The Hindu Business Line : Software czars, economists and other animals

THESE are, as Charles Dickens said famously, "the best of times, the worst of times". The global economy, after two years of recession, has picked up growth to 4 per cent (the forecast from the Institute of International Economics from Washington is that this will decelerate to around 3 per cent in 2005, with global oil prices rising as a result of the Iraq war).

There were no major economic crises in the year (no Japanese bubble-burst, no South American country going bankrupt, no dotcom collapse, no energy-trading firms going belly-up), in short, most economies chugged along quietly. But there was a trend that has caused some alarm among many of the worthies named in the headline: The decline of the venerated US dollar vis-à-vis a number of currencies.

The dollar has declined close to 9 per cent against the euro and the pound sterling since the beginning of 2004. It has been predicted that there will be a sustained fall in dollar rates against Asian currencies, such as the Chinese yuan, the Indian rupee, the Indonesian rupaiah, the Thai baht, the Philippine peso and the Japanese yen.

The Economist recently published its `Mac Index', which shows that the dollar looks overpriced in many of these countries, going by purchasing power parity (PPP) measured by the price of a Big Mac burger. The analysis also shows that the requisite correction has already happened in the euro and the pound sterling in 2004.

The analysis does not show India, because India does not consume beef-burgers. So you will have to depend on hacks, economists and other animals for news on where the greenback is headed vis-à-vis the rupee.

The declining dollar has given rise to fears that there will be a currency crisis and result in the feared `R' word that we dare not speak of, to borrow a phrase from Manoj `Night' Shyamalan's latest movie.

Why?

That, I am sure, is the question on the minds of many software czars and exporters in India (and elsewhere). With the US being India's largest trading partner, contributing $13 billion in exports, this is an important question. Though reams have been written on the reasons behind the decline of the dollar, and where it is headed, here is one take on this.

Yes, the culprits are the `twin deficits'— the US current account deficit ($650 billion) and the US fiscal deficit ($500 billion in 2004). For long, the dollar has been maintaining its position by a self-correcting mechanism. The US pays for its imports in dollars.

Exporters from other countries sell these dollars in their countries, where their central banks lap them up to provide price support to the greenback so as to keep the export gravy train running. As a result, many of these central banks (of Japan, China and India, for example) have built up huge dollar reserves. Some of them have invested these dollars back into the US in the form of dollar-denominated bonds.

It is estimated that 33 per cent of the US current account deficit is financed by debt, and that 25 per cent of this is financed by China. The US is the world's largest economy, and is also the world's largest debtor. As Kenneth Rogoff, an economist with Harvard University, said recently: "The US current account deficit cannot get much larger unless it starts borrowing from Mars".

As the US current account deficit continues to grow, more and more dollars are being sold in the global markets, exerting a downward pressure on the dollar. To some extent, the central banks are also running out of steam in their ability to provide price support to the dollar. Add to that the fact that dollar-denominated bonds give very low returns (2-3 per cent at best).

Taken together, some bankers may be tempted to offload their dollar investments and invest in other currencies that have wide acceptance and better returns, like the euro. There are whispered rumours in dealing rooms that China might have been gradually offloading some dollars. If this trickle becomes a flood, the doomsayers shriek, the dollar will crash.

Central bankers will sell their dollar-denominated bonds and there will be capital flight from the US. Ergo, there will be a payments crisis and interest rates will rise. This could kick off a recession. And if the US is in recession, you could swear on Lord Keynes that this will impact all of us.

Mr Stephen Roach, the reputed chief economist at Morgan Stanley, gives the US about 10 per cent chance of avoiding this `Economic Armageddon'. Alternatively, this rise in interest rates would attract capital back into the US, interest rates will fall again and things will go back to as they are: the self-correcting mechanism of the dollar will kick in.

There is another variable in the equation which may stop the decline of the dollar and will definitely avert a recession. That is the X factor on which everything now hinges.

The (ta)X factor

Recently, in an article in BusinessWeek Dean Foust, H. Gleckman and A. Barrett pointed out a recent change in the US tax laws whereby American companies can remit home pre-2003 profits at a reduced tax rate (effectively, about 5.25 per cent as opposed to the usual rate of about 35 per cent), provided these are remitted by the end of 2005.

The authors have estimated that US corporations have a mind-boggling $750 billion stashed away in profits in various tax havens around the globe, and expect that around $300 billion would move to the US as a result of this provision. If that happens, then the current account deficit is more than taken care of. That means no payments crisis and no interest rate problem and, hence, hopefully, no recession.

Americans would care little whether China invests in dollars or the Ethiopian Birr. That will also create a $300-billion demand for the dollar and will help to arrest the slide, at least for some time, provided these funds are not already held in dollars.

If these funds are already in dollars, then the greenback would continue to fall until the Asian central bankers decide to do something about it or the investment climate in the US improves radically vis-à-vis other countries.

The prognosis and how to plan for it

If the US can convince China to revalue the yuan, and tax remittances in 2005 do not create fresh demand for dollars, the dollar will continue to fall as long as central bankers reduce support to it. Then, it is a no-brainer that it will make exports to the US, say, from India, less attractive and domestic suppliers more competitive.

In other words, it could move some growth from countries like India and China back to the US. This would continue to happen till the movement of funds away from the dollar together with America's propensity for debt creates a capital shortage, jacks up interest rates, bringing back capital to the US, spiking the dollar and equating costs.

The spanner in the works could be Europe giving the US a run for its money as an alternative investment destination, sparking off a recession in the US. In any case, this will take some time to happen so exporters would feel the pinch, unless they hedge for it.

In the Indian context, most experts agree that the dollar is overvalued against the rupee from the PPP perspective: In fact, as per The Economist's Economic Intelligence Unit, India's per capita income in October 2004 was $600. As per PPP, the GDP per capita was $3,050. By that index, the actual exchange rate works out to about Rs 9 to the dollar. That's how low it can go, theoretically. But, then, it is generally accepted now that exchange rates are not about PPP, but about demand and supply.

Overall, the dollar has lost about 4.3 per cent vis-à-vis the Indian rupee since the beginning of 2004. Unlike the good old days (or would it be the bad old days?) when the dollar would move just one way (and that was up, up and away), it has swung considerably in the course of the year (see Graph), falling to a low of Rs 43.47 to the dollar on April 1, then rising to Rs 46.40 in July, before closing the year again at Rs 43.73.

The flurry of American Depository Receipts (ADRs), some of which have been issued, ironically, by Indian software companies, is also contributing to the fall of the dollar. The dismantling of textile quotas on December 31, 2004 is expected to have a positive effect on the industry, but this would also exert a southward pressure on the dollar vis-à-vis the rupee. A revaluation of the yuan would have a similar effect as dollars come rushing into India.

However, in my opinion, after the impending fall of the dollar in early-2005, the remittances resulting out of the tax concession will help to arrest its fall by the end of 2005, provided at least some part of these profits is now held in other currencies. It might even spike up dollar rates as companies rush in to beat the deadline.

Rising oil prices will also push up dollar prices to some extent. More importantly, 2004 has shown that all of us should be ready for two-way movements in the dollar. Last but not the least, whenever there have been economic disturbances in other economies, central bankers have moved funds to the `safe haven of the dollar'.

We should not forget that as per the AT Kearney report, the US still remains the world's No. 2 investment destination after China. This will definitely give price support to the dollar.

So, an exporter in India would do well not to enter into forwards on the dollar for 2005-end presuming that the dollar will fall uniformly to Rs 42, and is going to stay there. For all you know, the market could get better. Going in for put options on the dollar would be a much better idea.

If the dollar rises, you will be able to make extra profits (minus your option premium). If it falls, you gain again. Of course, given the uncertainty, the premium on options will be a lot higher, and there are fewer and fewer souls intrepid enough to sell these products in the market. The one-year forward dollar is trading at a premium now from the discount that it was going for a few weeks back, which means that at least some people in the dealing desks of international banks are thinking like this writer.

(The author is a Domain Consultant with the Financial Securities group at Infosys Technologies Ltd, Bangalore. He can be contacted at Raghuvir_mukherji@infosys.com. The views are personal.)

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