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Monday, Dec. 22, 2003

JAPANESE PERSPECTIVES

Dollar's depreciation due more to towering twin debts than euro


With the euro being quoted above $1.20, the media are now reporting that the euro has advanced against the dollar. But you cannot tell for certain whether you are witnessing the euro's appreciation or the dollar's depreciation, merely by looking at the euro's exchange rate vis-a-vis the dollar. This is because, under the float system, an exchange rate simply reflects the relative value of the two currencies in question. To determine the real value of a currency, you need to have a third standard.

During the pre-float years of the International Monetary Fund system, gold was that standard. Gold has recently been quoted above $400 per ounce. Its strength reflects not only increased geopolitical risks, such as terrorism and the continuing uncertainty in Iraq, but also the falling value of the U.S. dollar itself. It's the same reason crude oil refuses to dip below $30 per barrel.

And the dollar is falling against the yen as well. It has depreciated less sharply against the yen than the euro, but only because Japanese monetary authorities have intervened in the currency markets to support the dollar. The exchange rate doesn't correctly reflect the real value of the yen. Given these factors, we should realize that what we are seeing is not so much the rise of the euro as the fall of the dollar.

At the same time, the realities of the European economies do not warrant the euro's appreciation. Economic growth by members of the European Union remains slow, and there are doubts whether Germany and France can live up to the strict EU fiscal discipline that they themselves set.

On the other hand, the United States economy is enjoying a rapid annualized growth rate of over 8 percent. But if that's the case, why is the dollar so weak?

One major factor behind the dollar's weakness is the rising fiscal and external deficits of the U.S. economy.

While the U.S. was previously able to cover these towering twin deficits by using funds from overseas, recent statistics show this inflow to be slowing, thereby accelerating the dollar's depreciation. That means the U.S. is attracting less foreign capital -- even though Japan has recycled a large portion of the 18 trillion yen it spent on dollar-buying intervention in the January-November period by investing it in U.S. government bonds.

There are also rumors on the market that China, which has the largest surplus with the U.S., is turning to the euro for part of its foreign currency reserves. The market puts greater emphasis on the movement of capital than on economic fundamentals.

The U.S.-led occupation forces in Iraq have succeeded in capturing Saddam Hussein, raising the prospect that the tide of geopolitical risks may turn in Washington's favor. However, President George W. Bush -- and even the U.S. field commanders who were in charge of the raid -- have ruled out any immediate improvement in local security. The U.S. still has more problems on its hands than it has resolved, including the tough question of how Hussein should be tried, the inability to find evidence of weapons of mass destruction, and its failure to find Osama bin Laden. The U.S. stock market reacted calmly to news of Hussein's capture, and there is no reason to expect that the U.S. will see a sharp increase in foreign capital inflow anytime soon.

There is no doubt that the capture of Hussein -- long pursued by President Bush and his father -- will boost American consumer sentiment during the Christmas season. But the biggest problem for the U.S. economy remains a structural one: that external deficits will rise as consumers spend. The U.S. will naturally accumulate more external debt, which will in turn oblige it to rely more on funds from overseas.

The markets are worried -- not just because the fund inflow may not catch up with the debt increase, but also because of the worst-case scenario -- that funds could start flowing out of the U.S.

At the end of the previous year, the U.S. had external debts worth more than $9 trillion, and an outstanding net debt of $2.6 trillion, which is equivalent to 25 percent of its GDP. And the market's worries over the dollar do not appear to have calmed. What is happening now is not an appreciation of the euro, but a depreciation of the dollar.

Teruhiko Mano is an adviser to Tokyo Research International Ltd.


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