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Our currency, your problem!

January 12, 2005 16:33 IST

The panic selling that was seen across global equity markets (including India) during the previous week was a fallout of the Federal Reserve's view that US interest rates are in for a faster rise going forward.

This is because the pressure from inflation in the US is on a rise owing much to the recent depreciation of the dollar against major global currencies.

But, is the rise in US interest rates a long-term concern for Indian investors who fear a reversion of the 'hot' FII money? Maybe not! Why? Here is an explanation.

The causes for pain!

The developing regions of East and South Asia (excluding India) have been so 'engrossed' in being the manufacturing hub for the developed world (read again, the US) with all their low cost offerings, that they have almost failed to give heed to a more fundamental factor of growth - the internal demand.

As a result, countries like South Korea are currently facing the threat of deflation, as the demand for industrial goods has failed to pick up in the economy. On the other hand, the highly indebted and saving short US consumer is facing the double threat of rising inflation and consequent rise in borrowing costs.

The US has piled up a huge current account deficit (to the tune of around 6 per cent of their GDP, or a size of around India's GDP!). Now, despite such a strong consuming demand for credit, interest rates in the US have been lying low and the real interest rates (adjusted for inflation) have remained negative.

There are two key reasons for the continued strong consumption demand from US consumers. One, they are buying at negative interest rates and investing in emerging market equities that provide them with higher return than the much safer US treasury bills and bonds.

Two, to counter risks of currency appreciation due to high dollar inflows, the forex reserves that these emerging nations have built up are re-invested in US debt thus adding to the liquidity in the US money markets, which consequently results in interest rates remaining low. This has turned out to be vicious circle and has caused the current imbalance in global money and currency markets.

So, what is the remedy?

One major way to correct (or reduce) the impact of this imbalance is the gradual depreciation of the US dollar that would make US exports competitive, thus helping in reducing its current account deficit. However, there is a negative side to this as well. The depreciation of the US dollar will lead to heightened inflationary pressure in the country, a hint of which was given by the Fed in the recently announced minutes of its meeting held in December 2004. Here, the Fed has indicated that interest rates might increase faster in the future. And this led to panic selling in emerging market equities (as seen on the last Wednesday).

Another remedy for correcting this imbalance in global savings rate, i.e., extremely low US savings rate and high in emerging nations and partly in Europe, is to increase internal demand and reduce dependence on the US consumers to carry on the global growth engine. While India has a relatively lesser dependence on the export-led growth (around 12 per cent of GDP), it is not to say that the internal demand in India is yet to pick up pace.

If the global imbalances, as mentioned above, are not corrected shortly, the world (non-US) might have to deal with volatile currency markets and consequently other financial markets like equities and debt. Remember an old American saying, which goes like, "The dollar is our currency, but your problem!" The earlier non-US policymakers manage the same, the better it will be for the investors. While there will be teething troubles initially, things will be better in the long-term. Amen!

Equitymaster.com is one of India's premier finance portals. The web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.