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S. Balakrishnan

It's been a continuous alarm bell. The US economy is in the unsustainable mode of large budget and trade deficits and household debt, low saving and utter dependence on foreign capital — an explosive combination that will precipitate a dollar crash followed by a free fall of bonds and stocks.

Big money and names — Warren Buffett and Bill Gates — were betting on this scenario. But 2005 saw a resurgence of the American currency.

The euro pulled back somewhat in 2006. However, the dollar is still far from being routed. In fact, in recent weeks, it has strengthened significantly against its traditional bete noire, the Japanese yen.

The paradox is that even as economists cried themselves hoarse on the structural problems of the world's largest economy, Japanese, Chinese and Arab investors have poured tens of billions of dollars individually and hundreds collectively into US financial and physical assets.

Rush understandable

Their rush is understandable. No market comes anywhere close to offering the same portfolio diversification and liquidity. Shifts in reserve composition there may have been, but they have hardly caused a ripple.

The decision of China, Russia and several other countries to increase their euro assets did create some volatility in the dollar. Even so, the fallout was strictly limited and short-term.

What exactly determines a currency's behaviour intraday, interday and over a longer time horizon remains a mystery and explains largely the popularity of charts (as opposed to information and data) to predict exchange rates.

The focus of most players is on momentum trading, hoping to catch some up or downticks. Market-makers make money on their inside knowledge of big short-term flows in or out of a currency. These factors could and do overwhelm the reality of deficits, imbalances and disparities.

Dollar outlook

What of the outlook for the dollar?

For the moment, the trade gap factor seems to have receded to the background. There is a tug-of-war between the interest rate bulls and bears, which, thus far, is in the former's favour.

As a result, the dollar has recovered ground in recent weeks. American interest rates look to be largely currency-supportive this year.

Of more importance will be investment flows into the US with oil prices (and therefore petrodollar accumulation) falling, the demand for dollar assets will diminish — a negative for the currency.

Above all, 2007 and beyond should witness forex-rich countries such as China increasingly seeking out emerging markets — a process already well under way in the US.

So far, ironically, reserve-flush central banks have displayed an undiminished appetite for treasury bonds while American investors have their footprints all over the third world, where returns are in double digits compared to their own paltry low single-digit interest rates.

The dollar will fare better against its old rivals — the euro and yen — than against emerging market currencies.

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Emerging market currencies: Emerging from the shadows?

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