Passing the buck

The dollar should have rallied this year. Instead, it has faltered badly. There is a growing loss of confidence in the dollar and dollar assets.

The recent intervention efforts of the G-7 central banks seem to have put a temporary floor under the dollar's fall against the yen, but the dollar has continued its agonizing, slow-motion descent against the German mark and other European currencies. At DM 1.64 to the dollar, the dollar is now at its low point of the year against the German currency, despite central bank intervention.

The dollar falls steadily against the DM even as the Bundesbank repeatedly cuts German interest rates and the Fed simultaneously pushes U.S. rates higher. This unusual behavior is shocking to currency analysts.

What ails the dollar? Why are people losing confidence in it? The most important point to bear in mind is that the U.S. runs a huge current account deficit - over $100 billion in 1993. The deficit will be even larger this year. So unless there is a net capital inflow into dollar assets in excess of $8.5 billion every month, the dollar will depreciate under the weight of the deficit.

The current account deficit can be funded two ways: either by foreign private investors or central bankers. But there are important constraints that limit both investors and bankers. As to the central bankers, there are limitations on the level of dollar reserves that they are willing to hold.

As for private investors, they must first be persuaded that the U.S. is an attractive place to invest capital. These days the U.S. isn't so attractive, with both stock and bond markets extremely volatile. Returns on most U.S. financial assets are low, after adjusting for inflation and taxes. President Clinton's appointments to the Federal Reserve Board have cost the central bank credibility, and the Clinton Administration's glaring political problems have weakened the government's ability to make policy.

Any one of these factors could discourage foreigners. Collectively they add up to a real turnoff.

Thus far, foreign investors have shifted out of dollars and back into their domestic currencies only in a very modest way, but the danger is that this trickle could become a flood—and there is nothing the central banks could do to stop it. Let's say, for example, that I am a French investor who has decided to reallocate 20% of my dollar-based portfolio into a cash position because of the volatility in the U.S. bond markets this year. I’m also worried about the recent surge in commodity prices.

The question I am faced with is whether I want to park my cash in dollars and face further currency risk, or move the money back home into French francs. Overnight money in the U.S. currently yields 4.125%, while overnight money in France earns 5.75%. So unless there are other compelling advantages to holding dollars, the chances are I will bring the money home.

If investors around the world start thinking and acting this way, the dollar could be in even worse trouble. That’s because the potential supply of dollars is far greater than the demand. U.S. economic output accounts for only about 22% of global production, yet 65% of the world’s currency reserves are held in dollars. This is a carryover from the dominant role in world trade that the U.S. held after World War II, but the dollar’s role as a reserve currency has not sufficiently been adjusted to reflect the changing economic status of Germany and Japan. Put more simply, too many people hold too many dollars, given the relative size and condition of the U.S. economy.

All of this poses an enormous risk to the smooth functioning of the global financial system. Currently, foreigners hold approximately $2.5 trillion worth of U.S. assets. Imagine the chaos that would ensue if private investors reallocated 10%, say, of their dollar assets to alternative currencies and geographical groupings. The flood of capital flowing out of dollars would overwhelm the G-7 central banks’ ability to intervene. No telling how low the dollar could go.

A financial disaster is, of course, unlikely, but the dollar's prospects are weak enough that some insurance is a good idea, especially if you’re heavily invested in stocks. One policy I would consider is out-of-the-money puts on the S&P 500. The September 440 contract on the Chicago Mercantile Exchange, for example, is currently selling at 570. Whatever you do, exercise extreme caution in holding dollars.

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