The Hindu Business Line : The collapsing dollar

Once the process of dollar depreciation becomes clear to all stakeholders, they will want to dump the currency at the same time, creating what could be a disaster for the greenback. For now, the RBI should continue its non-interventionist policy and exporters should start focussing on other markets, says SHANMUGANATHAN N.

People tend to associate the word “collapse” with a big-bang event that happens over a short interval of time — a few minutes to a few days. The dollar collapse referred to here is not one such short-duration event that is going to happen on some particular date. The process of currency unwinding takes a long time, perhaps even a decade or two.

This dollar collapse started around 2002, and five years into this cycle, the dollar is down appreciably against most currencies and several hundred percentage points against major commodities.

Against currencies, in ways more than one, the progress (a dollar collapse, by definition, means that the other currencies have greater purchasing power) has been slower. But from the data in the Table, the trend is obvious: The euro is quoting at an all-time high; the British pound, Australian dollar and Canadian dollar are quoting at three-decade highs and almost all major currencies have appreciated.

Ironically, the currencies that have shown the least appreciation — Chinese yuan and Japanese yen — are from the countries with which the US is running the largest trade deficits. This is the exact opposite of what conventional economics would have predicted and if at all you need confirmation that currencies are manipulated, this is it.

The Japanese and Chinese central bankers have been irrationally suppressing their currencies to allow exports at the cost of reducing the purchasing power of their own citizens.The Indian rupee has been a late entrant to the party, primarily on account of the RBI’s previous interventionist policy. However, in the last few months given the non-intervention, the rupee has appreciated sharply.

The recent spurt thus has more to do with the explicit interventions over the last few years than with the more appropriate inaction over the last few months. In other words, the decline might have been much more orderly had the RBI had not insisted on propping up the dollar in the first place. The trend of the dollar depreciation against commodities and currencies will continue well into the next decade.

Looking Ahead

The dollar index, which is now at an all-time low of 80 (see “The Dollar Bubble of USA.com”, Business Line, May 11) may well fall to 40 over the next five years. Within the basket of currencies, some will obviously appre ciate much faster than the others — the Chinese yuan and commodity-backed currencies such as the Australian and the Canadian dollars are likely to lead the trends.

The only conceivable way in which the dollar slide can be prevented is by the US Fed raising interest rates substantially — perhaps by a couple of hundred basis points.

Given the immediate down-turn such a move would cause in the US economy and given the lack of political capital (a self-created situation in which the Fed has continuously painted rosy forecasts on inflation despite mounting evidence to the contrary), the Fed is very unlikely to indulge in such a move.

However, the Fed would eventually end up raising rates as explained in the article “US Fed: Between Scylla and Charybdis” (Business Line, June 20)”. But this is likely to be a case of “too little, too late 221; as all other countries are also increasing rates at a greater pace, that may only cause the differential to widen. What happens to the rupee? Well, the dollar’s depreciation against the rupee may continue as well. In fact, if you are an exporter dependent on a depreciating rupee, it would be safe to say that an orderly unwinding of the dollar over the next few years is your best-case scenario, though its depreciation is likely to be much more tumultuous.

The rationale is fairly straight-forward: Most people have not understood the process of dollar depreciation and still hope that the currency will either stabilise or even appreciate. Once they fully understand, everybody will want to dump the dollars at the same time and this could really be a recipe for disaster for the greenback.

What Should RBI do?

Nothing. For once, the RBI has not intervened in the forex market. Though the central bank Governor has stated that it would not intervene in any orderly movement of the currency, it is hard to believe in the bank’s new-found faith in a non-interventionist policy. Call me a sceptic, but it is hard to accept that an organisation which insists on micro-managing the interest rate that a public sector bank charges a borrower on a one-year loan in a remote village, is suddenly a believer in free markets when it comes to a macro issues such as exchange rates. If, however, the RBI does believe in market forces, it is indeed a good sign. And if so, one can only hope that it extends that belief to other aspects of its functioning as well.

The Exporters’ Angle

First, the thought that exports are a function of currency-exchange rates is short-sighted. The great export story of Indian IT companies, pharmaceuticals and auto-components had much more to do with international competitiveness and quality than exchange rates. The causal factors were a supportive business environment, lack of onerous Government regulations post-1990 and a free capital market.

If the Government is genuinely interested in promoting exports, it should immediately stop the export-subsidies now being proposed and initiate further reforms towards a free market economy. On top of the list would be labour reforms, permitting corporate investments in prohibited areas such as agriculture, mining, etc., besides outright abolition of various ministries — Heavy Industries, Shipping, Aviation, Mines and Telecom, to start with.

It is a tragedy that more than 15 years after reforms were initiated, ministerial interventions in economic activity are supported. It is not a decision between competent ministers and incompetent ones — it is entirely an issue of endorsing liberty and freedom.

The exporters, on their part, should stop asking for subsidies or for the dollar to be propped up and actually use this opportunity to demand faster reforms. They would do well to remember that it was the earlier RBI act of propping up the dollar that caused this sudden appreciation today. Besides, instead of focussing mainly on the US, it is likely to benefit by focusing on other markets. For one, other markets are likely to expand, both through currency appreciations, as explained above, as well as by faster growth in these economies.

(The author is a Director at Benchmark Advisory Services and can be contacted at shan.sundaram@benchmarkconsulting.in . His previous articles can be accessed at http://financial-musings.blogpsot.com)