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Thursday, 30 January, 2003, 08:24 GMT
Analysis: the dollar-euro relationship
Euro and US dollar notes
The euro was worth around 84 cents at its weakest

What is happening with the euro and the dollar?

At its weakest, the euro was around 84 cents.

Now it's $1.07 or $1.08. Still well short of the level of $1.17 from the early days when the euro was launched in January 1999.

With oil prices in dollars it [the decline in value] would be mildly helpful for some businesses

But even so it is a striking gain, especially when you consider that it's not as if the economy of the euro area is powering away and sucking in investment funds from around the globe looking for a decent return.

Gloomy picture

In fact the eurozone's economies are growing pretty weakly.

In the third quarter of last year (the most recent for which the full set of figures are available) the US economy grew by 1%.

For the three largest economies in the eurozone, the figures were a rather feeble 0.2% for Germany and 0.3% for France and Italy.

So why the declining dollar?

The central reason is the large and persistent deficit in US trade with the rest of the world.

The current account deficit - which includes trade in goods and services and some other payments - was about half a trillion dollars last year, 5% of the US economy.

Tough times

That deficit has to be financed, essentially by more foreign capital going into the US than there is American money leaving.

Car factory production line in Germany
In the third quarter of 2002 Germany's economy grew by just 0.2%

During the boom of the 1990s it was no problem.

Investors around the world were desperate to get a share of the gains to be made from the US stock market.

And there were many businesses eager to get involved in the US by buying American companies.

BP, Vodafone, Deutsche Telekom and many others did it, contributing to the capital going into the United States.

Now the boom has been over for two years and so is the global infatuation with investing in the US.

Foreigners are no longer so interested in acquiring whole companies or shares in them.

There is still investment going into the US, but it doesn't need investors to pull money out of the US en masse to put the dollar under pressure - it's just a question of them being more reluctant to provide the new money needed to finance the continuing deficit.

If they don't, there is still money flowing out to pay for all the imports of goods and services.

Attractive options?

The dollar has indeed declined, not very fast, it has to be said, which reflects the fact that nowhere else offers very exciting prospects for a quick profit.

Demonstration over Argentina's economic crisis
Investors now see emerging markets as higher risk

Europe is pretty sluggish, and Japan remains depressed as it has been for a decade.

Those developing countries that investors can easily put money into - the emerging markets - seem a lot more risky than they did.

But despite the lack of irresistible alternative places to invest, the pressure is on the dollar.

In short, several years of trade deficit is catching up with the dollar.

War threat

And it has been exacerbated by the war talk.

If there is a war in Iraq, the US will lead the military effort. So investors think it is especially at risk of some sort of retaliation.

It might not be anything that would bring the US economy to a grinding halt.

But terror attacks could easily damage consumer and business confidence.

And you can see it in the currency markets.

When political and diplomatic events suggest that war is more likely, the dollar usually falls.

Weak demand

The decline of the US currency should normally help correct the problem - the trade deficit - behind it.

It makes foreign goods more expensive for American consumers, encouraging them to switch to home produced goods.

It also gives the rest of the world an incentive to buy more US goods.

The trouble is that with Japan and Western Europe so weak, the booming demand for American exports just isn't there.

So despite the dollar's decline, the underlying imbalance is still there.

Uncertain future

It might, just might, be a nasty problem waiting round the corner.

A gentle, orderly fall in the dollar won't do much harm.

And with oil prices in dollars it would be mildly helpful for some businesses.

But a rapid disorderly fall would be disruptive.

The precise effects are unpredictable, but there would probably be some severe losses in financial markets, company profits and perhaps - indirectly - in jobs too.

See also:

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