The strength of the dollar

Much of my investment portfolio is in US dollars. I have been hearing that the dollar has been weakening in value and I am concerned as to how this could affect my investments. What is the impact of a weakening dollar on the economy and how does it inter relate to other currencies, such as the euro?

We have seen the dollar rise in value for many years. Now, the tide seems to be turning. Since February the dollar has fallen by 9% against the euro, to a 17-month low. It has also hit a six-month low against the yen and may well fall further over the coming year.

Two factors weigh against the dollar. First, it is by most yardsticks overvalued and second, America's large current-account deficit, at more than 4% of GDP and growing, looks unsustainable. If the dollar stays roughly where it is as the economy rebounds, then the deficit will grow. As a rule, once a country's external deficit approaches 5% of GDP, its currency tends to fall.

To trigger a slide, foreign investors do not have to become net sellers of American assets. The dollar will fall if they merely reduce the pace at which they add to their holdings. It will fall even more if American investors continue or expand this year's buying of foreign assets, notably European equities.

Most forecasters predict another fall in the dollar, but they generally expect it to be gradual and relatively painless - except, of course, for foreigners with large dollar holdings. For example, UBS Warburg expects the dollar to fall to $1.05 to the euro and to ¥115 by the end of 2003 - a drop of around one-sixth from its peak earlier this year.

An argument is that a gradual fall in the dollar would benefit the world economy. It would underpin America's recovery, by helping to bolster exports, profits and investment. A stronger euro and yen would also intensify the pressure for structural reform and corporate restructuring in the euro area and Japan.

By helping to hold down inflation in Europe, a strong euro would also reduce the pressure on the European Central Bank (ECB) to raise interest rates. For Japan, however, a weaker dollar would be bad news, threatening to choke recovery. With interest rates already close to zero, the exchange rate is one of the few policy tools left for the Bank of Japan.

America's economy would certainly benefit from a moderate fall in the dollar. Some economists fret that this would push up inflation and thus force the Federal Reserve to raise interest rates. Yet the Fed would probably be happy to see some increase in inflation.

While a moderate decline of the dollar might be beneficial for the world, a sudden plunge would be another story altogether. It would probably trigger a slump in American share prices, and a rise in bond yields, as foreigners pulled out their money. Foreigners own fully two-fifths of American Treasury bonds, a quarter of corporate bonds and 13% of American equities. Share prices around the world would probably be hit.

For now, most economists expect a moderate fall in the dollar towards its "fair value", rather than a plunge.

Please address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively he can be contacted on 2131-1121/9984-2614 (office hours).

Past performance is no guide to the future and except where amounts are guaranteed the price of your investments (and the currency in which it is denominated) may fall as well as rise. Malta exchange control regulations must be observed. Your personal tax situation will depend upon residence, always consult a professional adviser. This article does not intend to give investment advice and the contents therein should not be construed as such. Readers are encouraged to seek professional advice regarding their personal financial situation.