Nervous investors fuelling euro's rally

THE war may be officially over but the latest data from the US shows its impact is still being felt.

Last week, the Institute of Supply Management said American manufacturing continued to contract in April, despite the fact Baghdad had fallen by the time the survey was conducted.

American consumers are expressing more confidence now that the war is over, but businesses remain hesitant to start spending again.

And when it comes to the US, nervous investors are accentuating the negative at present.

Last week a rumour swept the market that Saddam was still alive and set to address the Iraqi nation; the dollar promptly lost 2% against the euro.

Then the survey detailed above confirmed that manufacturing activity in the US was still in decline and pushed the dollar to a four-year low against the euro, at €1.1270.

But the market isn't just nervous; the recent weakness of the dollar is symptomatic of more serious macroeconomic issues in the US. The 'fog of war' hid these concerns, but now they're taking centre stage.

Let's look at the causes of dollar weakness. For a start, there's the budget deficit. The US will be roughly $400 billion in the red this year and it will struggle to pay for roads, schools, and the war. The market knows the only way the US can offset this deficit is through bond issuance and tax increases, but President George W Bush is taking the opposite line, and cutting taxes. The chairman of the Federal Reserve has criticised this short-term stimulus measure.

Then there's the trade deficit. Because the dollar was so strong for so long, the US imported everything. As a result, American industry suffered to the extent that tariffs were necessary to save some sectors most notably the steel industry. Quite simply, it was cheaper for a US consumer to purchase an imported product than it was for them to buy an American- produced alternative.

Yet in a paradoxical sense, by causing the dollar to weaken so sharply, the war may have rescued the US economy.

In the six months leading up to war, the dollar depreciated by 14%.

War-related anxiety started the dollar's fall; and concerns over the twin deficits have taken over. Now the average US consumer will chose to buy an American product rather than an import, because it will be cheaper. So if US consumers, who are expressing increased levels of confidence, do start to spend again, the chances are that they will buy American.

That's why we're cautiously optimistic on the prospects for the year ahead.

Increased consumer confidence will lead to renewed business confidence, and that should result in modest, below trend US growth of roughly 2%.

That's good news for us all, because we in Europe need a US-led recovery; our own initiatives to fuel growth simply aren't enough. However, if you are involved in trade with the US, take note: this recovery scenario will only play out if the dollar remains weak, and reduces the trade deficit. That's good news if you're importing from the US, but exporters are undoubtedly already feeling some discomfort.

If it's any consolation, the European Central Bank, cognisant of your difficulty, will be hesitant to let the euro strengthen much further.

Niall Dunne, Ulster Bank.