Flying Higher

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Almost since the euro was born three years ago as Europe's common currency, analysts have been proclaiming that it was undervalued against the dollar. Despite the dot.com wreckage, a sagging stock market and the Sept. 11 terrorist attacks the dollar remained unexpectedly and even inexplicably strong. Now the euro's day may have finally arrived. Last week, the euro was trading 10% higher than in February and economists think it has room for further appreciation. But is the euro's new-found strength really good for Europe?

Maybe not. Sure, inflation will be held in check and prices for such imports as Jeeps and gasoline will go down if the euro is strong. But what really counts is why the currency is rising in the first place. "I think we're in a situation where the euro goes up because the dollar goes down," says Thomas Mayer, chief economist at investment bank Goldman Sachs in Frankfurt. "The biggest worry is that a sharp appreciation of the euro reduces profit expectations in European industry and leads to a broadly based weakness."

Take a German-based manufacturer of machine tools, for example. With the euro higher, the price of the company's goods on the world market will have to rise. That leads to lower profits back home in Germany from overseas exports. The manufacturer may decide to cut back on investment as a way to save money. Or he could reduce jobs because of declining sales. Not only would these cutbacks affect one employer, but all of the company's suppliers would be hit similarly.

What's more, investment is not flowing to Europe because of its strengthening economy — growth was up an anemic .2% in the first quarter of the year, after one quarter in 2001 when GDP actually declined. The strongest part of the German economy is exports, which increased a sharp 1.9% in the first quarter compared with the last quarter of 2001. If exports are driving the European economy, a higher euro could spoil the party by making European prices more expensive relative to the dollar and other currencies.

So if it's not Europe's strength, what's pushing the euro higher? There is evidence that fund managers worldwide have reached a consensus that U.S. stocks and bonds are overvalued, causing them to look for new outlets for investment. "The U.S. has long been the beneficiary of a virtuous circle of foreign investment in which a strong dollar and strong financial markets led to further investment in the U.S., which led to a stronger dollar and stronger financial markets," says an analysis by Bridgewater Associates, a U.S. fund manager. "It is our view that the virtuous circle will now likely flip to a vicious cycle as poor performance of U.S. assets leads to a drying-up of foreign demand." That could be bad news for U.S. markets because foreigners own 13% of the U.S. equity market, 24% of U.S. corporate bonds and 40% of U.S. treasury bonds, according to Bridgewater.

In a survey published in May by Merrill Lynch, 63% of global fund managers indicated that U.S. stocks are seen as the most overvalued in the world. The survey showed that only 22% of fund managers believe that the outlook for corporate profits is strongest in the U.S., down from 45% in March.

At the heart of the debate on the dollar is the continuing controversy over America's enormous current account deficit — $417.4 billion last year — which comes from Americans buying more goods and services overseas than they sell. Just to finance the current account deficit, foreigners will have to buy $1.1 billion a day in U.S. assets. But because there is less demand for American stocks and bonds, the value of the dollar is weighed down. And the appetite for U.S. assets has clearly slowed. In 2000, according to the U.S. Department of Commerce, foreigners invested $281 billion in the U.S. In 2001, however, the level of investment sank to $149 billion. While the strong dollar has allowed the U.S. to max out its national credit card with purchases overseas, the currency imbalance is starting to cause pain in the U.S. "There are signs that the U.S. economy is struggling hard because of the strong dollar," says Harmen Lehment, a currency analyst at the Kiel Institute of World Economics. "The strong dollar is not in the interest of U.S. policy." That in part explains why the U.S. government has slapped tariffs on imported steel and offered a package of new subsidies to American farmers. In Europe, a strong euro has the potential for both good and ill. On the one hand, exports might suffer; on the other, a strong euro will make it easier for the European Central Bank to meet its goal of 2% inflation across the 12 countries in the euro zone by bringing down the prices of imports. That might allow the E.C.B. to cut interest rates, now 1.5% higher for short-term securities than in the U.S.

The euro last week broke through the psychologically important barrier of 94¢, its highest level since March 2001. But that's still way off the $1.17 the currency fetched when it was launched in January, 1999. Hans-Werner Sinn, chief of the German IFO economic think tank, said last week that he foresaw the euro reaching parity with the dollar by year's end. "The euro will continue to climb and without difficulties can reach a dollar," Sinn told Reuters news agency. Stephen S. Roach, an economist for Morgan Stanley, said it's not whether the dollar will fall but by how much. "Our currency team believes the dollar is almost 15% overvalued — a classic setup for a fall," Roach said.

Up to now, everyone assumes the path will lead to a soft landing for the dollar, but that's not necessarily true. "The alternative, a hard landing, still keeps me awake at night," says Morgan Stanley's Roach. While there's no need to panic now, that's a fear that should be shared throughout Europe. Until the euro rises on its own strengths instead of on the dollar's weakness, the currency will fail to live up to the high hopes that accompanied its launch three years ago.