The dollar dilemma
NOV 21 -
While the global financial markets, led by the one in the US, have seen unprecedented uncertainty and volatility in recent months due to risks emanating from multiple global factors, the US dollar (USD) has performed remarkably well, particularly against emerging market currencies.
The USD has gained against the Indian rupee (INR) from INR 44.7 on Dec 31, 2010 to INR 50.66 on Nov 18, 2011. Currently, the INR is trading at its lowest level not seen during the last two and half years; and it looks like it will breach the level last seen during panic selling post-Lehman Brothers. As the Nepali rupee (NPR) is pegged to the INR, the USD has also appreciated substantially against our national currency—from a low of NPR 70.7 towards the end of July to NPR 81.54 on Nov 18.
One of the major reasons for the recent rise of the USD against currencies of emerging markets like India and Brazil is an increasing level of risk aversion among international investors. For a major part of the last 10 years or so, foreign institutional investors (FIIs) had been pouring money into high-growth emerging markets such as Brazil, Russia, India, China and South Africa (the so-called BRICS countries). The unprecedented level of capital inflows, so called “hot money” inflow, into these countries led to the appreciation of their domestic currencies against the USD.
This trend was first broken during the “flight to safety” period after the collapse of Lehman Brothers and subsequent global financial crisis towards the end of 2008. As things stabilised towards the end of 2009 and 2010 and the level of risk aversion subsided, again, capital started moving around seeking higher returns.
However, structural problems in Europe and risks of double-dip recession in the US have once again ignited fear and uncertainty among investors. As such, we are now witnessing a second phase of “flight to safety” within the last few years. A glance at the trend of 10-year sovereign bond yields of major economies will give an idea of which are “safer” countries and which are not. In spite of a rating downgrade by Standard & Poor’s, the US still belongs to the “safe” category. That has largely to do with lack of alternatives. Such is the scale of the problem.
Given that picture, it’s no surprise that mutual funds, pension funds and other institutional investors are liquidating their position in emerging markets and selling their foreign assets for the safer USD. In India, the recent wave of selling on the Bombay Stock Exchange has been predominantly led by FIIs. With the continuing volatility in the global market and the existing uncertainty about the global financial system, it is plausible that major FIIs will stay away from emerging markets like India for a while.
The larger question amid all these recent fluctuations in the dollar value and the ongoing global financial crisis is the long-term future of the USD. Though the greenback has risen substantially in recent months, to understand the contours of the USD in the future, one must analyse the fundamentals that influence currency values in the long run. Following are a few facts and observations that might help one understand the course of the USD in the coming days.
The US economy is still struggling to come out of the great recession of 2007-08 with a high unemployment level, a high public debt level and low consumer confidence, and economic growth coming out from the recession has been anaemic at best. In fact, there is a danger that the US economy might again head into recession. Henceforth, there are two dangers to the USD from this front.
First. with a dwindling economic growth rate, the USD will see its value decline because the long run value of a country’s currency is tied to its economic growth. Despite the current turmoil in the market, overall prospects for countries like India, China and Brazil are still bright; and they will continue to grow at a much healthier rate than the US economy in the coming years. Hence, their currencies should, in theory, appreciate against the USD.
Second, danger comes from the ongoing shift in the image of the US economy and its financial system. When the US economy went into recession in 2000-01, the USD held its ground against other currencies because foreign investors continued to buy US assets. At that time, the US was still regarded as, according to international finance expert Catherine Mann, “an oasis of prosperity” because of its high productivity and ability to innovate.
However, because of recent structural problems (read high level of debt and subsequent sovereign rating downgrade), the image of the US and its financial system has been tainted. Although, as mentioned before, because of lack of other alternatives (read problems with Euro Zone and long-run viability of the euro), investors are still buying US assets, going forward, this is expected to take its toll on the USD.
Furthermore, the recent surge of the greenback doesn’t bode well with the argument that the dollar needs further weakening to manage the high level of the current account deficit in the US. In 2007, before the onset of the financial crisis, weak dollar advocates and respected economists like Martin Feldstein and Kenneth Rogoff argued that the USD needs to decline by 8 to 25 percent against other currencies to manage the spiralling current account deficit in the US.
The depreciation of the dollar in the first half of 2007 was seen as a right direction—one that could help bring down the US current account deficit to more manageable levels. However, the recent rise of the USD could further strain the US current account deficit, which stood at approximately US$ 470 billion for the year 2010. With a weakened economy and decreasing consumer confidence, US imports are expected to taper off in the coming months. However, the stronger dollar coupled with a weaker global economy will hurt US exporters more and is expected to further widen the US current account deficit.
Overall, despite the recent gains, the future of the USD depends on the health of the US economy and its ability to attract foreign investors. Both aspects seem vulnerable right now. This rising US national debt level further undermines the future of the USD because serious doubts about the long-run sustainability of the debt level could spur selling off of dollar reserves in China, Russia and India, which hold over trillions of dollars as official reserves.
Source: Kantipur
