The Hindu Business Line : Weak economy, strong currency

While it may be not be possible for the rest of the world to be decoupled from the US economy, breaking free from its currency should not be difficult

S. Murlidharan

There are many in India wondering why the rupee is depreciating against the US dollar when the US economy is down with its financial system collapsing like a house of cards.

The answer lies in the lead that the US took way back in 1944 hot on the heels of World War II when together with its staunchest ally, the UK, it established the Bretton Wood twins and urged the world to adopt its currency as the international referen ce currency in exchange for an ounce of gold for every $35 surrendered.

Dual market

In fact, this heralded a dual market for US dollars — domestic and offshore. At a rough estimate, one reckons that the quantum of the US dollar in circulation in the offshore market at any given point of time can easily rival that in circulation in the domestic market.

The historical hostilities between the US and the then USSR gave a further fillip to the offshore market for the dollars resulting in a powerful Eurodollar markets in London, Paris and Zurich where the USSR government preferred to park its enormous export surplus from the US represented in dollars instead of in the US itself as is being done by India and China.

The clever positioning of the US dollar as international reference currency also resulted in the oil trade, the second largest item in the international trade basket after foreign currencies, being designated in the dollar, which in turn led to dollops of petrodollars. No other country’s currency has thus far enjoyed such a huge international credibility.

This perhaps explains why the US, despite its adverse balance of payments and despite it being the world’s largest debtor, has been able to insulate its currency from its economy. Indeed, the strength of one’s currency, among other things, lies in the strength of its economy. Two countries have defied this truism — China and the US: China by deliberately following the policy of keeping its currency devalued with a view to facilitating its export-led growth and the US through its policy of offering its currency as the international reference currency.

A rare luxury

A widely circulating US dollar has emboldened successive US governments to resort to deficit financing which implies printing more and more currency notes, a luxury not all can afford. The US could afford it because the resultant adverse impact on its currency would be absorbed by the entire world. Nations of the world lent strength to the dollar by not only adopting it for trade purposes, but also by parking their foreign exchange reserves in the US financial markets. China, which is credited with taking several innovative measures such as oil for infrastructure development in Africa, also did not consider it necessary to diversify its forex investments.

The first oil shock in early 1970s shook the dollar’s hegemony when countries flush with petrodollars demanded gold in exchange for dollars. That shook the US from its complacency and it abandoned the peg of its currency to the yellow metal — one ounce of gold for every $35.

In its wake, several currencies notably Swiss Franc, French Franc, Deutsche Mark, Japanese Yen and British Pound became floating currencies ready to take on the might of the US dollar. Competition normally has the tendency to humble even the invincible. But the dollar wasn’t humbled.

Right step

Perhaps, the other floating currencies competed with each other instead of taking the dollar head-on. Which is why most of these currencies rooted in the European region merged to become one single currency, the euro. The euro has had a chequered history vis-À-vis the dollar. But nobody can deny the fact its creation was a step in the right direction. The unrivalled dollar has come for some challenge at last.

India can disabuse the artificial awe associated with the dollar in this country, by taking the bold step of making the rupee a floating currency which would call for full capital account convertibility of its currency.

Calibrated measures

Already calibrated steps have been taken in that direction — allowing Indian residents to invest up to Rs 2 lakh abroad, allowing Indian companies to raise funds from abroad in the form of GDRs and ECBs to wit. And the recent ushering in of futures market for the rupee-dollar by the National Stock Exchange takes the country farther in that direction.

Full convertibility would enable the rupee to find its level. Given the better shape of the Indian economy vis-À-vis that of the US and the greater purchasing power of the rupee in India vis-À-vis that of the dollar in the US, the move could give better valuations for the rupee, may be to the chagrin of exporters here.

What perhaps holds the government back from taking the ultimate plunge is the mounting inflation. May be it wants to tame it first before taming the rather skewed and adverse valuation the rupee gets vis-À-vis the US dollar.

The decoupling theory which amounts to breaking free of the US economy may be Utopian given the fact that the US accounts for 25 per cent of the world’s GDP. But breaking free from its currency is not all that difficult, especially at a time when its economy is vulnerable. The push should become a shove.

(The author is a Delhi-based chartered accountant. blfeedback@thehindu.co.in)

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