12 January 2001, 17:59  FOCUS Bush administration will face early test on strong dollar policy

(repeating item transmitted early today)
---- by CHRIS ANSTEY ----
WASHINGTON (AFX) - Foreign exchange markets will get an early sample of likely dollar policy under the future administration of President-elect George W Bush next week, with the confirmation hearing of Treasury Secretary-designate Paul O'Neill, analysts said.
"How the next administration manages the currency policy will be an early, important test ... It will be important even from O'Neill's confirmation hearing," said Robert Hormats, vice chairman of Goldman Sachs International.
Hormats spoke at a conference on G3 currencies held at the Woodrow Wilson International Center.
O'Neill is scheduled to testify in his confirmation hearing at the Senate Finance Committee on Jan 18, starting at 9.30 am. O'Neill is expected to be questioned by senators on the incoming Bush administration's budget, tax cut, and pension reform proposals, along with its approach to the dollar.
"You'll have to watch very carefully (a) at what they say, and (b) at how the markets react," Hormats said.
The Bush administration takes office Jan 20; O'Neill must be confirmed by a Senate majority vote before he assumes his post. "The Bush administration will face an early question on (currency policy)," said Fred Bergsten, director of the Institute for International Economics.
The central question is whether the Bush administration will follow the strong-dollar policy established by former Treasury Secretary Robert Rubin, and continued by outgoing Secretary Lawrence Summers.
Although analysts do expect them to continue the policy, there will be questions in foreign exchange markets about O'Neill's background. As the retiring chairman of Alcoa Inc, some may ask whether he favors a weak dollar, which would help U.S. industrial companies against foreign competition.
"There are concerns that (incoming Bush administration chief of staff) Andrew Card and Paul O'Neill could lean to a weaker dollar, to help the trade deficit," said former Japanese financial official Eisuke Sakakibara, currently at Keio University.
As head of the American Automobile Manufacturers Association in the mid-1990s, Card was a proponent of a weaker dollar.
Analysts noted that when the Clinton Administration first came to office, then Treasury Secretary Lloyd Bentsen advocated a weaker dollar against the yen, which led to a significant decline in the currency. The fact that more than one administration official spoke about currency policy also generated confusion early on.
"The early Clinton administration was disastrous (in this regard)," Sakakibara said, and this will be repeated if the Bush administration takes the same initial approach in the face of a weakening economy and rising trade deficits.
Rubin, Bentsen's successor, established that only the Treasury Secretary would speak about the dollar, and instituted the widely-praised strong-dollar policy.
"Other administrations have made mistakes early on. Hopefully the (Bush) group will understand this," Hormats said, adding that "my own guess is they won't be any different from Rubin on dollar policy." Sakakibara added that who is chosen as the Treasury undersecretary of international affairs will be very important for exchange-rate policy.
"This is a key post," Sakakibara said. Bush has yet to designate candidates to fill senior positions at Cabinet departments. All must be confirmed by the Senate.
O'Neill's first opportunity to meet with his G7 counterparts, meanwhile, will be on Feb 17, when Italy hosts a G7 finance ministers' meeting.
The experts agreed it will be important for the Bush administration to continue the strong-dollar policy, given the dependence of the U.S. on foreign capital inflow to finance investment and spending.
"They should be very careful not to give the perception to the market that a strong dollar policy would be changed," Sakakibara said. Hormats said if senior Bush officials begin hinting they would accept a weaker dollar, this would be "very detrimental".
The experts predicted that the dollar will continue to fall against the euro this year, but adherence to the current policy, along with willingness to occasionally intervene in the market if the decline becomes precipitous, would help cushion a soft landing.
The U.S. economic slowdown, along with rising trade deficits, declining trans-Atlantic merger and acquisition activity, and a reversal in foreign equity investment will likely combine to weaken the dollar further in coming months, analysts said.
Hormats estimated that these trends will generate a 250 bln usd gap in dollar demand this year compared to 2000, including a reversal of last year's 100 bln usd net inflow of equity investment, which is expected to switch to a 30 bln usd outflow.
The rising attractiveness of Europe as an investment destination will also likely boost the euro's value, following structural fiscal, tax, and corporate governance reforms.
Hormats said the dollar could depreciate as much as 15 - 20 pct against the euro this year.
Norbert Walter, chief economist at Deutsche Bank, said "I can imagine a euro-dollar of 1.20 can be even overshot," although he forecast a range of 1.00 - 1.10 by the middle of the year.
Bergsten estimated that the "equilibrium rate" of the euro would be around 1.25 - 1.30 against the dollar, which would be a 35 - 40 pct depreciation from now.
The dollar's decline in itself does not pose a problem for the U.S. economy, but if the fall is sharp and quick, it could lead to a crisis in stock and bond markets, and leave the Federal Reserve unwilling to cut interest rates -- because of the inflationary implications of a declining currency, Bergsten said.
"The real issue is will the inevitable decline in the dollar be hard or soft," Bergsten said, adding that "there will possibly very early on be operational problems in (the Bush administration) trying to manage the exchange rate."
Analysts said it is more difficult to forecast the dollar's performance against the yen this year, because of Japan's uncertain outlook. Hormats said the yen will likely weaken in the first half, on the back of negative earnings surprises.
Sakakibara said continued economic stagnation, combined with lack of progress on crucial structural reforms, and political instability, will combine to push the yen down.
"I wouldn't be surprised if (dollar-yen) broke 1.20 next week," he said, adding that "if my pessimistic scenario is right, it could hit 1.40 (this year)."
Bergsten said this could also be an early test for the Bush administration.
"If one countenanced further yen depreciation, and at the same time put a ceiling on euro appreciation, I would expect a continued rapid increase in the current account deficit," Bergsten said.
At 5 pct of GDP, the U.S. current account deficit is unsustainable, Bergsten explained.
"The new administration's challenge is to try to manage a soft landing for the exchange rate," he concluded.

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