The dollar has hit another record low against the euro. It is set for further falls against major currencies in the coming year, even though American interest rates will rise

FORECASTING exchange rates, warns Alan Greenspan, the chairman of the Federal Reserve, has a success rate no better than calling the toss of a coin. But the dollar keeps coming up tails. At the start of 2004, holders of America’s currency had to part with $1.25 to buy a euro. At year’s end, they must fork out another dime or more. On Wednesday December 29th, it cost over $1.36 to buy a single euro, a fresh record.

The cause of the dollar’s decline is hardly a mystery: private investors have become less eager to finance America’s huge current-account deficit. The deficit widened slightly in the third quarter of 2004, to a record $165 billion, or 5.6% of GDP in that period.

America’s Federal Reserve gives information on monetary policy and statements by Alan Greenspan. See also the US Treasury Department. The People’s Bank of China, the Bank of Japan and the European Central Bank give economic statistics and publish statements on monetary policy. The Institute for International Economics posts research and policy briefs on exchange rates and monetary policy.

After the Indian Ocean tsunamis Dec 29th 2004
Ukraine’s re-run election Dec 29th 2004
Israelis and Palestinians Dec 29th 2004
The freeing of the world’s textile trade Dec 28th 2004
International accounting standards Dec 28th 2004
Buttonwood will return in mid-January

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These record deficits are adding to America’s foreign debts at an alarming rate. But as yet, America still earns more from its foreign assets than it pays on its foreign liabilities. That is about to change. As interest rates rise, refinancing America’s debt will become more costly. Goldman Sachs forecasts that net foreign-investment income is likely to shift to a sizeable deficit during 2005, growing thereafter. The investment bank estimates that, if America’s current-account deficit remains steady as a share of GDP and interest rates average 5% in future, net foreign debt-service payments will reach 4% of GDP by 2020—a significant drag on American living standards.

To avoid shelling out such large sums to foreigners, America will, ultimately, have to rely more on its own savings and less on savings imported from abroad. The country as a whole saved just 1.7% of national income in the first nine months of 2004. Households saved just 0.7%.

The dollar’s decline may force America to embrace thrift, argues Goldman Sachs. As the dollar falls, foreigners will demand more American goods. This will put pressure on America’s manufacturers, which are already operating at 78% of capacity. As supply is stretched, inflationary pressures will build. The Federal Reserve will raise interest rates, curbing domestic demand, and thus creating room for an export boom. The higher interest rates will thus promote the saving America has so sorely lacked.

This process has barely begun. Over the past two years, the dollar has lost almost 23% against the euro. But it has shed less than 13% against a broader basket of currencies (see chart), and it has not lost a cent against China’s yuan. As a matter of official policy, the Chinese currency has remained within a tight range around 8.28 to the dollar for the past decade. Forecasting the intentions of China’s policymakers may actually be harder than calling a toin coss. But many are trying. Offshore markets, for example, allow speculators to make a bet on the value of the yuan in 12 months time. At the moment, punters reckon you will get just 7.8 of them for your dollar this time next year.

Against the yen, the dollar is actually slightly stronger than it was in late November. The Bank of Japan has not intervened in the foreign-exchange markets since March, but the threat to do so remains. Japan’s finance minister, Sadakazu Tanigaki, gave warning this week that his country’s authorities would monitor foreign-exchange markets over the New Year holiday, a time when trading is thin and official buying can make a big difference.

If Japan’s finger is on the trigger, the European Central Bank (ECB) seems prepared to sit on its hands. Jean-Claude Trichet, president of the ECB, has lived with strong currencies before. As president of France’s central bank in the years before euro entry, he was dubbed “the ayatollah of the franc fort” for his unflinching support of a strong national currency. Indeed, for much of 1995, a weighted basket of the franc and the 11 other currencies that formed the euro was worth almost as much against the dollar as it is now.

In his press conferences, Mr Trichet has made it clear that recent rises in the single currency are unwelcome. But he has dwelt at greater length on the danger of rises in energy prices. His chief duty, as he sees it, is to convince firms and workers that inflation will remain well contained, despite the oil price spike of the autumn. It is a confidence game: if he can convince them an inflation spiral won’t happen, then it won’t. The strong euro will actually add to his credibility, by curbing the price of imports.

Besides, the hard men of hard money believe that weak currencies make life too easy for firms and politicians. Devaluing the currency provides an unsatisfying alternative to deregulating and restructuring the economy. An overvalued currency, on the other hand, leaves uncompetitive firms and tentative politicians with “no place to hide”, as Eric Chaney of Morgan Stanley puts it. They must reform or perish.

“You cannot devalue your way to prosperity,” says John Snow, America’s treasury secretary, somewhat hypocritically. The year to come may reveal whether Europe can revalue its way to the same end.

One of the main factors is inorder for foreign currencies to remain weak comparatively, they buy up all our bonds. This keeps exports cheap and more competative in our markets, but has the nasty side of inflation in their home countries. China has been mounting an assult of sorts inorder to tame their continued growth at 11%, but without any real bankning infastructure – it is a difficult task to say the least. Japan on the other hand is a little jublient that the inflation is carrying them out of a decade of deflation, and certainly keen on not returning any time soon. Both countries have experienced a nice spurt of growth in the past 6 months but if inflationary pressures get too high at home, they stop buying our $, and down we go.

Keep an eye on it
Jul 8th 2004
From The Economist print edition

After a buoyant start to the year, the dollar seems headed for a tumble

THERE was a time, not long ago, when economists and those who dabble in the foreign-exchange market could find scarcely a good thing to say about the dollar. Last year, John Snow, America’s treasury secretary, even managed to transform his country’s long-standing strong-dollar policy into a weak-dollar one. All this greatly irritated Europeans, especially; as the euro rose, international meetings of the great and the good were dominated by cross discussions about the beleaguered buck. Newspapers, including this one, were full of gloomy headlines suggesting that the greenback would, indeed should, fall farther.

So it did, for a while: by early January, the dollar was worth a quarter less, in trade-weighted terms, than it had been two years before. But when everyone is betting that a market will go one way, it often goes the other. By mid-May, the dollar had risen by 8%, bucked up, as it were, by the Bank of Japan, which bought ¥14.8 trillion ($138 billion) of foreign exchange in the first quarter, almost all of it dollars, in comfortably the largest-ever act of intervention by a central bank. Then, quietly, the dollar started to drop. By July 6th, it had fallen by 4.3% from its high. Not surprisingly, perhaps: the dollar’s prospects look even worse now than they did last year.

The dollar’s recent decline may seem puzzling, for it began while expectations were mounting that the Federal Reserve was about to put up interest rates. The decline has continued since those expectations were confirmed on June 30th. Rising interest rates, you might have thought, would halt any such decline.

That is true only up to a point. As the American economy brought forth jobs in the spring, and the markets started to expect that the Fed would increase rates sooner rather than later, the dollar was boosted. A prime reason was that traders who had previously borrowed greenbacks in order to exchange them for other, higher-yielding currencies now needed to buy them back in a hurry. Lately, however, softer economic data have sown the idea that the Fed might not have to raise rates so far and fast after all. That has done the dollar no favours in recent days.

In the longer term, though, higher interest rates may be a curse for the dollar, not a blessing. To see why, look at that large and growing thing that goes under the name of America’s current-account deficit. A country’s current-account essentially comprises two things: the trade balance and net income from foreign investments. America runs a trade deficit that in April amounted to $48.3 billion, up from $46.6 billion in March. This alone implies an annual deficit pushing $600 billion, or 6% of GDP. The current-account deficit would be greater still if America did not make more money on its investments abroad than foreigners earn in the United States.

That it makes a profit is odd, because it has net foreign liabilities (ie, the value of Americans’ assets abroad is less than that of foreign claims on America). According to the Department of Commerce’s Bureau of Economic Analysis, net liabilities amounted to 24% of GDP last year. America has an investment-income surplus because yields are much lower at home than abroad. All things equal, says Goldman Sachs, a yield of 6% on ten-year Treasuries would add 1% of GDP to the current-account deficit within a few years.

Economists fret about America’s current-account deficit because it is a measure both of America’s ability (or inability) to save and its attractiveness to foreign investors. The country’s heady growth of recent years has relied on foreigners’ willingness to invest there: Americans, in effect, spend other people’s money. That need not matter when the sums are small, but it does when they are large and getting larger. Most economists believe that at some point the dollar will need to get cheaper, maybe much cheaper, to encourage foreigners to finance the deficit. That point may be at hand.

There are two weighty pieces of evidence to support this view. The first is that America started this latest recovery much deeper in hock to the rest of the world than it did previous ones, says John Llewellyn, the chief economist at Lehman Brothers. As the chart shows, America has usually started to pull out of recession with its current account roughly in balance. This time, it began with a deficit of 3.2% of GDP. Because growth tends to increase the deficit—America has sucked in imports and borrowed more—the deficit has widened. “I can easily imagine it going to 7% and beyond,” says Mr Llewellyn.

The second piece of evidence comes from investors’ behaviour. Some say that the deficit is not a problem, but simply reflects foreigners’ boundless desire to invest in a vibrant economy. This may have been true once, but not any more. Net foreign direct investment (FDI) was negative, to the tune of $155 billion, in the past 12 months, says Goldman Sachs. This ought to be no surprise: in the first quarter returns on FDI in America were 5.5%, while those on FDI abroad were 11.7%.

In recent years, the current-account deficit has instead been financed by (less stable) portfolio flows into stocks and bonds. In the past year, three-quarters of such investment in America has gone into bonds. The biggest buyers have been Asian central banks, trying to keep their currencies from rising too swiftly against the dollar (or maintaining a fixed rate, in China) and parking the money in Treasuries.

But this intervention has had a cost: inflation. Because the central banks bought the dollars with newly minted local currency, inflationary pressures have risen throughout Asia. This is fine for Japan, which has deflation, but not for its neighbours. Intervention thus seems to have stopped; even Japan turned off the tap in March. The central banks might, of course, wade back in if their currencies rose too much. But given the risk of inflation, it would be brave to bet on this. And if they do not buy the buck, who will?

*********UPDATE**************
Jeremy Avnet knows an excellent reason for the problems caused by all those Big Macs eaten around the world.