages." Additional dollar worries center on continued risks of a terrorist attack against the U.S. and the possibility that Asian central banks could choose to reduce their huge dollar holdings and diversify their reserves more into other currencies.

While most analysts expect the dollar to remain weak throughout 2004, many believe its biggest declines will come against Asian currencies. Because Asian countries have consistently intervened -- buying dollars -- to keep their exports competitive, their currencies haven't risen as much against the dollar as the euro. By year end, Mr. Jen sees the euro at $1.23, the dollar at 102 yen and the pound at $1.81.

Last year, the low level of interest rates in most of the world on cash deposits "pushed investors into anything with yield -- whether in the form of corporate bonds, emerging-market debt, high-dividend stocks or high-interest rate currencies," notes John Normand, a strategist at J.P. Morgan in London. He adds that it is no coincidence that the highest-yielding currencies -- such as the Australian dollar, New Zealand dollar and South African rand -- performed best in a year when the gap in yields between government and corporate bonds contracted to near historic lows. "Yield will still be a primary driver of currencies in 2004, but valuation will play a much bigger role in determining relative performance," says Mr. Normand. "The cheapest currencies, like the yen, will play catch-up, while the relatively more expensive currencies -- like the euro and the commodity currencies [those of countries whose economies are commodities-driven] -- will lag." By year end, J.P. Morgan forecasts the euro will be at $1.30 and the yen at 95 to the dollar.

Looking back, 2003 will be remembered as "the year the dollar decline took hold," says Brown Brothers' Ms. Mills. It was also a year in which Sweden said "no" to adopting the euro, protectionism raised its ugly head and Japan spent roughly $186 billion to keep the yen from rising too far, too fast. What's more, it was a period when the U.S. and much of Europe called on China to stop pegging its yuan to the dollar and let it drift higher. That, many analysts contend, would make Chinese products more costly and, therefore, less competitive. Both Ms. Mills and Putnam's Mr. Morris put the odds of a yuan revaluation this year at 50-50. But "if China doesn't revalue, it could trigger a big political backlash in the U.S.," Mr. Morris warns.

He envisions two scenarios: "One, on the back of a Chinese revaluation, the dollar could fall further to about 100 yen and $1.35 against the euro," Mr. Morris says. "In contrast, if the Chinese don't move and a trade war breaks out between Asia and the U.S., Japan is the most exposed, given the frailty of its economy, and the dollar could go to 115-to-120 yen," while the euro stays firm in the $1.20-to-$1.25 range.

More Information on Social and Economic Policy
More Information on US Trade and Budget Deficits, and the Fall of the Dollar
More Information on Corporate Crisis and Bubble Capitalism

FAIR USE NOTICE: This page contains copyrighted material the use of which has not been specifically authorized by the copyright owner. Global Policy Forum distributes this material without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. We believe this constitutes a fair use of any such copyrighted material as provided for in 17 U.S.C Â§ 107. If you wish to use copyrighted material from this site for purposes of your own that go beyond fair use, you must obtain permission from the copyright owner.

Global Policy Forum