Keep faith with the dollar

By MOIN SIDDIQI

The foreign exchange (FX) markets are extremely volatile and unpredictable, far more so than commodities. Trader sentiments can change abruptly, by the minute, fuelled by speculation and rumours. Traditionally, exchange rate movements are determined by relative economic growth, inflation and interest rates expectations, as well as a country’s external trade balance. Apart from economic fundamentals, the main driving force is cross-border, i.e. global capital flows.

International investments are heavily influenced by interest rate differentials, and projected capital returns in the overseas capital markets.

This year could see the dollar appreciating against the yen, but depreciating, albeit modestly, against an embattled euro.

The dollar has over the past few years gained much strength, fuelled mainly by huge inward investments, especially from Europe.

From mid-1990s, the dollar’s trade-weighted value against a basket of 50 currencies has increased by about 33%. J.P. Morgan, Chase & Co research shows that the dollar, in real trade-weighted terms (i.e. adjusted for inflation differentials versus US major trading partners) is at its highest since 1985. Most currency forecasters would agree that the greenback is now overvalued.

The dollar refuses to buckle

A continuation of US balance of payments deficit, hitting a record high of 4.5% of gross domestic product in 2000, and a growing foreign debt (estimated at staggering $1.9 trillion last year) are often cited as justifications for a hefty dollar devaluation.

But until now, the dollar has defied continuing weaknesses in external accounts, and continues to depend heavily on large capital inflows. The Bush administration may however, favour a gentle dollar depreciation in order to aid struggling US manufacturers, who are complaining that an overvalued dollar is hurting exports and profits.

The futures markets indicate that US short-term rates could be 4.75-5.0% by June, as the Federal Reserve tries to stimulate economic growth. This, in turn, will further reduce the yields of US-denominated financial assets. The recent wave of earnings warnings from prime US blue-chips can also dent foreign appetite to buy into corporate America this year. The Economist magazine notes that “there is already evidence that mergers and acquisitions by European companies are starting to decline.”

If America experiences dwindling capital inflows into bond and equity markets in 2001, the dollar would obviously suffer, increasing imported inflation, and preventing sustained lower interest rates.

Some analysts are bullish on the euro because growth prospects are presently more promising in Euroland than in either America or Japan. By any conventional measurement of economic fundamentals, the euro should strengthen in 2001, underpinned by higher interest rates, and improving economic growth relative to America.

The Bundesbank comments: ‘Europe is at the beginning of an economic recovery, whereas America is at the end of its cycle.’

Markets are anticipating a hike of between 50-75 basis points in the European Central Bank’s repo rate (currently 4.75%) over the next three to six months. Thus the gap between US and euro-zone interest rates would narrow, and may even tilt slightly in favour of Euroland in the second half of 2001, assuming US rates come down aggressively. This will reduce the dollar’s competitive edge against the euro.

European portfolio investors can also help their single currency by repatriating some of the $70bn invested last year in US securities.

The euro could rise above parity with the dollar, but it may not regain its debut rate of $1.17 (1st January 1999) for some time. The single currency, which becomes sole legal tender across Euroland on 1st July 2002, could be worth $1.03-$1.10 by 2001. However, if the euro fails to reach parity at a period of severe US slow-down, when will it ever stage a recovery?

The yen remains firm

The yen’s strength over the past year is quite remarkable, considering Japan’s ailing economy, expected to grow by just a meagre 1.7% this year, and official interest rates close to zero (0.25%). The yen’s only supportive factor is Japan’s perennially large current account surplus. The yen’s upside potential now seems limited, and the yen/dollar rate could settle within a range of 120-125 this year, compared to an average of Y108 in 2000. But, if the yen depreciates towards its 1998 level of 130-140:$1, that might cause competitive rounds of devaluations in South-East Asia, and encourage protectionist sentiments in America, especially from the automobile industry lobby, because of Japan’s expanding trade surplus.

Sustained low interest rates of below (3.5%) have weighed on the Swiss franc, a favoured currency of fleeing capital from the developing countries. The prospects of a lax monetary policy in Britain, with official base rate projected at 5.0%-5.5% by year-end, would reduce the attractiveness of UK assets, thereby reversing capital flows into sterling. The latter is expected to fall modestly against both the dollar and the euro.

Global investors should not, however, lose confidence in US assets. The dollar’s position as the world’s leading investment and reserves currency remains largely intact.

The greenback benefits from an effective central bank, with a proven record of fostering sustainable economic growth. Despite the current downturn, America’s economy is structurally more stronger and competitive than Euroland, thanks to higher capital investments during the 1990s. Interestingly, falling interest rates could, in effect, bolster the dollar. The FX markets may look beyond the present weak economic indicators and start to anticipate a revival in US growth by autumn, or winter, thanks to the easing of monetary and fiscal policies.

Firmer oil prices supports the $

Firmer oil prices, averaging $25 a barrel are also supportive of the dollar. Higher OPEC revenues, which in 2000 totalled $226.6bn, generally increase investment into US assets which are popular among the Gulf producers.

With the global economy slowing down, and the prospects of more interest rates cuts in the pipeline this year (except in the euro-zone) the prime institutional and sovereign borrowers can benefit from lower borrowing costs - but investors will lose out from declining yields on money market instruments like certificates of deposit and short-term Treasury bills.

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