The Hindu Business Line : Why the dollar is in the doldrums

The US dollar is faced with the prospect of losing its pre-eminence as the dominant reserve asset as it weakens under the weight of its galloping current account deficit and the spreading contagion of sub-prime woes, say and D. SAMBANDHAN S.S. TABRAZ .

‘The Romans brought on their own demise, but it took them centuries. Bush has finished America in a mere seven years,’ observes Mr Paul Craig Roberts while making a pointed reference to the sinking dollar and the sinking American empire.

Perhaps that is an exaggerated statement, but it is likely to hold good if things continue to drift this way for long. The dollar has fallen to to its lowest level against the Canadian dollar since 1950, the British pound since 1981, and the Swiss franc since 1995. The euro rose to a new record — $1.4729 — before retreating. Alongside the slide of the dollar against the major currencies, the yellow metal has touched a 28-year high, surpassing the previous high of $800 per ounceunder the Carter regime in the late 1970s. The price of crude oil is nudging the $100 per barrel mark. What is happening to the major world currency now?

Right from the days of disintegration of Bretton Woods system in March 1973, the dollar has been on a roller-coaster ride, depreciating excessively in the late 1970s and appreciating in a more unwarranted fashion in the first half of 1980s. Under the impact of the economic growth facilitated by benign forces of globalisation, more particularly abundant cheap global finance flowing in from the rest of the world, the dollar did not experience much discomfort, at least until 2003. Now, however, , close on the heels of the sub-prime lending crisis and rising concerns over the huge US current account deficit, which is above $800 billion, investor confidence in the US dollar has been thoroughly shaken and the greenback’s real agony has just begun.

Gold, crude movement

To understand the dilemma of the dollar, let’s take a look at a few important recent episodes. Traditionally, oil and gold prices have been intertwined with the dollar’s exchange value. Whenever the dollar faltered, they have flared up.

The appreciation of currencies such as the euro and the pound sterling were not adequate enough to reverse the dollar’s weakness and precisely for that reason both gold and crude have responded in a manner that goes beyond the interplay of demand and supply factors in a typical commodity market. Rather they have started capturing the intrinsic worth of dollar in the world market.

Asian Parachute

For too long, experts in international finance had been predicting the crash of the dollar under the weight of the rising budget deficit and current account deficit, and had expressed fears that in the absence of any viable and credible alternative key currency, the stability of the international monetary system would be in jeopardy.

Although the current account deficit has been on the rise, reflecting a chronic imbalance between saving and investment , the US showed indifference to this macroeconomic imbalance. It could afford to do so as the rest of the world was willing and eager to finance these huge deficits.

The well-reasoned fears over the unsustainably high US current account deficit did not translate into any panicky situation as many Asian central bankers confronting huge dollar inflows preferred to play an accommodative role to the US central bank.

Many Asian central banks, especially Japan and China, and to some extent India, were content protecting the dollar through active intervention in the foreign exchange market lest their currencies appreciate and hurt exports.

Greenspan’s America

These central banks thus provided a comfortable parachute for the US economy to continue with the extravagant and almost profligate spending pattern, without feeling the need for real exchange depreciation for correcting its balance of payment deficits

The Fed also could continue to operate with a low interest rate policy. Indeed, one of the greatest achievements of Alan Greenspan’s America was to register more employment and high growth throughout the 1990s without igniting inflation and excessive external dollar depreciation.

Subsequently, a tighter monetary policy was followed since 2003 with the dollar turning vulnerable. The mid-2000s saw the housing bubble burst under the impact of high interest rates. The sub-prime lending mess, which surfaced rather belatedly, has forced the Fed to go for an interest rate cut.

Catch-22 situation

Now the US is in a Catch-22 situation. If there is a steady flight of capital away from the dollar, the US Fed would have to hike interest rates to defend the currency to a level promising positive real returns and thereby prevent the further erosion of confidence in the dollar.

But the US is also confronted with the sub-prime lending crisis and clear signs of recession — both warranting a low-interest-rate environment. The US can no longer take for granted the privilege of being the key currency country, as has been the case in the recent past.

Lessons from Current History

It is worth recalling that the Mexican peso collapse of 1994-95 and the Thai baht’s fall in July 1997 were triggered by current account statistics revolving around 8 per cent of the GDP. Currently, the US current account deficit is 7 per cent of the GDP. Extrapolating this with the US economy, it can be said that US is headed for a full fledged currency crisis of a magnitude never witnessed in its monetary history.

Countries such as Saudi Arabia, South Korea (both American allies), apart from China, Venezuela, Sudan, Iran and Russia, are said to be considering the option of diversifying their reserves away from dollar to the extent possible.

There might be continual/occasional inching up of dollar for a variety of reasons, but one thing is sure: the dollar’s script henceforward will be of a different nature from what it had been hitherto. The US has to take steps to correct its absorption behaviour and find an appropriate real exchange rate to correct the chronic trade deficit.

A weak and weakening dollar might be disruptive to the world economy but it is absolutely essential for the US to come out of its cumulative economic ailments. This is easier said than done, considering that the apprehensions voiced by the Fed Chief, Mr Ben Bernanke — that the US economy was going to get worse before it got better — received a chilly reception from both the Wall Street and political powers-that-be.

(The authors are on the faculty of Department of Politics and International Studies, Pondicherry University.)

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