Comment: Don't write off a dollar comeback
Tuesday 08 September 1992
In the past few days the British papers have been full of articles pointing out how cheap the US is to anyone visiting from Europe. At dollars 2 to the pound, the papers shout, it is 'spend till you drop'. The true purchasing power parity for sterling would be about dollars 1.50, raising the obvious question as to how long the dollar can remain so undervalued.
The whole history of currency movements screams that at some stage in the next five years the dollar will move back closer to its purchasing power parity, maybe beyond. The issue is whether that movement will start this autumn.
The basic bear case for the dollar - that there will be no recovery for at least a year or two - is easily made.
It is the one that is ruling the exchanges at the moment. It starts from the low dollar interest rates, notes the fact that these will probably go lower still and argues that, since even at this stage in the cycle the US current account is in deficit, the dollar will continue to be undervalued for a decade or more. A cheap dollar is the result of a decade of financial and economic mismanagement that will take years to correct.
A variant of this bear case brings in the possibility of a Clinton victory in the presidential election in November. A Democratic president will pursue different policies from the Republicans, but they may not be more conducive to a strong dollar - indeed, they may actually weaken it in the short term.
David Hale, chief economist for Kemper Financial Services, the Chicago fund managment group, was explaining the Clinton programme to some clients and friends in London yesterday. He pointed out that to the Democracts the budget deficit was a symptom of low growth, not a problem in its own right.
So the programme, which involves an increase in public spending by dollars 200bn over five years, is being criticised not as too profligate but rather as too tame. Mr Hale pointed out that while the rhetoric behind the programme was supply side - boosting US productivity by investment in infrastructure and education - the reality was Keynesian.
There would be some tax increases, like a rise in the top marginal rate on income tax from 31 to 35 per cent and the introduction, in some form or other, of a tax on energy. But the deficit would not be tackled directly in its own right.
It would be expected to be corrected gradually over a number of years.
In a US political context this might seem perfectly rational, and there is respectable support for the Democractic package from people as diverse as Professor James Tobin, the economics Nobel prize-winner at Yale, and Felix Rohatyn, senior partner at the investment bankers Lazard Freres.
But what seems sensible and rational to the best and brightest of America is liable to alarm foreign investors. To be fair, Mr Rohatyn also argues that the deficit has to be cut. In a recent speech to a council of state governments conference in Boston he pointed out that without action the deficit would explode to over 20 per cent of GNP by the year 2020. 'No responsible political leader can ignore this monster,' he said.
Still, faced with a Democratic presidency that is talking of spending increases, the markets can be expected to take fright, so some further decline in the dollar is perfectly plausible. Indeed, given the uncertainty over the election it would be unwise to look for any turning point before November. But by then other things may well have happened that would prepare the way for a reassessment of the dollar.
One would be a realignment of the ERM. The problem here is not sterling, but the lira. The lira will have to be devalued within a matter of months, not so much because it is overvalued but more because the high interest rates needed to defend it are increasing the cost of funding the country's public debt.
The average maturity of Italian official debt is less than two years, so increases in short-term interest rates immediately make the deficit even less manageable. So the lira will be devalued - the only issue is the timing of the move.
Once the lira - and maybe the peseta - have been devalued, the focus will switch to sterling and the French franc. These will, on balance, probably retain their present DM parities and there will be an awkward period while this is digested by the markets.
But, once the credibility of the core of the ERM is re-established, the markets will start again to assess the ERM's attractions vis-a-vis the dollar. It is not difficult to see recession in Germany leading to some decline in DM interest rates, and once the markets sense this funds might shift back across the Atlantic.
The other thing that will be much more evident by the end of the year is whether the recent economic support package in Japan has secured the stability of the stock market and done something to underpin land prices. A measure of financial statility in Japan would in theory help the dollar, for it would remove any danger of Japanese funds being repatriated from the US to support business at home.
In short, while the bear case for the dollar looks very solid at the moment, it is possible to start building the foundations of the bull case.
It would include the following elements: the presidential election out of the way and the new president (of whichever side) showing awareness that at some stage the deficit needed to be tackled; a feeling that there were no further easy profits to be made by holding the mark in the ERM; some sign of falling German interest rates; and no new financial instability in Japan.
There is no guarantee, of course, that the timing will hold. It is perfectly possible that the dollar will only recover slightly and remain seriously undervalued for most of the 1990s.
But fashion plays a big part in financial flows. The dollar is unfashionable at the moment, despite the fact that long-term dollar assets, property and bonds, offer good yields, even if short-term assets like cash do not. It would not need a lot to swing that fashion back. It is certainly the thing to look for in the coming months.
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