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The future of the dollar

February 16, 2005

On February 4, Alan Greenspan made a major speech in which he signalled clearly that the Fed believes in a weakening dollar and higher US interest rates as the key to rebalancing the US economy.

It was a thoughtful speech that accepted the US responsibility for the macro rebalancing between the mega economies of the US, Europe, Japan, and China, but also challenges the others to respond.

On the same day, an ICRIER seminar contributed its rupee worth of wisdom.

The general consensus was that the dollar, sterling, euro, and yen would continue to hover around their current levels relative to each other, and that the main readjustment would have to be a substantial appreciation of the Chinese yuan.

As for the rupee, the expectation is that the RBI would counteract the upward pressure exerted by the huge inflows of portfolio capital.

US interest rates will go up perhaps by about 50-75 basis points on the current 2.5 per cent level. But these guesses are probably of lesser importance than what the head of the Fed thinks!

So much for the astrology. But what are the underlying planetary dynamics?

Since 1995, there has been a persistent disequilibrium in current accounts -- a large US deficit and equally large surpluses elsewhere, particularly in Asia.

Until the mid-nineties, market forces, assisted by some policy measures, ensured that even large current account imbalances were corrected in good time and with limited disruption. These traditional mechanisms do not seem to work.

One reason advanced by Greenspan is that the growth of the Internet and electronic transactions has made the holding of foreign assets look "less exotic and less risky" by reducing transaction costs and ensuring readily available information.

But a large part of the accumulation of foreign assets is by Asian central banks, and that surely is not the result of changing asset preferences but a deliberate policy stance of protecting domestic growth.

The current account imbalances have to be corrected. The US current account deficit is expected to respond to the weakening dollar and rising interest rates, helped by some renewed attention to lowering the fiscal deficit.

Greenspan argues that "the increased flexibility of the American economy will likely facilitate any adjustment without significant consequences to aggregate economic activity."

The main snag in this argument is the high volume of consumer and mortgage debt in the US. This is the reason for the collapse of household savings in the US, which are now just about 1 per cent of income.

Higher interest rates could burst a few asset bubbles and also reduce consumer spending much more than anticipated as the sense of wealth generated by property price appreciation evaporates.

What if the slowdown in consumer spending leads to US growth falling to, say, 1 per cent? What will be the implications of this for the Asian economies, which depend so heavily on the US market? Will they not be tempted to put off their exchange rate adjustment?

A weakening dollar also means a rising euro. But can Europe really sustain this appreciation? For the past couple of years, as the euro has appreciated, European exporters have coped by reducing their margins.

Thus, their dollar export prices increased by less than 10 per cent while the dollar depreciated by over 30 per cent in this period. They cannot keep reducing margins and a reduction in European exports to the US is unavoidable.

As it is, Europe faces high unemployment and low growth. An appreciating euro and higher interest rates will not help matters. Even the casual observation of visitors to Europe and the US suggests that the current exchange rate is out of line with purchasing power parity.

The adjustment that Greenspan seeks may actually worsen the underlying global imbalance.

The situation in Japan is not much better. They too face a stagnating economy and can hardly afford a further appreciation in the yen. Yes, they are accumulating reserves.

But past evidence does not suggest that a higher yen will reduce their surplus sufficiently to stop this. The belief that a rising exchange rate stimulates structural reforms has not been borne out.

That leaves China, the one country that is growing rapidly, accumulating reserves, and not appreciating against the dollar. An adjustment in the yuan exchange rate will have to be large, and this may not happen through the normal processes of gradual market- induced change.

A negotiated agreement may be required. But any such exchange rate agreement would have to cover much more than that. How easy will it be to secure such a broad-based macroeconomic accord? Will China cave in as easily as Japan did in the original 1985 Plaza Accord? Or, will the new accord do to China what the earlier one did to Japan, which is to choke off growth drastically?

In short, it may be difficult to secure a soft landing with exchange rates realigned and macro policies readjusted so that growth momentum is maintained in the US, reduced in China, and enhanced in Europe and Japan.

This pessimistic outlook led to two important questions being asked at the ICRIER seminar. First, do we face the risk of a speculator-led sudden assault on the dollar or the yuan that could precipitate a crisis? Second, what is the long-term future of the dollar as the preferred reserve and trading currency?

The risks of a speculative crisis are never zero in any market that depends so much on expectations. But the situation is not quite what it was when Soros mounted his famous 1992 raid on the pound.

The dollar is more widely held and the resources available to fight off a bear run are substantial. In any case, the real problem for the dollar is whether market factors and policy responses will allow it to depreciate as much as US authorities would want.

As for the yuan, speculators would dearly love to mount a bull run on it, but cannot, because it is far from being a freely traded, widely-held currency.

The long-term future of the dollar is a more open question. But please note that when the dollar declined sharply after the Plaza Accord, it was not displaced as a reserve currency by the yen or the mark.

Its status depends more on the confidence that savers have in the future of the US economy and the range of services they can get from US financial markets.

Where does that leave the rupee and the prospects for the Indian economy? Over the past few years, the rupee has appreciated against the yuan and some other Asian currencies.

An upward readjustment of these against the dollar would help to correct this if the RBI is able to neutralise the huge FII inflows. That will help Indian exporters, but involve some inflationary pressures.

But, if the fears of a hard landing voiced above are borne out, then the slowing down of growth in the US and elsewhere will hurt India. It may even put some downward pressure on the exchange rate if the investment inflows dry up.

So the upshot of all this is that anything could happen in exchange markets. So toss a coin, as Greenspan suggests, and hope that the US does not fix things so that heads they win and tails we lose!

The author is former chief economic advisor to the government of India, and former under secretary general, United Nations

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