The Hindu Business Line : Why dollar is in the doldrums

While a major withdrawal from the US market has not taken place so far, there is a limit to the investment by foreign banks because of the ever-increasing risk of over-exposure to a fall in the dollar.

THE continuing decline of the dollar has been analysed in the Indian media largely in terms of its implications on exports and the prices of the stocks of companies engaged in the activity. The implications, however, are infinitely more complex and worrisome.

The truth of the matter is that the dollar is at the centre of a series of processes that are contributing to global financial imbalances. On the one hand, the growing US balance of payments (BoP) gap threatens to end in a collapse in the dollar's value. On the other, any action that may be undertaken to reduce the BoP gap will almost certainly trigger a global recession because the US is the chief international market for exports.

The crisis has not come out of the blue.

In early January, the International Monetary Fund (IMF) had warned that the growth of the US external debt and the rising budget deficit were threatening global financial stability. In a report, "US Fiscal Policies and Policies for Long-Run Stability," the IMF had said that massive US budget deficits represented "significant risks" for the US and the rest of the world and that the spiralling US external debt, estimated to touch the equivalent of 40 per cent of GDP in the next few years — an "unprecedented level" for a large industrial country — could well destabilise global financial markets. The ever-increasing US demand for finance from the rest of the world — its BoP deficits currently absorb about three quarters of the world's surpluses — together with a decline in the dollar value "could possibly lead to adverse consequences both domestically and abroad". This, the IMF had noted, could lead to a collapse in international investor confidence in the US, thereby pushing up interest rates and resulting in investment cutbacks and a rapid slowdown in the world economy.

Washington had been characteristically arrogant in its dismissal of the IMF's misgivings, saying the Fund had been proved wrong in criticising the Bush administration's tax cuts and that action was being taken to reduce the budget deficit. The US Treasury Secretary, Mr John Snow, had said that the administration would cut the deficit by half within five years and bring it down to about 2 per cent of GDP.

The IMF may not have joined issue with the US, but others did.

The Financial Times, in a scathing editorial, pointed out that "the administration's reaction to the IMF's criticism was to intone the mantra that it plans to halve the federal deficit in five years. Higher economic growth, it says, will raise tax receipts. But as a commitment to long-term fiscal responsibility, this is disingenuousness bordering on dishonesty".

The Morgan Stanley chief economist, Mr Stephen Roach, had taken to talking about the "perfect storm" of surging oil prices, a potential slowdown of the Chinese economy and the initiation of a Fed tightening cycle which threatened the sustainability of the world economic recovery. According to Mr Roach, while markets had started to move in expectation of tightening interest rates (around mid-2004), "the risk is that the Fed now has much greater distance to travel than most investors are willing to concede." The "normalisation" of Fed policy by lifting interest rates from their historic lows was a greater risk to economic growth in the US and the rest of the world than a decade ago, he had noted at that time. This was because the "carry trade" was more significant and monetary tightening would "exacerbate the downside of the home mortgage refinancing cycle" which had been a powerful source of the growth in consumer demand.

In short, he had warned that the coming together of three deflationary forces — rising oil prices, a slowing Chinese economy and increasing US interest rates — could make the recovery then in progress in the global economy one of the shortest on record.

And then again, in a study published before the US presidential polls, the well-known economists, Mr Maurice Obstfeld and Mr Kenneth Rogoff, had said that a "current account collapse", sparked by the withdrawal of funds from international investors, had to be "problem number one on the new president's international financial agenda." They had expressed their doubt that it would be because of the "proliferating versions of the revisionist theory that there is simply no problem."

According to this view, the US's international debt does not represent a problem at all for the simple reason that foreign investors, particularly official ones such as central banks, will continue to finance it, and even if the value of the dollar did fall dramatically the consequences would not be severe.

Messrs Obstfeld and Rogoff had written in the Financial Times: "We are very sceptical... When one looks closely at the US twin deficits (current account and fiscal) in the context of open-ended security costs, geopolitical tensions, rising old age pensions, higher energy costs and extraordinarily stimulative macroeconomic policies, we see stronger parallels to the early 1970s than to the late 1980s. The years following Richard Nixon's 1972 re-election were not pretty for the dollar or for the world economy. If current accounts are forced towards balance in the context of a difficult global economy, the effects could include financial crises, higher interest rates and a big drop in global output."

The US President, Mr George W. Bush, may be many things. But he is not a man who is over-burdened with financial acumen or the inclination to accept sound advice. And so, in his first press conference after the election, he had insisted that he had earned "political capital" in the campaign — and that he intended to spend it.

But with the US standing in need of an inflow of around $2.6 billion a day to fund its trade and budget deficits, and with 92 per cent of the $1trillion increase in debt over the past four years financed by foreign lenders, nobody was convinced that he had the necessary economic capital.

The current fall in the dollar's value was touched off by a report in the Shanghai publication, China Business News, that China had reduced its holding of US treasuries. China, which has in excess of $515 billion in foreign currency reserves, has been one of the main purchasers of US financial assets and it was plain to all that any withdrawal from the market could well precipitate a rapid exit by other central banks and foreign investors.

It did not help matters much that this report came in the wake of a statement by Mr Alexei Ulyukayev, First Deputy Chairman of the Russian central bank, to the effect that the bank was inclined to step up the proportion of foreign currency reserves it held in euros. "Most of our reserves are in dollars, and that's a cause for concern," Bloomberg News quoted him as saying. "Looking at the dynamics of the euro-dollar rate, we are discussing the possibility to change the reserve structure." At about the same time, the Bank of Japan also indicated that it was contemplating a change in its mix of foreign currency reserves. The country had been prominent by virtue of its absence from the US foreign exchange market over the preceding six months.

Asian banks, as of the end of last year, held $1.89 trillion of foreign reserves, most of it in dollars. If the Asian currencies are revalued, significant losses will be incurred on these holdings. According to calculations by the New York Federal Reserve, if the yuan appreciates 10 per cent against the dollar, China will take a capital loss equivalent to almost three per cent of its GDP.

If the won rises by 10 per cent, South Korea would incur a similar loss. The impact will be more severe on other economies: Singapore will take a loss equivalent to 10 per cent of GDP and Taiwan eight per cent.

The Economist has observed in this context: "To avert such an appreciation, Asian central banks would have to amass ever greater holdings of dollars. But this would only expose them to greater capital losses down the road. Alternatively, they might seek to avoid the consequences of a dollar fall, by diversifying into other reserve currencies, such as the euro. But that would only bring the dollar crashing down all the more quickly. In other words, Asian central banks are caught in an awkward dilemma: either they try to break the dollar's fall, or they try to escape from underneath its collapse."

As of now, the growth of both the fiscal and BoP deficits to record levels notwithstanding, the US bond market has remained firm, thereby keeping interest rates low. But all that could change instantaneously if the Asian central banks, whose purchases of US treasuries have largely sustained it, decide to pull out.

Given the massive losses they could incur, the players in the US market will inevitably keep a wary eye on each other. They, of course, would like the inflow of funds to continue so that they there is no erosion in the value of their assets.

But, at the same time, they are all looking for a way to scale down their dollar holdings to reduce their risk exposure. In these conditions, even a relatively minor movement out of the US market by one of the major players could provoke a stampede which will end in the collapse of the dollar and an escalation in US interest rates.