-Caveat Lector- from: http://www.aci.net/kalliste/ Click Here: <A HREF="http://www.aci.net/kalliste/">The Home Page of J. Orlin Grabbe</A> ----- Currency Markets The Dollar Looks Peaky The euro returns. After two years of high-flying defiance, the dollar has started to wobble AT THE start of both 1999 and 2000, most currency forecasters predicted that the euro would rise against the dollar. In practice, the opposite happened and the euro tumbled. So, for 2001, should one just toss a coin, or will the currency tipsters be more accurate this time? At least one of them is likely to be right�if only because of the enormous range of forecasts for December 2001. The euro could by then be worth $0.85, according to Salomon Smith Barney, slightly below its current rate of $0.89. Alternatively, if you believe Goldman Sachs, the euro will be worth $1.22 by the end of next year. This range of almost 44% is abnormally wide, reflecting even greater uncertainty than usual about what is driving currencies. Traditional forecasting models have been little use of late. According to the textbook, currencies with higher inflation rates and large (and growing) current-account deficits are supposed to fall. But somebody forgot to tell the dollar. Since mid-1995 its trade-weighted value against a basket of some 50 currencies has risen by about one-third. J.P. Morgan says that, in real trade-weighted terms (ie, adjusted for inflation differentials), the dollar is at its highest since 1985. The currency is not quite so overvalued today as it was then, but many forecasters are convinced that it is now past its peak, and that the euro will rebound in 2001. Already the euro has regained 8% against the dollar since it hit a low in October. This week it briefly topped $0.90 for the first time in three months, before dipping back. In contrast, the dollar has gained against the yen in recent weeks, hitting a 16-month high after the Bank of Japan admitted that the Japanese economy is recovering more slowly than expected. The dollar�s fate over the next year will depend largely on America�s rate of growth relative to other economies, and on equity markets. Its rise in recent years has been driven by much stronger growth than had been expected, which attracted large inflows of foreign capital�especially from Europe. Growth differentials, however, are now shifting in the euro�s favour. In the third quarter of 2000, America�s GDP growth slowed to an annual rate of 2.4%, slightly less than the 2.8% in the euro area. Goldman Sachs reckons that the American economy will grow by only 2.5% in 2001, while growth in the euro area will slow more modestly, to 2.9%. If so, it will be the first full year in which Europe�s growth has outpaced America�s since 1991. At its policy meeting this week, the Fed left interest rates unchanged (at 6.5%), but signalled that it has abandoned its bias toward tightening economic policy. It now believes that the risk of �economic weakness in the foreseeable future� is greater than the risk of inflation. In other words, the next move in interest rates will probably be downwards. The market is expecting the Fed to start cutting rates at the end of January. On the other hand, the European Central Bank (ECB) is expected to leave interest rates steady at 4.75%. There is even a chance that it may raise rates again. In November, inflation in the euro area rose to 2.9%, a six-year high; core inflation (excluding energy costs) held steady at 1.6%. These rates are both lower than in the United States, but the ECB is more hawkish than the Fed, with an inflation target of 2% or less. The bottom line? The gap between interest rates in America and Europe is likely to narrow. A gaping hole America�s current-account deficit reached a record 4.5% of GDP in the third quarter of this year. Since the mid-1990s, however, the increase in inflows of foreign direct investment and equity purchases�lured by expectations of high returns�has been more than enough to finance this deficit. As a result, the country now has net foreign liabilities of more than $2 trillion: around $20,000 for every American household. That makes the dollar highly vulnerable to the whims of investors. If growth in the United States, and hence profits, slows sharply, American assets will start to look much less attractive to foreigners. In 2000, stockmarkets in Europe have actually outperformed Wall Street in local-currency terms; it was only the rising dollar that gave American assets the edge overall. There is already evidence that mergers and acquisitions by European companies in America are starting to decline. If foreigners� willingness to hold an increasing stock of dollar assets should fade, it could lead to a sharp correction in both financial asset prices and the dollar itself. Taking the average prediction of six American and European banks, the euro is currently forecast to rise to just above parity with the dollar within a year�s time (see table). The yen and the pound are also tipped to gain against the dollar, but to fall against the euro. The most bullish forecast for the euro (from Goldman Sachs) implies a jump of more than one-third from the currency�s current level, which would leave it stronger than it was at its birth in January 1999. In contrast to the euro, the strength of the yen until recently seemed to pose something of a puzzle, for the Japanese economy is still ailing. Yet, although domestic demand is weak, real interest rates remain high because prices are falling. A tight monetary policy and a loose fiscal policy are the ingredients for a strong currency, just as America�s fiscal profligacy pushed up the dollar in the early 1980s. However, the Bank of Japan will be loth to allow the yen to strengthen by much more. That would choke off exports and risk tipping the economy back into recession. If the yen moves towards �100 to the dollar, expect the central bank to intervene in the foreign-exchange markets. There are forecasters who reject the picture of a steady rise in the euro against the dollar. They argue that America�s long-term structural rate of growth remains higher than that in the euro area. Although the euro may briefly rise in the short-term, they believe it will then fall again as the American economy bounces back. It is true that there is still no evidence that Europe�s productivity growth has been boosted as it has in America, but exactly how much of America�s productivity gain is structural rather than cyclical has yet to be tested. As the economy slows, the markets are likely to trim their estimates of sustainable growth in both productivity and profits. A modest slide in the dollar would bring some benefits. For one thing, it would help to reduce America�s current-account deficit. It would also help to silence American car makers who have seen their profits squeezed by the strong dollar and who might otherwise lobby for new import barriers. A cheaper dollar would also give a lift to those emerging economies (from Argentina to China) that tie their currencies to it, by making their exports more competitive. However, a sharp fall in the dollar would be awkward for the Fed. Not only has the currency�s strength helped to hold down American inflation, but a collapse would make it harder for the Fed to slash interest rates if the eco nomy were to slow more sharply than expected. In this way, the desired �soft landing� could easily be turned into a hard one, in which the dollar, share prices and output all tumble downwards in a vicious spiral. After the euro�s embarrassing debut, the ECB would applaud a recovery of the single European currency, which it has long believed to be undervalued. A modest rise would help to hold down inflation and so reduce the need to raise interest rates. But the ECB�s delight would be short-lived if the euro were to surge just as the American economy was being jolted by a hard landing. Europe might then wonder whether a strong dollar and a booming American economy were not the better option. The Economist, December 24, 2000 ----- Aloha, He'Ping, Om, Shalom, Salaam. Em Hotep, Peace Be, All My Relations. 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