The Hindu Business Line : Current account matters in currency market

Over the past five weeks, the broader trade-weighted index has shed 2.5 per cent of its value. This erases all of the gains recorded during the preceding five weeks and brings the cumulative decline from the peak of February 2002 to 16.8 per cent.

The latest dollar losses have significantly occurred despite the futures market pricing in a more aggressive Fed Funds Rate (FFR) target by December near 3.9 per cent now compared with 3.6 per cent in early February.

Why is a higher prospective `return' not producing a stronger dollar? The answer is because return is just one part of the motivation to hold a particular currency. Just as important is the associated risk. That risk can be deemed to be the current account balance (CAB). And in the case of the dollar , the CAB risk is hardly receding because there appears to be no meaningful deceleration in domestic demand, certainly not to below-trend levels.

How do we know this? Observe the US monetary base or high-powered reserve money H. For all the FFR increase from one per cent in June 2004 to 2.5 per cent now, H has risen from 4.8 per cent year-on-year (3 mma basis) to 5.4 per cent in the same period.

And the behaviour of H is nothing but a reflection of demand for money from the financial system. Whilst that is not soaring alarmingly, it is not declining either. If such is the case, the end-demand for money in the US real economy remains okay. Indeed, it bears mentioning that US commercial and industrial loan growth (y-o-y basis) is now in the black after being in the red for 37 consecutive months ending September 2004.

If the adjustment in the American CAB is not all that imminent, investors are right to demand a higher risk premium on the dollar. However, by the same token, to the extent India's own CAB has narrowed, should investors demand likewise for the rupee? There is little fundamental reason to do so because just as important as the CAB's directions are its levels. It is one thing for the annual CAB to move in the wrong direction from minus 5.4 per cent of GDP (as in the case of the US) and another thing altogether to move so from roughly zero per cent of GDP (as in the case of India).

How much cushion does India's CAB have in any case before it becomes a concern for the rupee? To answer this question, we conduct an exercise outlined by Tim Carlen and Paul Cashen in an IMF paper published in December 1999 (Assessing external sustainability in India). The basic premise is that the status quo on the rupee will be preserved if the ratio of India's external liabilities (EL) to GDP can be maintained at current levels. As EL should include both debt and equity, we are assuming the ratio for India to be 30 per cent today. Whilst this figure is admittedly not all that accurate, it is unlikely to alter our conclusions any materially.

The Table shows the various permissible CAB levels to stabilise the external liabilities at 30 per cent of GDP, based on different assumptions of real GDP growth and real cost of foreign liabilities.

For instance a (6,6) matrix would throw up a sustainable CAB of minus 1.80 per cent of GDP. Of course if India's GDP expands at a seven per cent annual clip, it should be apparent that even a CAB in excess of minus two per cent of GDP can be tolerated. There is still some buffer before India's CAB reaches that threshold.

To be sure, the same could be said for the CAB dynamics of many other Asian currencies. However, the reason to be relatively bullish on the rupee is because local manufacturers, not just service-providers, are gaining market share in the international markets.

Based on the latest World Trade Organisation data, India's goods export share in the globe rose from 0.66 per cent in 2000 to 0.75 per cent in 2003.

This is no mean feat because no other major East Asian country with the exception of China has registered a higher share in that period.

And whilst the data for 2004 is not available, the graph confirms a higher export growth rate for India than for the Asian universe.

There can be no mistaking India's improving competitiveness.

(The author is a Senior Regional Economist at HSBC Singapore. The views expressed herein are his own and not necessarily those of his employer.)

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