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Business
FINANCIAL SCENE
The dollar retains impact despite weakness
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Even over the medium term observers foresee no threat to its pre-eminence in global finance
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The U.S. dollar has depreciated in trade-weighted terms by as much as 11.5 per cent over the past six months against the yen, the euro, the Canadian dollar as well as the Australian and New Zealand dollars. Though not for the first time, the dollar’s weakness has raised concerns.
For a global economy slowly emerging from a deep seated crisis, the sharp decline of the dollar in relation to other major currencies is not good news at all. If the dollar falls further precipitously it may choke off the nascent recovery.
Chances of such a large fall that would probably invite coordinated global intervention are not ruled out. If the normal laws of economics work, one would expect the currencies of countries with current account surplus — China ’s yuan, the Japanese yen — to appreciate in dollar terms. But China, despite intense pressure from the U.S. and certain other countries, including recently at the International Monetary Fund-World Bank meet at Istanbul, has not revalued the yuan.
Moreover, the structural defects of the U.S. economy remain in tact. The U.S. has a very high level of external debt and runs a huge fiscal deficit — roughly estimated at 13.5 per cent of its GDP — which it is making little attempt to control.
Meanwhile, the U.S. is creating vast amounts of money but still enjoys low rates of interest. The primary reason for this situation of course is that the American dollar has remained the world’s reserve currency staving off successive attempts to displace it. In one area however the U.S. had made impressive strides in correcting an imbalance. Its current account deficit has come down sharply to three per cent of its GDP, less than half of what it was before the financial crisis. For the time being, the cheaper dollar helps American exports. It will help correct global imbalances and lower the threat of deflation in the U.S.
In fact, according to Paul Krugman, noted economist and columnist, the weakening dollar is a sign of strength, not weakness for the U.S. economy. During the mid-point of the financial crisis investors sought the safety of dollars causing its appreciation. Not that the fear has waned investors are diversifying their investments. That involves a partial shift away from the dollar.
For overseas investors, especially Asian central banks, the U.S. currency and the dollar denominated securities have for long held a special attraction. That might wane from time to time — the present situation is one of those periods when ‘alternatives’ to the dollar are being considered — but even over the medium-term observes foresee no threat to the dollar’s pre-eminence in global finance. Two recent developments support that view.
There has been plenty of interest in what China will do with its very substantial dollar denominated reserves. The Chinese authorities have expressed concern over the depreciating dollar and its impact on their foreign currency assets. There has been a concerted call to elevate the yuan to reserve currency status. (According to many observers that is premature.)
Some of its new investments have been in energy sectors and even in commercial real estate around the world. These funds might have gone into American government securities taking the route of earlier investments. However, China has not reduced its existing dollar investments.
The absence of an alternative also explains why the OPEC and other big oil producers persist with the dollar in the invoicing of petroleum. There have been unsuccessful attempts to shift to other currencies.
Search for alternatives
Recently there has been a move to substitute the dollar with a basket of currencies in petroleum trade. It is not clear how this will work. The fact that the oil countries have had to prune their sizable dollar assets has more to do with the collapse of the oil prices and the consequent low revenue generation by the exporters. (Global oil prices have since perked up but are still ruling less than half their peak of $147 a barrel in July-August last year.)
Other threats loom from Japan, for instance. The world’s second largest economy might countenance an appreciation of the yen up to a certain point.
The Japanese current account surplus might come down and there would be fewer investments in dollar securities.
Stronger rupee
The dollar’s weakness is reflected in the rupee’s strength. The rupee is trading just above 46 to the dollar. The rupee appreciation is naturally a matter of deep concern to exporters. Imports, of course, become cheaper but because international oil prices expressed in dollars are firming up the import bill will still be substantial.
The stronger rupee is also due to robust capital inflows into the stock markets. India, China and a few other developing countries are in the forefront of the recovery phase.
Foreign portfolio investors have started coming back to the Indian markets in a big way. That of course is no unmixed blessing. A bubble may be building up in the stock market; very few retail investors are participating.
For the Reserve Bank of India, there are major policy dilemmas.
To prevent rupee appreciation it has to intervene and buy dollars. There will be a substantial augmentation of rupee liquidity which will fuel inflation.
The central bank will then have to raise interest rates and mop up liquidity. None of the policy choices are appealing at this juncture. Economic recovery is still at a nascent stage and monetary tightening may choke it.
C. R. L. NARASIMHAN
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