More O'Neill

["Ian Murray" <seamus2001@xxxxxxxx>]

[FT]

Hands off the dollar
There are signs the US Treasury believes the markets are the best
judge of the currency's value, says Alan Beattie
Published: August 19 2001 18:41GMT | Last Updated: August 19 2001
18:48GMT

At least there is one O'Neill whose views on the dollar are absolutely
clear. Jim O'Neill, the chief currency economist of the US investment
bank Goldman Sachs, says: "Sometimes it feels as if I have spent most
of my adult life saying that the dollar will weaken."

In fact, it has been closer to two years - still a long time for a
leading investment bank to be wrong on the world's largest currency.
Last week's falls in the dollar, particularly against the euro, have
therefore given Mr O'Neill hope that some sanity is returning to the
foreign exchange markets. But if the slide accelerates, it will pose a
challenge for another O'Neill - the US Treasury secretary Paul.

After a confusion of comments on the subject from Mr O'Neill and other
members of the Bush administration, there are now signs that the
Treasury is moving towards replacing the deliberate support for a
strong dollar with the idea that the markets are the best judge of
where it should be - buttressed with the claim that current economic
fundamentals justify its strength. H o w far such a hands-off policy
would survive if the US currency went into free fall is an open
question.

The reasons why the dollar should weaken, at least against the euro,
are well known. The currency is markedly higher than almost any
plausible estimate of its fair value. Goldman Sachs estimates that the
currency's medium-term equilibrium rate is about $1.17 against the
euro, though it seems close to fair value against the yen.

The widening US current account deficit, supported for so long by
voracious domestic consumption driven by rising asset prices, now
looks vulnerable. The Beige Book - a collection of anecdotal evidence
from the Federal Reserve's regional banks - recently suggested the
weakness in manufacturing was beginning to spread throughout the
economy. And recent downward revisions to US productivity growth have
helped undermine the idea that a US economic miracle can justify a
permanent, sharply higher level for the dollar.

This, after all, is how open-economy macro-economics is supposed to
work. Economies with large trade deficits and where domestic demand
has run ahead of supply should see their currencies slide to boost
exports relative to domestic demand.

But saying the dollar ought to fall against the euro is not enough.
Dollar bears have been disappointed before by slides in the currency
that were quickly reversed. The dollar endured another long hot summer
in 1999, with a similar rash of questions about the durability and
meaning of the strong dollar policy, before it recovered of its own
accord.

Such reversals have made analysts increasingly reluctant to call the
turn in the dollar. The latest independent forecasts from banks and
consultancies collected by Consensus Economics shows it strengthening
against both euro and yen by November from its current position.

There are other reasons to be cautious. The US economy looks a lot
shakier than it did in the spring, after the Federal Reserve cut
interest rates so sharply. But as the Bank of England pointed out
recently when it cut UK growth forecasts, although the US economy is
the biggest risk to world growth, the eurozone economy has
deteriorated at an even faster rate in the past two months. The
deciding factor may well be the gap between outcomes and expectations
for the US economy.

"At the beginning, everyone talked about the slowdown lasting six to
eight months rather than two to three years," says Sassan Ghahramani,
president of G7 markets at Medley Global Advisors in New York. "Hardly
anyone is talking about a swift US recovery now."

Market participants say most of the dollar selling so far seems to be
from hedge funds and short-term speculative players, but large fund
managers are likely to join in if the dollar fails to recover soon.

Capital flow data are notoriously slow to be released and in any case
are imperfectly correlated with exchange rate movements. But guesses
in the market - such as Goldman Sachs' estimates of potential flows
arising from mergers and acquisitions - suggest that flows may be
turning against the US.

Of course, a generalised dollar fall would be more welcome in some
parts of the world than others. A stronger euro is good news for the
eurozone, allowing the European Central Bank to cut interest rates by
removing the threat of imported inflation. The same cannot be said for
Japan: the US economy may look weak but Japan's is weaker. Unlike the
ECB, the Bank of Japan seems to have run out of ways in which it can
or will loosen monetary policy, notwithstanding last week's
announcement that it was tinkering with its balance sheet to try to
get banks to lend again. The last thing it wants is a stronger yen
tightening monetary conditions. Recent verbal warnings from Japanese
politicians against yen strength are likely to turn into renewed
market intervention if the dollar falls further.

This contrasts with the laisser faire policy taking shape in the Bush
administration. In an interview with the Financial Times last month,
Mr O'Neill gave a robust defence of the dollar's strength. "How do you
know the dollar is too high? Compared to what? What is it you know
that the market doesn't know?" he asked. "Show me your evidence."

At the time, this looked like a reiteration of the strong dollar
policy. But as time goes on, it begins to look more like a plea that
the level of the dollar should be determined by the markets, not by
where policymakers want it to go. This could be a way of reconciling
Mr O'Neill's continued use of the expression "strong dollar" with
comments from President George W. Bush that the value of the currency
is best determined by the markets.

In a CNBC television interview last week, Mr O'Neill said the policy
on the dollar was unchanged, while studiously avoiding any comment on
what that policy was.

"The administration's commitment to a market-determined day-to-day
exchange rate is a clear alternative to feeding the perception that it
can - or will - influence the exchange rate via the nuances of a
'dollar policy'," says Mickey Levy, chief economist of Bank of
America.

"They favour economic fundamentals consistent with a strong dollar,
but this does not imply a willingness to intervene either directly or
verbally to boost the dollar or lower it."

This interpretation was backed by Mr O'Neill last week when he said he
thought the dollar would remain strong because of continued US
productivity growth.

As long as the dollar enters a gradual depreciation, allowing the
trade balance to adjust and investors to reposition themselves
smoothly, Mr O'Neill's hands-off policy may pay dividends. But in the
face of an accelerating depreciation, the credibility of this strategy
would be less clear. Implying that any level of the dollar supported
by the market is acceptable could lead the currency into free fall,
destabilising markets and threatening a severe loss of confidence
among US consumers and companies.

Moreover, observers note that while Mr O'Neill may have softened the
mantra that the dollar should be strong, he seems to have adopted a
prediction that it will be strong. This approach has its own risks.

Confident predictions about currencies, in the face of evidence to the
contrary, have been the undoing of more than one policymaker. Mr
Ghahramani notes that the only time in the past two years that ECB
policymakers have got the rise in the euro they wanted is when they
went on holiday and stopped talking about it.

"If Paul O'Neill keeps on saying he is in favour of a strong dollar
while it is going down, he may well find himself a victim of the
Duisenberg syndrome," says Jim O'Neill. "He would be better off just
keeping his mouth shut and enjoying it."