FINANCIAL SCENE
Dollar under pressure
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A revalued yuan will help in correcting the serious trade imbalance with China
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The dollar's prolonged weakness against key currencies may be a precursor to major changes in global financial systems.
— PHOTO: AP
GLOBAL IMBALANCES: U.S. Commerce Secretary, Carlos Gutierrez (centre), witnesses the signing of business deals in Beijing by Twentieth Century Fox and Chinese partner Zoke recently on the sale of reasonably priced licensed DVDs to undercut pirated products in China. Gutierrez's trip assumes significance amid growing U.S. concern over record trade imbalances with China.
FAR REACHING changes in the global financial system are expected in the wake of persistent weakness of the American dollar in relation to other major currencies. In normal times, currency movements are seen to be what they are, essentially short-term fluctuations, of interest to currency traders and those directly involved with exchange rates such as importers and exporters.
For policy makers and central banks such as the Reserve Bank of India, the horizon is different. They seldom express a view on day-to-day currency movements. Exchange rate policies in India and elsewhere seek to ensure orderly conditions in the forex markets and check excess volatility. What are of greater interest to central banks are the long-term trends in currency movements and more specifically their implications for exchange rate management and the external sector.
Depreciation phase
However, these are hardly normal times for the world's major currencies. The dollar's recent sharp fall in relation to the euro, the sterling and to some extent the yen seems to be in continuation of its depreciation phase that began some five years ago. Though by no means in a one-way movement, the dollar has depreciated against the euro by 30 per cent since 2001. There is an expectation that it may fall below its all time low of $1.29 to the euro.
The dollar depreciation by itself need not be a matter of concern as much as the underlying factors that affect the global economy. These, referred to as global imbalances, have significant repercussions, not only on the U.S. economy but also on practically all other countries.
On a trade weighted basis the dollar's fall has been much less. That is because many Asian central banks, the RBI included, have been intervening aggressively in the exchange markets to check a sharp appreciation of their currencies. A strong rupee will make India's exports uncompetitive.
India currently has a managed float where the RBI allows the market forces to determine the rupee's external value, but intervenes to keep the changes within a narrow but undisclosed band. Even now a cheaper home currency is on the wish list of every exporter.
The debates of yesteryear in India — when the rupee was pegged to the dollar — have a strong resonance, albeit for very different reasons, in the context of ongoing efforts by the U.S. authorities to persuade China to revalue the yuan. When India had a fixed exchange rate, the classic case for devaluation of the rupee rested on the premise that exports would get a boost. Today the issue is not one of encouraging but discouraging exports from China to the U.S. A revalued yuan will make Chinese exports to the U.S. more expensive and consequently help in correcting the serious trade imbalance, so heavily tilted in favour of China.
Massive U.S. deficits
Currency realignments by themselves may not set right the consequences of the serious structural imbalance in the U.S. economy. Its twin deficits — budgetary as well as on current account — reflect to a large extent the imbalances in the entire global economy. The U.S. current account deficit is estimated to touch $900 billion this year or 7 per cent of its GDP. As long as the deficit is funded by Asian countries, the U.S. is not in any great hurry to address the root cause of its huge deficit, namely, the savings-investment imbalance in its domestic economy. Mirroring the distortion have been the "excess" savings by Asian countries that could not be invested at home.
The reasons why Asian countries fund American deficits are not far to seek. To varying degrees the Chinese strategy of pegging its currency lower against the dollar as a means of export promotion has been replicated by many Asian countries. That has had major consequences for their economies. Heavy dollar inflows — in the context of more open capital account regimes — had to be mopped up by the central banks and consequently were added to their reserves. It is not surprising that most of the reserves of Asian banks are invested in dollar assets. China's reserves have exceeded $1 trillion by the end of October and most of these are dollar denominated. A weakening dollar naturally reduces the value of the reserves. Since these reserves are parked in relatively low yielding U.S. government paper, Asian countries collectively have kept the U.S. interest rates down.
The U.S. dollar has been the world's reserve currency since at least the end of the Second World War. It was only after the euro started growing in stature in recent years that investors had a choice. The American economy is by far the world's largest. U.S. institutions and markets are highly developed. Apart from its reserve status, the dollar is overwhelmingly favoured in international trade.
The guessing game
A prolonged weakness of the dollar coupled with signs of slowing down of the American economy has led to intense speculation as to whether global imbalances can at all be moderated in an "orderly'' fashion. There is keen interest to know what the leading countries will do with their interest rate policies, which are closely linked with exchange rates. Very recently, the U.S. Federal Reserve chose to keep its benchmark interest rates unchanged at 5.25 per cent. A lowering of rates might have been a stimulus to its economy but higher interest rates elsewhere might encourage large dollar outflows.
In India too, the dilemma over interest rates is becoming clearer by the day. The recent RBI decision to raise the cash reserve ratio for banks by 50 basis points was to drain liquidity. Reduced lendable resources with banks are likely to push up interest rates. There has been a surge in domestic rupee resources partly because of the RBI's action in mopping up dollars and releasing rupees.
Coordinated action by the U.S. and East Asian countries — a depreciation of the dollar matched by an appreciation of the yuan and other currencies — could be the first, though highly improbable, step to unwinding imbalances in a systematic way. The term "global imbalances'' may sound esoteric but even as they defy easy solution they have wide ranging implications for all countries.
The dollar's prolonged weakness against key currencies may be a precursor to major changes in global financial systems.
C. R. L. NARASIMHAN
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