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08.07.03, 16:37
US dollar’s "virtuous circle" may be turning vicious
By Nick Beams
18 June 2002
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There are clear signs in financial markets that the long-predicted day of
reckoning for the US dollar may be close at hand. Last week the dollar slid
to a 17-month low against the euro, marking a decline of nearly 14 percent
from the levels of last July. Stock markets around the world turned down with
the Dow Jones Index dropping 3.4 percent for the week and markets in Europe
and Asia generally reached their lowest levels since the immediate aftermath
of the September 11 terrorist attacks.
Predictions of the dollar’s decline have been based on the implications of
the unsustainable financial position of the US economy. With imports
exceeding exports by about one third, the US has been running a balance of
payments deficit of more than 4 percent of gross domestic product, requiring
a foreign capital inflow of more than $1 billion a day to finance it.
That did not present immediate problems during the stock market boom of the
late 1990s. As long as markets kept rising, funds poured in from the rest of
the world to purchase shares, corporate bonds and treasury notes, financing
the foreign debt and keeping up the value of the dollar. But the collapse of
the share market bubble and concerns over the real financial position of
corporate America in the wake of the Enron scandal have started to shake the
confidence of investors, prompting fears that at some point there could be a
massive capital outflow.
There are signs that the turnaround may have already started. Warning that
the US dollar was “very vulnerable” to a change in sentiment about American
assets, the Economist of June 14 noted that there had been a shift in the
flow of funds to the US over the past year. “Foreign direct investment
financed 91 percent of America’s current-account deficit in 1999. By last
year, that had fallen to 43 percent, having been supplanted by more fickle
capital flows. Foreigners own no less than two-fifths of American Treasury
bonds, a quarter of corporate bonds and 13 percent of American equities.”
Long-time Australian economics analyst Max Walsh commented in an article in
the Bulletin magazine of June 4 that while the US dollar was anywhere between
15 and 30 percent overvalued, this did not set the limits to the potential
fall because in the current era of large capital flows, exchange rate
movements developed a momentum that fed upon itself.
According to Walsh, foreign investors hold US corporate bonds with a value of
more than $1.3 trillion, Treasury bonds of more than $600 billion on top of
$1.5 trillion in corporate equities. “A high proportion of this capital is
footloose, ready to take off if there is a more promising investment at hand,
or if the value of US investment looks like contracting,” he wrote.
Some commentators have dismissed the prospect of a capital outflow from the
US on the grounds that investment opportunities are no better in the rest of
the world. That may well be the case provided the value of the dollar is
sustained. However, if it starts to rapidly lose value, then investments may
well be liquidated, not because there are better opportunities elsewhere, but
in order to try to avoid massive exchange rate losses they would sustain by
continuing to hold dollar-denominated assets.
Investor nervousness is also being fuelled by the continuing revelation that
the much-vaunted strength of the US economy is far from what was claimed.
At the macro level, figures show that since 1997 profits as a proportion of
GDP have steadily declined. Yet in that period S&P 500 companies have been
reporting earnings growth in excess of GDP growth. This result has been
achieved by a series of accounting practices designed to inflate profit
results in order to boost share market values.
So rampant have been these practices that the Wall Street Journal recently
pointed to a “growing awareness of how deeply flawed ... US financial markets
really are.” One of the main problems, it said, was that the so-called
watchdogs, charged with keeping the financial world honest, had lost
credibility themselves. Outside auditors bent the rules to please corporate
clients, analysts shaped stock recommendations to woo investment customers,
while government regulators were “too timid or too overwhelmed to keep track
of the frenzy.”
According to the WSJ: “Boasts about world-class corporate disclosure,
bookkeeping and regulation of American financial markets have become
laughable in the wake of the Enron and Arthur Andersen scandals.”
But such concerns have been blithely dismissed by US Treasury Secretary Paul
O’Neill. Speaking after a meeting of the Group of Seven finance ministers at
the weekend O’Neill said market fears about corporate governance in the wake
of the Enron collapse were overdone and would eventually dissipate.
“The important thing is the fundamentals of what is going on in the real
economy, which I continue to believe are quite good,” he said. The problem
with this and other optimistic assessments is, however, that such is the
state of accounting practice and the vast overstatement of profit results
that there is no objective measure of one of the most
important “fundamentals” of any capitalist economy—the real level of profits.
Brushing these issues aside, O’Neill said markets had placed too much weight
on concerns over corporate transparency and accounting standards and in any
case he did not “worry about things I can’t do anything about.”
Unsustainable trends
Whether or not the present turbulence is the start of a sustained slide of
the dollar, it is clear that the economic trends of the past period cannot be
maintained, with major consequences for both the US and world economy.
The dollar began its ascent in 1995 after reaching a record low of 79 yen in
April of that year. With Japanese manufacturers facing bankruptcy because the
high value of the yen was pricing them out of export markets, financial
authorities agreed to lift the value of the US dollar. While this resolved
the immediate crisis it had longer term consequences. In particular the East
Asian economies, whose currencies were tied to the dollar, now experienced a
downturn in export growth, one of the factors that helped spark the so-called
Asian financial crisis of 1997-98.
For the US, the turnaround in the value of the dollar resulted in a rapid
inflow of foreign capital into its financial and equity markets. This
financial boom sparked investment spending and the increase in US economic
growth in the latter years of the 1990s. This increased US growth led in turn
to a widening balance of payments gap, requiring an increased capital inflow
from the rest of the world to finance it.
The hoopla over the “new economy” at the end of the 1990s served to mask an
increasingly untenable situation in which world economic growth was becoming
increasingly dependent on the expansion of the US economy, which, in turn,
was going deeper into debt. Now the stage has been set for a violent
financial adjustment.
Last March, US Federal Reserve Board chairman Alan Greenspan pointed out that
for the past six years about 40 percent of US capital stock had been financed
by foreign investment, requiring an ever-greater outflow of interest and
other payments. “Countries that have gone down this path,” he said, “have
invariably run into trouble and so would we.”
If the dollar does continue to fall and sets off a withdrawal of funds,
this “trouble”
