Against the Odds, Financial Crisis Helps Stimulate the Dollar

Glboal flight from risky asset to US safer assets, like Treasury, and unwinding of bests made with US dollars helped dollar... The U.S. may be facing the worst financial crisis since the Great Depression, but you wouldn't know it from watching the dollar. Rather than sinking under the financial-sector bailout, the greenback is buoyant. That is a surprise to many who expected rising government spending and a tanking U.S. economy to cripple the dollar. Instead, the dollar has benefited from the global flight from risky assets as well as the unwinding of bets made with borrowed cash. The scope of the crisis also has helped: It is clear that economic and banking woes aren't unique to the U.S. "The dollar's strength has surprised me," says Barry Eichengreen, an economist at the University of California, Berkeley. "There are not a lot of more-attractive alternatives at the moment." Since the start of September, the dollar has strengthened 8% against a trade-weighted basket of 26 currencies, according to a Federal Reserve index. The index is roughly at its February 2007 level, effectively erasing the dollar's slide through the collapse of Bear Stearns Cos. and a series of interest-rate cuts by the Fed. The dollar has risen so rapidly that investors warn that it is due for a breather. Just as the dollar benefited from tumult in global markets, stabilization could see it give back some recent gains. In the longer term, the dollar's health remains dependent on foreigners' appetite for U.S. assets, which may be tested as the economy falters and government spending grows. For now, the dollar has proved resilient, supporting the views of those who say its long slide bottomed earlier this year. The dollar's recent climb is part of a massive reversal of longstanding investing trends, such as buying emerging-market stocks or wagering on rising commodity prices. When investors retreat from such investments, they are often selling them in exchange for dollars. After sending money overseas for years, U.S. investors now are bringing it home. In July and August, the latest months for which Treasury Department data are available, U.S. investors sold $57 billion more in foreign stocks and bonds than they bought -- the largest-ever such repatriation. The dollar also has been boosted because banks from South Korea to Switzerland are scrambling for dollars after normal channels for borrowing between banks all but ceased to function during the past month. The U.S. currency remains the most popular among global banks, accounting for 55% of the assets and liabilities they hold in foreign currencies, according to the Bank for International Settlements. Some investors say the appetite for dollars is akin to that for Japanese yen, a currency that is the major exception to the dollar's strengthening trend. The yen often thrives during turmoil because in better times, investors borrow in yen to take advantage of Japan's ultralow interest rates. When volatility rises or investors need to cover losses elsewhere, they undo these maneuvers -- known as carry trades -- and buy back yen, boosting Japan's currency. Judging from the recent demand for dollars, it seems that investors, hedge funds and banks have been using the dollar as a funding currency, much like the yen. Amid the upheaval, investors also have favored U.S. Treasury bonds as a haven. Demand from foreign central banks is especially important because they are a major customer for U.S. debt. One gauge of that demand is the amount of Treasurys held on behalf of other central banks by the Fed. The most recent data show that such holdings of Treasurys increased by about $100 billion over the past four weeks. That signals foreigners' confidence, which is critical to the U.S. financial system. If foreigners stopped buying American assets or started selling them, the dollar would plummet and interest rates would soar, battering the already-weak economy. Some investors worry that the fiscal cost of bailing out the U.S. financial sector eventually will weigh on the dollar, but economists caution that the ultimate impact isn't clear yet. Gross government debt in the U.S. as a percentage of gross domestic product is moderate compared with countries such as Japan and Italy and slightly lower than Germany. "Empirically it is very hard to demonstrate a big effect of budget deficits on the exchange rate," says Kenneth Rogoff, a professor of economics at Harvard University. In theory, the bigger effect is on interest rates, he notes. In recent years, growing budget deficits have gone hand in hand with a weaker dollar, but in the 1980s the opposite was the case: An expanding deficit accompanied a stronger dollar, particularly amid high interest rates. Far more important to the dollar's health, economists say, is the current-account deficit, a broad measure of how much more the country imports than exports. This measure has improved but has far to go. The International Monetary Fund estimates that the U.S. current-account deficit will narrow to 3.3% of GDP next year from nearly 6% in 2006. If market turmoil subsides, investors may focus anew on the growth prospects of the U.S. economy compared with those of its major rivals. Unlike other central banks, the Fed more than a year ago began lowering interest rates, which punished the dollar. Now it could be a positive, as other central banks catch up. In the U.S., "a lot of the heavy lifting has already been put in the pipeline," says Stephen Jen, global head of currency strategy at Morgan Stanley. "The same cannot be said of Europe."