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Sunday, July 18, 2004

FT.com / Business / US How low will the dollar go?

FT.com / Business / US


A little lower, maybe, or not
By Jennifer Hughes in New York
Published: July 19 2004 5:00 | Last Updated: July 19 2004 5:00

As the curtain rose on 2004, there was one sure-fire bet in the market: the dollar was going to fall.


Warren Buffett was investing overseas for the first time because of the dollar, George Soros had said he was shorting it, and Jim Rogers, his former partner, described the greenback as "fundamentally flawed".

Despite the predictions, the greenback, after an early decline, has stabilised so far this year. Did the investing luminaries get their dollar bet wrong? And does that mean the dollar's slide is over and it is fairly valued?

While valuing a currency is a slippery notion, many market participants are as confident as ever in predicting a slow, inexorable decline in the dollar.

Most currency watchers say the greenback's recent stability was inevitable after its previous performance. The dollar's slide really began in 2002 when a euro was worth about $0.87. The single currency's peak around $1.29 in January this year represented a hefty 48 per cent decline in the dollar. And by that point, the unanimous expectations for its decline played a part in capping the move. Once everyone is betting on the same horse, the old timers warn, the odds don't look so good and contrarian views get a look-in.

So what would be a fair value for the dollar? Ask any currency strategist and you'll be plunged into a discussion of abstract notions more suited to a classroom than the fast-moving foreign exchange markets.

"Concepts of value in FX are incredibly loose and slippery," explains Mark Austin, head of currency strategy at HSBC.

The key is that unlike stocks or bonds, a currency represents nothing in itself. As a unit of exchange, its perceived market value rests on a series of factors that vary in importance over time.

By most academic measures of currency value, economists say the dollar is probably relatively fairly valued at the moment.

"But fairly valued doesn't mean that it's not going down from here," adds Mr Austin.

The dollar's detractors claim the central problem is that the currency's role as the world's reserve currency is giving it a status similar to the emperor's new clothes.

In other words, the dollar is worth what the market says it is because so many people have a stake in believing that it is. International commodities such as oil and gold are traded in dollars. Greenbacks are accepted the world over and in some countries more widely than the local currency.

That the dollar is the reserve currency is a fact, too. In 2003, of the $502.8bn worth of new currency collected in central bank reserves - a record - only 12.2 per cent was not in dollars.

The dollar's status stems from the Bretton Woods system of fixed exchange rates established after the second world war, with the dollar, convertible into gold, as the lynchpin. The system broke down in the early 1970s as the US struggled to cope with the costs of Vietnam and currencies floated.

Currency value is fundamentally based on the health of its domestic economy. Suffer an event that puts a country in turmoil and the currency will suffer.

Detractors say the dollar's reserve currency status is acting as a cushion for the US economy and distorting the risks the economy poses for the currency.

"In the past, foreign citizens accumulated US dollars so they could purchase American-made goods. Today, foreign central banks accumulate dollars so that Americans can purchase foreign-made goods," says Peter Schiff, chief global strategist at Euro Pacific Capital. The size of the current trade gap implies that the US imports goods each month worth about $45bn more than it exports. To balance its books the US then needs to attract about $1.5bn each day in foreign capital.

Economists at Citigroup estimate that something like 10 per cent of the rest of world's gross savings are being invested in the US.

"You have to wonder what the US would need to offer investors just to maintain the value of the dollar if the deficit rises faster than global savings," says Marvin Barth, global currency economist at Citi.

This year to date, Treasury data show overseas interest in US equities has been anaemic at best and that inflows are concentrated in bonds - much of which is attributed to Asian central banks buying dollars to limit their own currencies' appreciation. The risk of the US failing to attract the necessary capital is not really priced into the dollar, warns Lara Rhame at Brown Brothers Harriman.

"Generally, a big characteristic of any price bubble is when underlying risks are not being priced in," she cautions.

So when, and how quickly, will the dollar fall? That is anybody's guess. The currency market crosses borders and operates around the clock. About $1,200bn is traded daily and, since currency is needed for transaction purposes, physical demand plays a more important role than in stock or bond trading.

The good news for greenback investors is that it is used as one side of 90 per cent of all currency trades, and the countries whose currency would appreciate as a result of a dollar decline will not be willing to see a sharp move lower.

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