The mighty buck bites the dust

Blame Kobe, blame Mexico - but dollar hegemony could be over for good, argues Rupert Cornwell
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The Independent Online
It seems an eternity ago. But only a few months back, end-of-year investor newsletters, many economists and a majority of market tipsters really were predicting that after a string of false dawns, this finally was it: the Year of the Dollar. The fundamentals are right, these unhappy seers intoned, mantra-like, as they reeled off the perceived virtues of the US economy: robust growth, a falling budget deficit, low inflation and the prospect of further interest-rate increases that would make dollar- denominated assets more appealing.

So much for conventional wisdom. The potential star pupil has become the dunce of the financial class. Since the start of the year the dollar has dropped 8 and 11 per cent respectively against the yen and the German mark, the two other anchor currencies of the international monetary system. In the past grisly week alone it has plunged more than 5 per cent. So what has gone wrong? The answer, not to put too fine a point on it, is everything.

Acts of God, global and domestic politics, macroeconomic trends, even humdrum book-keeping technicalities, have turned in unison against the dollar. To America's immediate south, the crisis in Mexico is seen - rightly or wrongly - as a crisis of financial credibility for North America in its entirety, and especially for the US, which has pledged $20bn to an increasingly dubious rescue mission for the peso. In distant Japan, Kobe was shattered by a massive earthquake whose repair will require the return of Japanese capital from abroad, first and foremost from the US. If that were not enough, Japanese concerns are repatriating funds to tidy up accounts for the end of their financial year on 31 March.

At home, defeat of the balanced budget amendment only reinforced in foreign eyes Washington's reputation for incurable fiscal profligacy. And most important of all, the tectonic plates of interest rate expectations have abruptly shifted. With its increase in February, the Federal Reserve seemed to say enough, at least for now. Simultaneously, the conviction grew that German rates were poised to rise. For a market stampede, there could be no more perfect formula.

Washington now has three basic options. First, the Clinton administration and Congress can make deeper cuts in public spending to reduce next year's federal deficit from the planned $197bn. After the demise of the balanced budget amendment, this would send a signal that the world's largest debtor remains determined to put its financial house in order. The mood in the Senate, not to mention Newt Gingrich's cohorts of tax-cutting Republican supply-siders in the House, inclines in that direction.

The second option is a conventional defence of the currency, including intervention and an increase in interest rates, to make US investments more attractive to foreign investors. Humouring these investors, however, does not appear an overwhelming priority, if a speech last week by Susan Phillips, one of the Federal Reserve governors, is anything to judge by.

"Certainly the dollar is something we look at. But bear in mind the US has a very large domestic economy and domestic economic considerations in many ways are certainly primary." Had she been more truthful, Ms Phillips might have replaced "economic" with "political".

For one thing, a rise in short-term interest rates would only make life even more uncomfortable for Mexico (and other Latin American and developing countries in the dollar orbit) - perforce casting even greater doubt on the wisdom of the administration's decision to invest so much money and attention in Mexico.

Then there is the electoral calendar. Right now, Ms Phillips and her colleagues at the Federal Reserve reckon that seven carefully calibrated interest rate increases in 12 months have brought them within an ace of the central bankers' dream, a "soft landing" that shifts the country painlessly from unsustainable boom into steady, non-inflationary growth. But another rise now could send an already slowing economy into a fatal recessionary stall in 1996, at the very moment the presidential race enters the finishing straight. One may only guess where Bill Clinton's lowly approval ratings would stand today, had not the economy performed so decently during his term thus far.

Incontrovertibly, however, a full blown recession would reduce his re- election chances from today's slightly less than even money to zero. The Fed is an independent central bank. But few central bank governors have finer political antennae than Alan Greenspan. And so to the third, and likeliest option: that beyond rhetoric, the US will do nothing.

And from the perspective of this century's broader financial trends, what can it, or should it, do? Inflation is the price of a tumbling currency. But only seen from Europe is the dollar tumbling; its tradeweighted value, factoring in the Canadian dollar and the Mexican peso, is more or less steady. The EMS dbcle in Britain, meanwhile, is proof enough that even massive central bank intervention is no match for today's instantaneous and unified global currency market. And in the marginally longer term, even a sharp increase in US rates would be little more than spitting into the wind of history.

The dollar, put simply, is not what it used to be. The mark and the yen have usurped part of its role as a reserve currency. The vanishing of the Soviet Union has robbed it of its "safe haven" function. What remains is, by most recent measures, just a lousy investment. Consider the fund manager from Japan, the world's largest creditor nation, which, given the reluctance of Americans to save, must largely finance the US deficit. Assume he bought US assets back in 1981, the dawn of Reaganomics when the dollar fetched around 180 yen. Today the rate is yen 92.50, a halving in 14 years.

And what reason is there to suppose the decline will be reversed over, say, the next 10 years, during which the US, on current trends, will rack up a further $3 trillion or more of budget deficits? At bottom, the dollar's plight is one of supply and demand. Mr Clinton is entitled to boast that the US deficit, in relative terms, is an internationally respectable 2.5 per cent or so of GDP. But in absolute terms, the world continues to be flooded with dollars it does not especially want.

And indeed, apart from speculative profit-taking and the technical rebounds that intermittently aid any oversold currency, it is hard right now to think of a good reason why the currency should rise. For it to return to lasting favour, one suspects, nothing short of a remilitarised Russia marching in the direction of Germany, or rock-solid evidence that the US budget is moving back to balance, will do. Byzantine theologians may argue over which is more probable.

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