Mighty dollar will bounce back

The US is in an economic 'soft patch' and this has effectively played to theeuro zone's advantage, writes Niall Duggan

In his 2003 New Year address, the president of the EU Commission, Mr Romano Prodi, confidently proclaimed the euro as the "big new protagonist in the world economy".

At first glance his confidence seems well placed. After all, last year the euro rose in value by 18 per cent against the dollar, the world's reserve currency. The real question, however, is whether the euro's new-found strength is sustainable. A second glance would indicate the answer is no.

It is in fact US dollar weakness that provides the euro with its apparent strength. Concerns about the scale of the US's rising current account deficit, and its ability to draw in foreign capital to fund that deficit, are weighing on the dollar.

The US is importing almost $130 billion (€120 billion) more, each quarter, than it is exporting. The deficit is approaching the critical 5 per cent of gross domestic product level. At this point, fundamental exchange rate depreciation may be the only remedy available to cut the deficit, making exports cheaper and imports dearer.

Foreign investors have poured some $2,500 billion into the US since 1987, attracted by its larger, more liquid markets and consistently better returns. The US's current account deficit now demands a daunting $1.9 billion of foreign capital per working day to keep the show going.

The US is going through what the chairman of the Federal Reserve Bank, Mr Alan Greenspan, calls an "economic soft patch". It has seen rising unemployment, falling business and consumer sentiment, slowing consumer spending and negligible business investment growth.

Conflict with Iraq seems inevitable, making for further US dollar weakness. The euro could hit $1.10 in the coming weeks as investors dump or hedge US assets ahead of any military action. The conflict, an oilmen's war, could unfold in a number of ways.

Compliance by the Iraqis on foot of UN/US pressure or a short, sharp military conflict, in which the US and its allies triumph and oil production is not disrupted materially, are "favourable" outcomes already discounted by the markets. Crude oil prices should peak in the midst of this conflict at about $35 a barrel.

A more troublesome and extended military campaign is possible however. This would result in disrupted oil production - particularly sensitive if the current Venezuelan oil production strike continues - US and allied forces getting bogged down in a protracted conflict and Iraqi missile attacks on neighbouring states.

Neither of these scenarios is attractive. Crude oil prices would rise well clear of $40 a barrel, business and consumer confidence in the major economies would be shaken. This would be bad news for the US dollar, probably bringing the curtain down on the rally of recent years.

If, however, the Iraqi crisis is resolved quickly, oil prices will fall back to the mid $20s owing to reduced demand from both seasonal factors and the weakened global economic state. If there is a speedy resolution, the US economy will pick up quickly and outperform the euro zone for a number of reasons. The Fed's cutting of US interest rates to a 40-year low, increased US government spending and various tax-cutting packages should convert better business and consumer confidence into solid US economic growth later in 2003. Official estimates expect the US to grow by 2.6 per cent this year and a very creditable 3.6 per cent in 2004.

The recent US dollar depreciation makes US exports more competitive and dampens the demand for imports. The US's current account deficit will improve materially in the coming months and reduce its reliance on overseas capital flows. It also will reduce the foreign pricing pressure on US domestic producers' output and boost corporate earnings.

Being the reserve currency, the dollar's special position will allow the US to continue attracting foreign capital successfully. A key attraction for foreign investors is the availability of better returns on US investments. This is seen in the continuing net capital inflows from the euro zone to the US for both portfolio and foreign direct investment purposes.

One reason for the US's better returns is its greater productivity.Labour productivity in the US has risen by an average 2.1 per cent a year over 1996-2002 while the euro zone could only manage 0.8 per cent a year. Longer working hours and greater IT investment have made US workers more productive. This will remain the case, allowing US real wages to rise faster, sustain growing US consumer spending and provide growing corporate earnings. This productivity advantage helps make US assets attractive.

By contrast, the euro zone is bedevilled by policy inaction and division. Germany, France and Italy, the major euro-zone economies, are being forced to comply with the Stability and Growth Pact rule that government budget deficits cannot exceed 3 per cent of GDP. Compliance will mean both tax rises and spending cuts, illogical actions to stimulate growth at this stage in the economic cycle.

The euro's recent appreciation is dampening export growth, cheapening imports and putting greater pricing pressure on euro-zone producers. Inflation in the coming months will fall below the ECB's 2 per cent target, providing it with the opportunity to take a pro-growth stance in its monetary policy. Further euro interest rate cuts are likely by next summer. The weak domestic demand and falling export growth will make for anaemic euro-zone economic growth in 2003. Official forecasts suggest, at best, a 1.8 per cent growth rate for the euro zone in 2003, with German growth likely to be no more than 1.4 per cent.

Contrary to President Prodi's assertions, the euro's current strength is poorly based. Consequently, Irish importers should make hay by buying their net currency needs forward at current exchange rates to protect them from the US dollar rally expected later this year.

On the other hand, Irish exporters should avoid selling their net foreign currency receivables until more favourable exchange rates arise later this year.

Niall Duggan is head of FX Sales, Bank of Scotland (Ireland)