Dollar's comeback could be imperiled by deficit

February 06, 1993|By Ian Johnson | Ian Johnson,New York Bureau

NEW YORK -- Only four months after being given last rites in the world's currency markets, the U.S. dollar has made a strong recovery and is poised to climb further over the year ahead as foreign interest rate cuts, such as those seen this week, take hold.

But currency analysts cautioned that the dollar's long-term vigor remains in serious doubt unless Washington makes a serious attempt to cut the federal deficit. Combined with fundamental structural problems in the U.S. economy, the deficit could push the dollar further along its 20-year downward spiral vs. other major currencies.

But in the short run, the dollar has shown unexpected strength.

Since Sept. 2, when the dollar traded at a historic low of 1.3860 German marks, it has rallied 20 percent, closing in New York yesterday at 1.6583. Against the yen, it has risen 5 percent from a record low of 118.65 on Sept. 29 and closed yesterday at 124.44.

"It's a case of the best-looking horse in the glue factory. The dollar is doing well not because of redeeming features in the U.S. economy, but because the rest of the world is doing so poorly," said Francis Scotland, editor of the Montreal-based International Credit Market Analyst.

While the U.S. economy has been showing signs of unspectacular but steady growth over the past 10 weeks, the European and Japanese economies have been locked in recession. This has caused an easing of interest rates abroad that should help push up the dollar by year-end, said Paul Boltz, chief economist for T. Rowe Price Associates Inc. in Baltimore.

"Our view is that the dollar will continue to strengthen because the United States is ahead in the business cycle compared to Germany and Japan," Mr. Boltz said.

Many currency traders believe that, because Germany is still in recession, it would cut its interest rates further. Thursday, it cut its discount rate to 8 percent from 8.25 percent and is likely to cut the rate to 6 percent by the end of 1993.

"A further 2-percentage-point cut looks entirely reasonable for this year," Commerzbank AG senior economist Juergen Pfister said from Frankfurt.

While German interest rates are being cut, the United States might be increasing its rates slightly as the economy heats up this year, which would further strengthen the dollar. The dollar could easily end the year at 1.80 German marks, said John Rothfield, chief currency analyst at the First National Bank of Chicago.

"The dollar has been in a downward channel since 1987, but there is excellent evidence that this year will be a counter trend," Mr. Rothfield said.

Several factors, however, will probably ensure that a bullish year for the dollar in 1993 would be an exception. For one, inflation may remain weak well into next year, so any rise in U.S. interest rates would likely be limited into next year.

More importantly, however, the federal budget deficit remains a big drag on the dollar. Every dollar saved, Mr. Scotland said, is consumed by the deficit, so any expansion by U.S. industry is essentially financed by foreign investors.

As long as Europe's and Japan's economies are weak, this reliance on foreign investment will be no problem, Mr. Scotland said. When their economies pick up and money is needed at home, however, the United States will have to attract foreign capital through either higher interest rates or a devalued currency.

Given that low interest rates are seen as crucial to the current recovery, the dollar may be allowed to sink in about 18 months, prompting new concerns about the dollar's health.

Until the deficit is under control, the dollar should continue its general downward course, despite this year's expected uptick, Mr. Scotland said.

Support for this ultimately bearish view comes also from this past week's seemingly good news for the dollar. As Germany and Japan cut rates and one favorable report after another was released on the U.S. economy, the dollar should have rocketed upward, Mr. Rothfield said. Instead, it remained little changed and even declined slightly yesterday against the mark and the yen.

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