ANALYSIS ON THE DOLLAR: A STALLED REVOVERY

by

Rosanna Arguelles

This nervous reaction marked a change in sentiment. Previously, any signs of a buoyant U.S. economy would wreck havoc on equity and bond markets but would help boost the dollar. This time, bad news for Wall Street translated as bad news for the U.S. currency. And despite a subsequent recovery in Wall Street, the dollar remains in the doldrums. As uncertainty continues over the health of dangerously inflated U.S. equity markets, investors and traders could be persuaded to unwind equity and dollar-denominated positions.

Another stress point for the dollar in recent weeks has been in regard to potential increases in Japanese interest rates. Easy monetary conditions to spur the Japanese economy and heavy buying of dollars by the Bank of Japan, some $20 billion in the first quarter of 1996, helped support the greenback. In May, Japan's foreign currency reserves rose to $207 billion or an increase of 33 percent from a year earlier. But Japan's appetite for dollars may be reaching satiation levels. As the economy recovers, the BOJ will be less inclined to intervene on behalf of the dollar, and by extension, Japanese export industries. If trade relations should sour, the dollar would have to live without Japan's crucial support.

Nor can the U.S. count on Germany. Bundesbank officials have stopped talking about an undervalued dollar, in part because attention has turned to worries over the European Monetary Union and weakness in the French franc. But stronger than expected growth in the economy may bring the Bundesbank's period of easy monetary policy to an abrupt close.

Under these circumstances, structural weaknesses in the U.S. currency would reassert their influence on the dollar's exchange rate vis-a-vis the "hard" currencies. America's inflation rate, which tends to be higher than in Japan, Germany or Switzerland, will erode the dollar's purchasing power in relation to those countries' currencies in the long run. Chronic U.S. current account deficits resulting from Americans' high propensity both to consume and to import goods also tend to keep the dollar undervalued. Given that Americans import proportionately more than Japan, Germany or Switzerland, import prices need to rise (the dollar remain cheap) in order to keep the deficit at sustainable levels.

The upswing in the U.S. economy has already resulted in larger trade deficits. The trade deficit in April 1996 has widened to $16.5 billion compared to $14.7 in the same period last year. Credit Suisse Research estimates the amount needed to fill the financing gap in the U.S. current account for 1996 to be around $130 billion, or not much below that for 1995. Last year, foreign central banks funded three-quarters of the deficit through dollar purchases. If central banks are less inclined to buy dollars this year, the question remains: who will fund the deficit?

In the weeks and months ahead the dollar's fate will be influenced by the performance of the Japanese and German economies and developments in U.S. asset markets and external balances. There is plenty of potential for bad news on these fronts to trigger a rush to safety and quality. Potential turbulence in the run up to a single currency in the European Union may or may not help the U.S. dollar. The Swiss franc, however, would remain a significant beneficiary of greater perceived risks in Wall Street and in the U.S. currency.