The euro's appreciation against the dollar may prove a mixed blessing, with negative factors such as reduced demand for euro-zone exports outweighing positives. There is a real risk that the dollar's correction has only just begun. Factors that caused the dollar to depreciate by 13 per cent against the euro in the last seven months remain... the market has sold the dollar becauseits confidence in corporate America has been shattered
The euro traded above parity with the dollar this week for the first time since February 2000. Many factors have combined to see the euro rally 13 per cent against the dollar in the year to date, but it took a fall in US consumer confidence in July to finally give the market sufficient reason to push the euro beyond parity.
However, the rapid appreciation of the single currency could yet prove to be a mixed blessing. At current levels, benefits will accrue to the euro zone thanks to the stronger euro. But if the dollar's depreciation is allowed to continue unchecked, the global economy could well suffer a major setback. From a euro-zone perspective, the current strength of the single currency has an immediate and tangible impact.
A stronger euro reduces inflationary pressures in the euro zone because it forces the prices of goods and services down to compete with cheaper imports. The European Central Bank (ECB) has acknowledged that the euro's recent rally to the $0.96 range had an equivalent impact to a 0.25 per cent rise in interest rates from an inflationary perspective.
If the euro holds at these levels, the ECB should be able to leave rates at current levels of 3.25 per cent for the rest of the year to stimulate economic growth. Only two months ago, there was a real risk that the ECB would have to raise rates to combat inflation, which would have restricted euro-zone growth.
Yet if the dollar's fall continues, negative factors will come to outweigh the benefits. Euro-zone exports to the rest of the world will become more expensive, a particularly worrying development.
The nascent economic recovery in the euro zone this year can be attributed largely to demand for exports. If the dollar continues to weaken, demand for European exports from the US will diminish and the strengthening single currency will actually harm the euro-zone's economy.
And there is a real risk that the dollar's correction has only just begun. The factors that caused the dollar to depreciate by 13 per cent against the euro in the last seven months remain; none has been resolved. The market has sold the dollar because its confidence in corporate America has been shattered, and it is unlikely to be restored in the near future.
One factor that may cause the dollar to fall further is that currency markets tend to over-exaggerate movements in prices, as momentum can often drive a currency lower than economic fundamentals suggest its fair value is. At the moment, momentum is squarely against the dollar, despite the fact that the real economy is the US shows signs of life.
In addition, fears of further corporate governance and accountancy scandals still pervade the market.
The chairman of the Federal Reserve Mr Alan Greenspan admitted this week that further "misdeeds" were likely to be discovered in the US market. And some pricing models still suggest the US market is over-valued when compared to historic levels. If the equity market falls further, the dollar is likely to track its descent.
However, accountancy scandals were by no means the only factors that caused the market to lose faith in the US. Investors were already pulling out of US markets ahead of Enron and WorldCom because of concerns over the sustainability of the US's $450 billion trade deficit. It was also recently announced that the US is set to record a budget deficit in excess of $160 billion this year, due in no small part to the $40 billion the US is spending on its military.
The prospect of a trade deficit approaching 5 per cent of GDP (a level that has triggered currency collapses in other countries) allied to a growing national debt, will further deter investors from buying US denominated assets, and hence keep the dollar depressed.
Yet, excluding the euro, the only other major currency against which the dollar has collapsed is the Japanese yen. The Federal Reserve in the US estimates that, on a trade-weighted basis, the dollar has only depreciated by 4 per cent on average against its key trading partners. This suggests that the dollar will have to devalue further against other major currencies before the US can hope to reduce its trade imbalance and begin to attract inward investment again.
Finally, the Bush administration has effectively abandoned the "strong dollar" policy maintained by the US Treasury for the past 10 years. So, all of the available evidence points to further dollar depreciation. If the forthcoming decline is gradual, it should not be of concern. Yet if the dollar's decline accelerates, the consequences for the global economy will be disastrous. Obviously the euro-zone export-led recovery will collapse but, in the US itself, a sharp dollar decline will cause inflationary pressures and force the Fed to increase interest rates.
Neither the US stock market nor the US economy could take that blow right now, and the implications for the global economy of a double-dip recession in the US would be painful. Nevertheless, if the market senses new weakness in the US economy, it will try to push the dollar lower. For the sake of the global economy, we must hope the relevant authorities are ready to take appropriate action to impose some order should the current collapse of the dollar accelerate, to halt the decline before it damages hopes of global recovery.
