The Hindu Business Line : Default by stealth: The declining greenback

ECONOMIC history is full of stories of rulers bringing down the value of their debt by debasing their currencies. They repay their creditors in currency of lower intrinsic value than they borrowed in.

A more opportunistic version of erosion of liabilities is through inflation, which diminishes the value of the currency. The creditors of many European economies after the First World War faced this fate.

The more recent technique — not deliberate, but nonetheless a result of economic mismanagement — is devaluation. Great Britain had accumulated sterling balances of its erstwhile colonies during the Second World War. Immediately after the War, it had to devalue the pound sterling. The holders of sterling balances, including India, saw their accumulated wealth in the form of deposits with Britain, diminish sharply in value.

The decline of the US dollar — which has been in the offing for quite a while and is now gathering speed — will deal a similar death-blow to the holders of debt paper (and equities) denominated in US dollars.

Some of the consequences of the decline of the US dollar are the rapid rise in the price of gold, with consequent adverse impact on the economies of many countries addicted to the yellow metal.

Even the rise of crude prices is partly to compensate for the fall in the greenback. Be this as it may, the coming fall is expected to be sharp in the eyes of many observers.

In a recent paper written along with another eminent economist, Mr Maurice Obstfeld, Prof Kenneth Rogoff, currently at Harvard, discusses the fate of the US dollar in the near term. They predict that the dollar will fall by another 20 per cent in real trade-weighted terms even if America's current account deficit unwinds gradually.

If it adjusts abruptly, the fall may be even sharper. In a recent article, the Economist of London cites Mr Kenneth Rogoff as saying "The world is set to jump off the top of a waterfall without knowing how deep the water is below."

In their NBER (National Bureau of Economic Research) study, "Unsustainable US current account position revisited," the authors return to some of the issues discussed by them in their earlier paper on the same subject in 2000.

They argue that with the current account deficit estimated at 5.4 per cent of GDP, compared to nearly half earlier, the potential collapse of the dollar may be larger than previously estimated.

The current account deficit of the US (meaning the excess of imports over exports) is now significantly larger than the critical levels, which sparks a crisis of confidence in respect of other countries. Just because the US is able to issue debt in its own currency, it has an advantage, which other similarly-placed economies in distress do not have.

Will other nations continue to finance these deficits with purchases of US bonds and equity?

There may come a time when the central banks of Asia, which are sustaining the US current account deficit, may divert their resources for other purposes.

Fortunately for the US, the confidence level in the world's greatest debtor (the US) is still high. Asia still sends its surplus resources to finance the consumption of the American public and the US Government.

After a sophisticated and detailed technical general equilibrium analysis of the global economy, the authors come to the conclusion that the situation requires a much larger change in the exchange rate than they had earlier estimated.

At a minimum, the authors estimate the US dollar has to depreciate another 20 per cent as the US current account rebalances. Too rapid a reversal may cause a decline by 40 per cent.

There may also be a fallout on US borrowing rates. The forecast of the authors is that a significant closing of the US current account will mean a large exchange rate adjustment, which will be sharper the longer the process is delayed.

This gloomy forecast contrasts with the Pollyanna-like assumptions of the US Treasury Secretary, Mr John Snow, who is still talking of a strong dollar. He is not alone in this. The US Federal Budget is predicated on continuing support by the Asian economies to its bonds, which presupposes a strong currency. All in all, a situation reminding us of the sterling balance crisis.

There have been other recent episodes when the US dollar had faced similar prospects, once in the seventies when USA broke off its dollar-link with gold, and then again in the eighties, when it resorted to nudging other economies to revalue their currencies against the US dollar.

Many observers recall the 1980s' experience now. The 1980s saw the Plaza accord, when representatives of the major economies gathered together at Hotel Plaza in New York and worked out a consensus, which demanded that other currencies "revalue" themselves upwards against the US dollar.

In a perceptive analysis of the situation, Mr Peter Bernstein points out in the Financial Times of November 7, 2004, that the situation is different now. For one thing, Ministers and Governors of Central Banks, who had gathered at Hotel Plaza, were old pals used to finding solutions to common problems.

The Western powers and Japan dominated the world and everybody genuflected before them. The differences today are significant. First, the scale of the problem is daunting. Second, the rest of the world is not in such a curve as the US and its cities.

Third, in many parts of the world, economies are dependent on exports, which need weaker, not stronger, currencies. Unless the focus of growth in these economies shifts to domestic instead of export growth, a new Plaza accord cannot come about.

It is significant that in spite of all this talk of a decline of the dollar, the US' net investment position vis-à-vis the rest of the world gains precisely because of the denomination of its liabilities in terms of the dollar. As the dollar depreciates, the real value of its liabilities is diminished.

By the same token, the real value of its assets, mostly denominated in other currencies, increases. Also, while the rate of return on US dollar-denominated assets is decreasing, that on the rest of the world denominated assets is increasing. This is to the US' advantage.

The authors point out that the current flow of red ink on the US budget is also "skewing" the picture. The investment by Asia's central banks in US assets is almost equal to the size of the US budget deficit.

With increasing security concerns and higher costs of the global commitments, this is also bound to rise. The rest of the world has so far financed well over 35 per cent of the US' gilt-edged securities. This is a disturbing feature of the US' public finances.

Any similar behaviour by lesser nations, like the developing countries, would have brought down the wrath of the Bretton Woods twins on them, not to speak of downgrading of the credit ratings of these nations by US-based rating agencies, which would have meant choking off further flow of funds. There is obviously one law for the entrenched rich and another law for even deserving poorer nations.

In whatever manner the US current account unravels, it is clear that the world is facing a serious potential currency crisis. If the dollar falls by 40 per cent or more, as the Rogoff-Obstfeld review indicates, this could amount to the biggest default in history, except that this would be a default by stealth.

Given such a prospect, one can only hope that the RBI, with its customary prudence, has ensured that its forex assets are not over-weighted in US dollar-denominated assets. Otherwise, we will be "singed" by the widely anticipated devaluation of the greenback. Let it not be said that we have not been warned. The least the RBI can do is mitigate the risk of the expected collapse of the dollar.

While the RBI has been quite transparent about India's external account and disclosed the broad disposition of its reserves in terms of types of securities, it has found it difficult to disclose the currency composition.

Apparently, it believes that disclosure of its investments in such detail will affect the markets. But, as the largest investor in this country, the RBI has a duty to disclose the broad details of the distribution by currency without identifying the institution in which the resources are invested.

Transparency of this limited order is required if we are to ensure that we are not overtaken by events such as those predicted by competent observers like Obstfeld and Rogoff.

Granted, the RBI would surely be resorting to hedging techniques, but to what extent and in what manner such hedges are deployed is a confidential matter.

There is need to assure the public that the deployment of forex reserves by the RBI keeps this risk well in mind.

A review by competent external experts with experience in forex management would help to elicit possible risks and reduce the impact of further collapse of the dollar.

More Stories on : Forex | Insight | Economy

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Engagement by economics

Labouring for nine, you brother mine

`You name it, we will make it'

Victims of insularity

Default by stealth: The declining greenback

A big deal in US retail

Law's course

LIC clarifies