End of the dollar's mighty reign?

The US dollar, until recently the benchmark international currency, is on the slide. This means that international investors are losing faith in the strength of the American economy and are looking for safer havens. The implications for Africa are profound.

The US dollar, a traditional safe-haven currency in times of global turmoil, has not been looking very sound recently. This summer, US equity culture suffered heavy blows from the demise of Enron, America's seventh-largest energy trader, and WorldCom, the telecoms giant. America may be the most powerful nation on Earth, but its financial markets are experiencing one of the most testing periods in many years.

A flood of corporate accounting scandals at some prominent blue-chips like Citigroup, JP Morgan Chase, Xerox, Johnson & Johnson, Merck and more recently AOL Time Warner, the world's largest media and entertainment company, has also dented confidence.

The dollar, as the biggest beneficiary of capital inflows into US equities, has been weakened as a consequence. One Wall Street observer said: "As long as US equity prices remain depressed, and we expect the prospect of more billions going missing in the accounts means that equities will be depressed for a while yet. A dollar rally is going to be short-lived."

The correlation between US asset markets and the dollar remains strong. This year the under-performances of leading market indices, such as the Dow Jones industrial average (the barometer of top-30 stocks), Standard & Poor's 500 composite, and the tech-laden Nasdaq market have undermined the dollar's value on the foreign exchange markets.

Reasons behind the dollar's bull-run of the late 1990s were superior returns on US financial assets relative to Europe and Japan, and an increasing global demand for dollars fuelled by US corporate globalisation.

END OF ECONOMIC MAGIC?

Have international investors finally lost faith in the magic of the US economy? HSBC comments: "The US has spent years telling the rest of the world how to run their economies and now markets are finally awakening to the problems of the US economy." Morgan Stanley, the global investment bank, echoed this opinion saying: "What is going on in financial markets is a crisis of confidence in the US."

The general consensus is that the mighty dollar's reign is over. The greenback has been the worst performing currency of any industrialised nation over the past eight months, falling by between 10%-15% versus major US trading partners.

Whereas the infant euro, once described by many forex traders as a 'toilet currency', is beginning to show signs of maturity. On July 15, it reached parity with the dollar for the first time in two and half years.

The European Central Bank (ECB) has welcomed the euro's strength and noted that a faltering dollar is simply "a reflection of the deteriorating economic and financial fundamentals in the US." A resurgent euro is supported by lower and more attractive Eurozone equity valuations and higher money market rates: the ECB's key re-financing rate stands at 3.25%, compared with America's 1.75% Federal Funds rate. However, Europe's single currency is still below its debut value of $1.17 on January 1999.

It appears the Bush administration has dropped the 'strong dollar policy' of its predecessors. The US Treasury Department's present views are that markets should decide the currency's true value. The Bank for International Settlements, the central bankers' central bank, recently commented: "An orderly dollar depreciation was expected."

The greenback is weighed down by a combination of factors. These include investors' concerns over the vigour of US economic recovery, eroding confidence in 'corporate America,' equity meltdown caused by depressed outlook for corporate earnings, an unsustainable trade deficit and deteriorating fiscal position, i.e. resurgence of a budget deficit, as well as low interest rates.

BLOATED DEFICIT A RISK

The International Monetary Fund (IMF) warned recently that America's bloated current account deficit, which is projected at between $460bn-$500bn this year - or 5% of gross domestic product, was one of the `significant risks' facing world economy. As a rule, when a country's external deficit hits 5% of GDP, its currency tends to weaken.

The US needs to attract about $1.7bn in overseas funds every working day in order to prevent its currency from weakening. But dollar-assets are losing their lustre among investors, and continuing pessimism about US equities can hit inflows of foreign investments making it difficult for the US to finance its mounting trade deficit. Commerzbank (Germany) note: "With US asset markets looking weaker, the market is very much beginning to question the sustainability of the US dollar. We do see an end to the dollar 'bull run'."

Moreover, foreign corporations may now curtail their US expansion programmes because of worries over corporate governance. This will lead to a slowing of merger and acquisition (M&As) activities. The flows of M&As are gradually shifting in favour of Western Europe.