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The Buck That Didn't Stop

Confounding Experts, Dismaying Industry, Damping Inflation, the Dollar Has Only Gotten Stronger

By John M. Berry

Washington Post Staff Writer

Sunday, June 10, 2001; Page H01

By now the U.S. dollar was supposed to be on the ropes. That's where many economists and policymakers confidently predicted it would be as a result of the sharp slowdown in economic growth, big declines in interest rates and steep fall in previously high-flying stock prices.

All of those developments were expected to turn off the foreign investors who had been pouring hundreds of billions of dollars into the United States as they snapped up companies, built new factories and made large investments in U.S. stocks, bonds and real estate. To make such investments, foreign individuals or firms have to swap their own currencies for dollars, which drives up the value of those currencies.

But foreign investors haven't been turned off at all and the dollar has continued to outshine all the world's other major currencies.

As of Friday, a broad index of the dollar's value compared with the currencies of 38 countries -- including the 12 that use the euro -- stood 27 percent higher than it did at the beginning of 1997. Even adjusted for differences in inflation rates, an important factor in determining exchange rates, the dollar has appreciated by nearly one-fourth over that period.

The dollar is now so strong that some beleaguered industries are crying for help. The high dollar has hurt their sales abroad by making U.S. exports much more expensive for foreign buyers. Meanwhile, the high dollar has made foreign goods much cheaper in this country, encouraging more imports of goods that often compete with U.S.-produced products.

On the other hand, as Federal Reserve officials have been quick to note, the strong dollar has also played an important role in holding down U.S. inflation at a time when businesses' costs have been increasing.

The driving force behind the relentless rise of the dollar has been the flood of foreign money into U.S. assets. A number of analysts and policymakers say foreign investors have largely ignored this country's current economic difficulties because they believe the long-term outlook for profits, adjusted for risk, is higher here than in other countries.

The Japanese economy, for instance, is virtually dead in the water with little prospect for revival soon, and other East Asian nations' growth has sagged, analysts point out. European countries generally are in much better shape, but uncertainties abound.

Many analysts and investors question whether the European Central Bank will be able to adequately manage growth in the nations that have adopted the euro as their shared currency. When the ECB cut short-term interest rates recently, its explanations left currency traders confused about whether the central bank was focusing on the deteriorating prospects for economic growth or the region's rising inflation rates.

Some economists have speculated that nervousness about the upcoming transition to euro cash, in which the 12 countries will retire their national currencies and exchange them for euro bills and coins, may have prompted some Europeans to park their money in dollars for safekeeping.

Furthermore, most European countries face long-term structural problems, including overly rigid labor markets and seriously underfunded social welfare systems that could lead to higher taxes in the future, a prospect that deters some long-term investments, analysts say.

These and other factors have undermined confidence in the European outlook to the point that on Friday the euro was worth about 85 cents, 28 percent less than it was when the currency was introduced at the beginning of 1999.

In sharp contrast, the dollar has blossomed as investors have put a steadily rising amount of money in the United States.

The Commerce Department reported last week that foreign investors spent just more than $320 billion last year to acquire or establish U.S. businesses. That was a 17 percent jump over 1999 in "foreign direct investment." As recently as 1997, such investment was only about $70 billion.

Complementing that flow of direct investment was more than $450 billion worth of portfolio investment -- that is, net purchases of stocks, bonds and other such long-term securities. And the portfolio flow has continued to soar this year.

According to recent U.S. Treasury figures, portfolio investment reached $155 billion in the first three months of the year, by far the highest level in history. Almost $100 billion of that money came from Europe, though a portion of it may have been purchases made by European financial institutions or brokers on behalf of individuals or firms in other parts of the world.

One continuing attraction for portfolio investments is that U.S. financial markets are the largest and most liquid in the world, which means that dollar-denominated assets of all types can be more easily traded with lower transaction costs than in other markets.

Another attraction has been the rapid acceleration of productivity growth in the United States, which has so benefited the country in recent years. Similar gains have yet to appear in other industrial nations. In some cases, productivity growth elsewhere has slowed rather than accelerated.

Nevertheless, most analysts and policymakers are still taken aback by the great strength of the dollar in the face of so many problems in this country.

In a speech in Edinburgh, Scotland, late last month, Federal Reserve Governor Laurence H. Meyer acknowledged just how puzzled he is about the situation -- and while he didn't say so, his central bank colleagues are just as uncertain about the forces at work.

"Normally, we would expect the exchange rate in the country [where growth is] slowing down to depreciate, more so if the country was aggressively cutting policy interest rates," Meyer said. "And we would expect even more depreciation if concerns about returns on capital were sharply depressing equity prices.

"The prevailing view until late 2000 was that the U.S. dollar was strong against a broad group of currencies -- and especially against the euro and several other European currencies -- because, to a large degree, internationally mobile capital sought higher rates of return in the United States," Meyer said. "Following this logic, a slowing of the U.S. economy, a decline in expected profits and a correction of asset prices should have weakened the dollar."

It may be, Meyer said, that investors expect "the current slowdown in the United States . . . to be only temporary, and capital flows may be influenced more by differentials in long-term growth prospects than by shorter-run cyclical fluctuations. The prospect of a return to robust growth in the United States that is above the longer-run expected rate of growth in Europe may therefore continue to favor dollar-denominated assets."

Even in the shorter term, the recent advantage in growth Europe has enjoyed may be fading. Year-over-year growth in the 12 euro nations has dropped steadily, to 2.5 percent in the first three months of this year from 3.7 percent nine months earlier, and some forecasters expect it to run at less than a 2 percent rate for the rest of this year.

U.S. economic growth has hovered around 1 percent for the last nine months, but many economists and policymakers expect it to rise slightly later this year and get up to around 3 percent by the middle of next year.

Whatever the calculus that has produced the very strong dollar, it has made some industrialists very unhappy.

Earlier this month, Jerry J. Jasinowski, president of the National Association of Manufacturers, met with Treasury Secretary Paul H. O'Neill to ask for a "clarification" of Treasury policy on the dollar. That is in order, Jasinowski said in a letter sent to O'Neill last week, "to be certain that it is not seen as endorsing an ever stronger dollar irrespective of the economic fundamentals."

Those fundamentals include rapid declines in production and profits and the loss of a half-million factory jobs since the middle of last year, Jasinowski said.

The presidents of five other groups -- the Aerospace Industries Association, the American Forest and Paper Association, the Association for Manufacturing Technology, the Automotive Trade Policy Council and the Motor Equipment Manufacturers Association -- also signed the letter.

A Treasury spokesman said O'Neill told Jasinowski "that current policy is not going to change" and that O'Neill has a "strong faith" in the ability of entrepreneurs to succeed even under such circumstances.

The current policy, the spokesman said, was summed up in O'Neill's most recent public statement on the issue: "The strong dollar has served us well."

At the same time, the Bush administration agreed last week to file a case with the International Trade Commission seeking authority to set quotas on steel imports. U.S. steelmakers have been arguing for years that government subsidies have allowed foreign steel producers to compete unfairly against them. The high dollar adds to the industry's competitive difficulties.

However, a significant weakening of the dollar, while it might help some industries, would also have a broad impact on U.S. economic and financial conditions.

David Gilmore of Foreign Exchange Analytics told his firm's clients last week that if the dollar were to fall and foreigners cut back on their investments here, "interest rates will rise and the economy will be at greater risk of recession."

Furthermore, Gilmore said, "the United States is sensitive to the problems Japan faces in implementing painful structural adjustment" in its economy. "Sanctioning dollar weakness means yen strength. The last thing Japan need in coming months is a rising yen."

© 2001 The Washington Post Company

-- (M@rket.trends), June 10, 2001