Behind the dollar's lengthening slide

The American dollar showed signs of getting a bit flabby last week. Victory in Iraq didn't boost the dollar as expected.

Treasury Secretary John Snow repeated the obligatory mantra about the United States wanting a "strong dollar." That had little effect in foreign exchange markets.

On Wednesday, the dollar hit a four-year low against the euro, the common currency of 12 European nations. The greenback was also at a three-year low against the Canadian and Australian dollars.

The trend will be costly for Americans taking vacations abroad. Last year at this time they paid about 92 cents for a euro; now it will cost them about $1.11. French cheese and German cars could become more pricey for those staying home.

How come?

Well, sorting out the motives of the millions who buy and sell currencies each day is tricky.

Travelers generally just pay whatever exchange rate they get when using an ATM for cash or a credit card for a purchase. But investors influence exchange rates by deciding where to put their money - in the US, in Europe, China, or elsewhere. Most analysts figure their basic motive is simply trying to make a buck - or a euro, or a yen, or whatever other currency.

A question right now is whether war in Iraq, with its geopolitical consequences, has made the dollar less attractive.

It's important. As of 2002, foreigners owned 31.5 percent of US Treasury securities, 12.3 percent of government agency securities, 20.8 percent of US corporate bonds, and 11.5 percent of US stocks.

Some of that investment money, especially that in short-term Treasury securities, is owned by foreign central banks. China, Japan, Taiwan, and some other Asian nations have been piling up dollar assets, trying to prevent their own currencies from getting so strong that their domestic firms find it harder to export.

Foreign central banks bought a huge $96.6 billion of US assets, mostly Treasuries, last year, up from only $5.2 billion in 2001.

Private investors, though, are usually just making investments. "They are not making geopolitical decisions of any kind," says Richard Cooper, an economist at Harvard University, in Cambridge, Mass.

The war has left some hard feelings between the US and European critics. "But most investors are pretty hard headed on these things," says David Hensley, an economist at JPMorgan Chase Bank in New York. Its effect on investors will be "minor."

The US remains a sound place to invest, Mr. Cooper says. It doesn't confiscate foreigners' investments, as a rule. The inflation rate is sufficiently low that the value of their investments erodes only modestly.

But right now, interest rates in Europe are higher than in the US, where short-term rates are at the lowest in 40-plus years. So private investors are more tempted to buy European stocks, bonds, and notes. Further, some foreign investors are troubled by the rapidly expanding US federal deficit.

The Treasury announced last Wednesday it plans to sell a record $58 billion of new three-, five-, and 10-year notes this week to partly finance the deficit. That deficit, experts reckon, will exceed $400 billion this fiscal year as a result of the Iraq war and the loss in revenues from the economic slowdown and tax cuts.

"It's bearish for the dollar," says Robert Hormats, a director of Goldman Sachs International in New York. Like many other experts, he sees the dollar falling further in the months ahead. Whether it will be a fast or slow decline is anybody's guess.

"Avoiding a rout in the dollar would be a good thing," says Jane D'Arista, an economist with the Financial Markets Center in Philomont, Va.

The dollar will have to drop another 15 to 20 percent to reach a level where it encourages enough US exports and discourages enough imports to make the nation's balance of payments deficit sustainable - not disappear, reckons Dean Baker, an economist at the Center for Economic and Policy Research in Washington. The US will remain a "safe haven" for some foreign investment money, he says.

Last year, the deficit in the US current account was running about $500 billion, or 5 percent of gross domestic product, the nation's output of goods and services. "You need a big change to correct that sort of imbalance," says Mr. Baker.

With the dollar down only 5 percent so far since its peak in February 2002 - measured against the currencies of most of its trading partners - and with the price of oil again weaker, Mr. Hensley forecasts only the stabilization of the current account deficit. It shouldn't expand further.

Like Americans, foreigners haven't been making big new investments in US stock. They have been buying more bonds.

And last year, "net US purchases of all foreign securities turned negative for the first time in more than 40 years," Hensley notes. Their purchases of foreign stock declined more than 80 percent between 1999, during the bull market, and 2002.

The "big story," according to Hensley, is that US companies have slashed their investments abroad. Also, private foreign-capital flows into the US have declined by $165 billion, or nearly 25 percent, between 1999 and 2002.

Correction

Last Monday's Economic Scene column, dealing with executive pay, reported that the AFL-CIO "is petitioning" the Securities and Exchange Commission to give institutional investors more clout in selecting independent directors. A more precise phrase would have been, "preparing to file a petition."

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