New Contender for the Throne?

By Tom Petruno

May 3, 1998 12 AM PT

The almighty dollar has been just that for most of this century. No other currency has been able to challenge the buck’s preeminent status in the world economy.

The dollar is, in economists’ vernacular, the “reserve currency” of the planet, the one medium that virtually any party engaged in commerce--nations, banks, businesses, gunrunners, drug dealers, etc.--finds acceptable for transactions and for storing wealth.

Now comes the euro, the planned common currency of a united Europe. You don’t have to read very far into any story about the euro to understand how momentous an event this will be for Europeans, of course. But it also has the potential to cause a major shift in the status of the dollar, and, by proxy, the status of U.S. interest rates and stock prices.

The euro, says Bill Gross, who manages more than $100 billion in bonds for Pacific Investment Management Co. in Newport Beach, will be “trying to compete head-on with the dollar and with the [Japanese] yen for the title of reserve currency.”

As the saying goes, “It’s good to be king”--and that’s as true for currencies as for people.

Think about what the United States has gotten away with as the issuer of the world’s reserve currency. While Asian countries that ran up large trade deficits and heavy government and corporate debts have seen investors flee over the last 12 months--devaluing the countries’ currencies by 50% or more and destroying many years of economic progress--the United States has, over the last decade, become the world’s largest net debtor nation with seemingly little penalty.

True, the dollar has dropped sharply in value versus some key currencies, such as the yen and the German mark, since 1985. But foreign investors still have been eager buyers of dollar-denominated assets--stocks, real estate, industrial plants and, perhaps most important, U.S. Treasury securities.

As Americans, we may debate the wisdom of “selling out” to foreigners (remember the controversy over Japan’s real estate purchases in the late 1980s?), but all in all it has been better to have our currency, and assets, in demand by others than not in demand.

On the other end of the spectrum, economically struggling Japan, which in many ways has kept itself closed to foreigners and foreign capital even as its economy has mushroomed in size since World War II, debates today whether that has been such a wise policy.

To be sure, the dollar has enjoyed its reserve-currency status partly by default. America is the single largest national economy, and since the Soviet Union fell it has been the only true superpower.

The country’s relative political stability also makes it a place where foreigners feel comfortable investing for the long haul--as opposed to, say, Indonesia.

But the U.S. also has been able to maintain the dollar’s allure--and entice foreigners to finance our massive federal budget deficits over the last three decades--thanks to the reinvention and reinvigoration of our economy, lifting it to its current status as the world’s most competitive, by many measures.

Could the euro launch a meaningful challenge to that status? Many American economists and money managers think it could--not overnight, but over time.

A united Europe, with its investments, debt securities and goods prices suddenly denominated in a single currency, immediately becomes an easier place to channel significant sums of money.

For global investors (including Americans) who, for whatever reason, may no longer wish to hold as many dollar-denominated securities, the euro means “they now have a place to go,” said Robert Brusca, economist at Nikko Securities International in New York.

The Boston-based Loomis Sayles mutual fund group, for example, is expecting the now-modest European corporate bond market to boom with the euro. “We think many European companies that haven’t issued bonds before will be doing so” as monetary union greases the process, said John DeBeer, a portfolio manager at Loomis.

Foreign central banks, meanwhile, are estimated to hold more than 60% of their official reserves in dollars today, mostly in U.S. Treasury securities. “We certainly could see that figure decline over time,” with the advent of the euro and a unified European credit market, said William Dudley, financial markets economist at Goldman, Sachs & Co. in New York.

Foreigners overall own about 37% of marketable Treasury securities, a sizable chunk that reflects American deficit spending for so many years.

That capital has, in effect, subsidized our way of life. If it were to disappear, we would have to supply it ourselves--boosting our savings rate--or we’d face the prospect of a lower standard of living. Or both.

Yes, the federal budget is in balance now. But the U.S. trade deficit remains enormous. In sum, the United States remains “very, very much a credit-dependent economy,” said Rick Schwartz, a portfolio manager who helps oversee $23 billion at New York Life Asset Management.

If foreigners were to decide, even gradually, to shift capital away from the United States and into Europe, probably the most disturbing result would be upward pressure on our interest rates, as our market would seek to compete more aggressively for funds.

And higher interest rates, of course, would almost certainly be troublesome for the high-flying U.S. stock market--not to mention any potential home buyer.

All of this, however, rides on a huge assumption: that monetary union will work in Europe. The opposite could very well happen--that union, and the euro, fail.

The questions that remain to be answered include whether Europe’s diverse countries can survive under a single central bank with a single monetary policy that may simultaneously be too restrictive for some countries and too loose for others, depending on their individual economic cycles. (It is, after all, a big continent.)

If investors don’t believe that the new European Central Bank can keep inflation down--and the economy growing--capital may flee Europe rather than seek it out.

Because of the uncertainty, “it’s very unlikely that we’ll see a wholesale move into the euro” in 1999, said Morris Goldstein, analyst at the Institute for International Economics in Washington.

Moreover, U.S. Treasury bond yields are already above the yields paid on most European countries’ bonds, which partly reflects the U.S. economy’s robustness. “We are the high-yield market--and the high-quality market,” said Bruce Steinberg, economist at Merrill Lynch & Co. in New York.

That premium could keep foreign capital satisfied enough to remain in America, near-term.

Still, longer-term it’s clear that if the euro takes hold, and Europe thrives under monetary and economic union, the United States will face much more pressure to maintain its appeal to global investors.

That means inflation will have to be kept under control, the federal budget will have to remain in balance (or at least nearly so), and American firms will have to do whatever it takes to keep their edge.

In short, the euro means the great challenges of global capitalism are about to become even more intense.

Tom Petruno can be reached by e-mail at tom.petruno@latimes.com

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Will Holders of U.S. Debt Be Tempted by Euro Securities?

Foreigners Own a Lot of Treasuries. . .

The 12 largest foreign holders of Treasury debt as of Jan. 31 and the amount owed, in billions:

Britain: $300.1

Japan: 293.3

Germany: 90.0

Netherlands Antilles: 55.7

Spain: 52.5

China: 50.0