On a trade-weighted basis, the dollar has depreciated by 11.5 per cent over the last six months, principally against the euro, the yen, the Canadian dollar, and ‘commodity currencies’ like the Australian and the New Zealand dollars and the Norwegian krone. The recent fall has also attracted a lot of political flak for the Obama Administration. One only hopes that the criticism does not push it towards trade protectionism at a time when the world economic recovery is still fragile.
While the Chinese have so far resisted pressure from the G7 and the IMF to up-value their managed exchange rate, most recently at the Istanbul meeting, both China’s current account surplus and the US’ current account deficit have come down. In fact, the US deficit is running at around 3 per cent of GDP, barely half the rate compared to what it stood at before the financial crisis. It remains to be seen whether the improvement would last once more normal conditions are restored. The Chinese surplus too has fallen, though by much less. The fact remains that, for this imbalance to be reduced, both the US and China may need to make a wrenching change in their economic cultures: The US from the borrow/import/consume culture to a save/invest/export culture, and vice versa for China. In the meantime, in many ways, the China-US trade and investment relationship are based on the good old MAD doctrine of mutually assured destruction, which had kept the US-Soviet Union cold war from becoming hot and nuclear. China needs the US market to maintain its growth rate as it is determined to; and the US needs Chinese goods to moderate inflation, and Chinese investments to help finance its budget deficit without a sharp hike in bond yields. Both, therefore, need to keep the dollar from crashing.
The key to the dollar’s exchange rate remains capital inflows particularly from Asia. There is some possibility of these coming down, at a time when the fiscal deficit is running at something like 13.5 per cent of GDP and needs huge financing. There are several reasons why Asian purchases of the US currency and securities could slow down:
* The surplus of oil exporters has come down with the price of oil;
* The Japanese current account surplus has also come down and, if the Bank of Japan does not intervene in the market to buy dollars, Japanese investments in the US may also fall;
* Other Asian countries, however, are buying dollars to stop the appreciation of their domestic currencies.
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The big question is China, the largest buyer of dollars and investor in US securities in recent years. The Chinese have not only publicly expressed concern about the value of their dollar assets, but seem to be aggressively diversifying from financial to real assets. They have built up stockpiles of oil and gold and their Sovereign Wealth Fund is investing in equities and other riskier assets like distressed debt, mortgage-backed securities at deep discounts, and even commercial property. They have stepped up investments abroad in the resources sector, particularly oil. Clearly, they are diversifying away from US treasury securities, but there are no signs of a shifting of existing dollar reserves into other currencies.
But the apparent willingness of the Japanese to accept a yen appreciation and the on-going strategic diversification of Chinese reserves, clearly, are bearish factors for the external value of the US currency. So are the reported discussions amongst major oil producers and consumers (other than the US) about pricing oil in a basket of currencies. The dollar is also being used to fund ‘carry trade’ in preference to the traditional low-interest currencies — yen and the Swiss franc. This too tends to weaken the funding currency as speculators short it.
Two points are worth making. One, at some stage, a further fall of the dollar against the currencies of Asian countries with current account surpluses is perhaps inevitable. (One hopes that our authorities do not overlook the fact that we are a deficit country and do not need appreciation.)
Two, a precipitate fall of the dollar would be extremely destabilising for the global economy just when it is trying to recover. In such an event, one should not be surprised if there is coordinated intervention in support of the dollar. (Over the last 25 years, starting with the Plaza Accord of 1985, there have been five different occasions when the G-3 and other central banks have undertaken concerted intervention.)
But to turn to the longer-term issues, The Economist wrote recently (September 26) that “It is hard to think of a parallel in history. A country heavily in debt to foreigners, with a government deficit it is making little attempt to control, is creating vast amounts of additional currency. Yet it is allowed to get away with very low-interest rates. Eventually such an arrangement must surely break down and a new currency system will come into being, just as Bretton Woods emerged in the 1940s.” But more on this later.
The author blogs at avrajwade.blogspot.com