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Monday, Dec 13, 2004

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Dollar fall — How much and how far

Ajay Jaiswal

FINANCIAL world is going through an interesting period where the current foreign exchange system is close to being tested.

Dollar has one again entered a period of overall decline. The US economy is running an unprecedented current account deficit of over $550 billion. The largest economy is now running budget deficits and does not have any chalked out plans to return to surplus. US savings rate is an abysmal 1.4 per cent. Its foreign liabilities are close to $3.3 trillion which is around 28 per cent of the GDP.

The US continues to borrow for long tenor at low rates. The 10-year Treasury yield is around 4.10 per cent and much below the historical average. There is a clear mismatch in borrowing rates and financial position. Ever since the new foreign exchange system replaced the era of gold standard, dollar has been the world's reserve currency. There was no obvious currency that one could even look at as an alternate. Euro is now emerging as an alternative. There is a large eurozone economy and its financial markets are open and deep. There is something macro and longer term in play here and is not about a short-term dollar trend.

There are a few arguments on why the deficit may not matter and things can be sustained in this fashion. One of these arguments is that American strong demand and weak overseas demand creates this deficit and this is a sign of its might rather than weakness. Whatever be the logic, this deficit has to be financed from external sources.

As long as the world keeps lending and financing this deficit the things would continue in this way. Currently, 75 per cent of the world surplus is being mopped by the US. The current account deficit is now close to 6 per cent of the GDP.

Even though US ran a large current account deficit in 1980 but at that time it was a net foreign creditor. Asian central banks have been buying dollars at an alarming pace to keep their currencies from appreciating and hurting their exports. The global foreign currency reserves have risen by $1 trillion in the last 18 months. The previous $1 trillion increases in reserves took almost a decade.

These inflows are also creating problem of handling the surging liquidity in their economies. Some central banks are now slowly looking at shifting some part of the reserves into other currencies.

The dollar share of global foreign exchange reserve has fallen from around 80 per cent around three decades ago to 65 per cent today. Some argue that large US companies operate around the world and these companies import their output in America. Such imports are a large part of the deficit. There is still no going away from financing this deficit, what so ever be the identity of the creator of this deficit and hence this argument does not hold.

US administration is following the policy of letting the dollar decline. It would not be easy to bring down this gap by encouraging exports. It imports are around 50 per cent larger than exports. This would mean that exports would have to rise mush faster than imports for the deficit to shrink.

Another alternative would be to the US to save more and finance a larger part of this deficit internally. This would also mean that the administration would have to tighten its belt and this looks unlikely given the political agenda of the new Government and the Iraq war effort.

The management of the reserves is also creating a moral hazard.

Even though the central banks would like to see a larger non-dollar proportion, any such move would further reduce the value of their assets and hurt. If there is a sudden and sharp decline of the dollar it would hurt the overall system.

Interest rates in the US would rise if the central banks try to sell some of these assets. There have been murmurs of such threats by Japanese and Chinese.

US cannot afford a selloff on its assets, as this would seriously affect its housing sector. Roughly the mortgage market in US is around 50 per cent of its economy. US would not be able to watch the dollar decline as it could turn into an interest rate problem.

It would have to put its economy in order and move towards surplus; otherwise it may start loosing its dominant position as the reserve currency.

Sterling lost its status as the reserve currency after it turned a net borrower from a net creditor. Sterling continued as the reserve currency for more than four decades even after the US economy became bigger than Britain's.

Hence, you can continue to ignore all these warning sign for quite some time but if corrective action is not taken, it would have far reaching consequences.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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