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Dollar's strength may not last

October 21, 2008 14:01 IST

The dollar's unexpected strength in the current financial turmoil may not be sustainable.

The world, India included, has entered a period of substantially lower growth, which is likely to be prolonged because the balance sheet implications of the end of an unprecedented financial high wire act will take time to play out.

Concomitantly, the medium-term growth profile increasingly looks L-shaped, and not U, V or W. Recent data releases for the US and eurozone confirm that these crucial economic blocs are faltering sharply (almost a "sudden stop" threshold response from the real economy to the banking crisis).

It is impossible to know with confidence how long the global financial sector unclogging will take, but no country will be spared the collateral damage.

Capital flows (in net terms) to India are estimated at about a third of last year's level, and domestic raising of (equity) risk capital has almost dried up entirely, thus investment spending will be adversely affected.

The softness in the domestic investment cycle that could be discerned at the end of 2007 has gained traction this year, and the international environment does not bode well for this particular dimension going into next year.

An unusual aspect in the current milieu is the behaviour of the dollar. It has appreciated in value by 17 per cent since mid-July of this year against the euro (about the only currency that can challenge the dollar's 63 per cent share in official reserves).

If we take the erstwhile German Mark's share in international reserves as a proxy for the euro for the pre-1999 period, then the share of the euro in official reserves has increased substantially from about 14 per cent in 1998 to 27 per cent in 2007.

Prima facie, it would seem that recently, confidence in the dollar has soared even as the severity of the financial crisis has intensified.

The dollar is defying textbook gravity; if any other country had got itself into this situation, its currency would have been hammered into oblivion, let alone appreciated.

Several factors can be put forward to rationalise this. Firstly, the US current account deficit is expected to decline even faster as the US recession gathers pace and is now expected to be prolonged.

Secondly, as the effects of the crisis move out from the epicentre and towards Europe, there is the prospect that European policymakers may act in a manner which would make the US interventions look better/more effective; this is possible since, in the eurozone, financial sector supervision and regulation are almost completely national responsibilities although financial markets are integrated.

Within about a week, several European banks with cross-border operations were bailed out, Germany announced protection of current and savings accounts, and Ireland went furthest by guaranteeing all the liabilities of its six largest banks.

Earlier, access to the European Central Bank's liquidity facility (with mortgages as collateral) came without associated regulatory constraints that should be placed on counterparties that benefit from these windows (the US Fed, to its credit, has done this).

All these uncoordinated strategies can (but not necessarily) be a recipe for an unpalatable broth. In other words, if the exchange rate is a gauge of relative competence in financial crisis management then the US may score over Europe.

Thirdly, the uber confidence -- dubbed 'exorbitant privilege' by politicians and academics -- that has sustained the dollar for decades has not been undermined despite the US financial sector implosion; essentially this allows US claims on foreigners to earn a higher rate of return than foreign claims on the US and makes it easier to finance persistent imbalances (it must be cautioned that there are dely varying estimates of this differential). 

There is another perspective contrary to the above. If one takes a longer snapshot, the dollar since 2002 has declined by about 35 per cent against the euro, 25 per cent against the yen, and 16 per cent against the renminbi. In light of developments this year, arguments in favour of a strengthening dollar are difficult to sustain.

The global supply of the greenback has been upped considerably. The current and potential expansion of dollar-denominated liquidity by the US Fed comprising of the enhanced Term Auction Facility, forward TAF auctions and cross-border swap authorisation facilities, is about one-and-a-half trillion dollars.

Also, the US fiscal deficit in 2009 is now expected, by some estimates, to touch as much as 6 per cent of GDP, virtually close to double the number the US Congressional Budget Office forecast sometime back.

The primary drivers are obvious enough, including lower tax revenues from virtually all segments of the economy due to the slowdown, and costs associated with the following steps: the $700 billion Troubled Asset Reconstruction Programme; underwriting the two mortgage government-sponsored enterprises (Fannie Mae and Freddie Mac); and the bailouts of Bear Stearns and AIG.

According to Willem Buiter, the US (and, for that matter, also the UK) appears to have paid an effective negative nominal rate of return on its net external liabilities (the US earns a positive net foreign investment income despite a negative net international investment position).

In other words, there is a 'premium' based on real, or, perceived competency -- for which the rest of the world has thus far been willing to accept a haircut in terms of returns -- of the Wall Street (and the City of London) as bankers to the world.

The US financial system is presently deemed unworthy to support that country's own recovery, let alone that of the rest of the world.

The competency premia enjoyed by these banking centres for all these decades may well have come to an end. 

The loose monetary and fiscal stance forced upon the US does not seem to entirely square up with recent exchange rate developments.

Almost half of the outstanding US Treasury Bills are held abroad; it would not be out of place to predict that an even larger foreign appetite for US government-issued assets may require higher yields in the future.

Urjit R Patel
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