<b>A V Rajwade:</b> Exchange rates and growth

WORLD MONEY

A weaker dollar is largely responsible for the US growth.

Last weekend, the US government took over Fannie Mae and Freddie Mac, the giant housing finance companies. This removes one major uncertainty dogging the US housing market. Would this mean that the market could stabilise now? One will have to wait and see, but it is a curious feature of the current global economy that while its dependence on the US as the growth engine has reduced, that country’s financial markets continue to be of crucial importance to the rest of the world: More than $4 trillion of reserves are held in US currency!

But this apart, one should admire the US economy’s capacity to rapidly adjust to changing circumstances. The rise in oil prices has already led to a sharp fall in consumption — of the order of 800,000 barrels per day! Indeed, the fall in US consumption is perhaps the single-most important factor driving oil prices down to less than $105 recently. Not too long ago, the price was nearing $150 and pundits were forecasting a rise to $200! (Most other commodity prices have also fallen.) The resilience of the US economy is also reflected in the fact that the OECD recently increased its forecast for US GDP growth in the current year to 1.8 per cent (the earlier number was 1.2 per cent), even as it lowered growth forecasts for the European Union to 1.3 per cent and Japan to 1.2 per cent. One reason underpinning US growth is increasing exports, thanks to a cheaper dollar. To be sure, major problems remain: Apart from the uncertainty about the housing market, consumer spending has slowed and unemployment has jumped to 6.1 per cent in August, a five-year high. Headline inflation is at a 17-year high of 5.6 per cent. But a major economy in very deep trouble seems to be the UK: Its Chancellor recently characterised the conditions as perhaps the worst in 60 years. And, changes in the exchange rates inter se the major currencies seem to be parallelling the growth prospects.

See the attached graphic showing the exchange rate of dollar against the euro, the pound, the yen and the rupee: The graph has been re-based to 100 on April 23, 2008, the date on which the euro was at an all time high of $1.60. Since then, the dollar has been appreciating against the euro, initially gradually, but very sharply since the beginning of last month. The pound also has been moving in a more or less parallel fashion. In contrast, the dollar’s rise against the yen has been far more muted. The parallel movement of the pound and the euro against the dollar in the last six months or so, however, is somewhat deceptive. The key exchange rate for the pound is that with the euro, and here the change has been equally significant. For a few years until late last year, the pound was trading at or above ¤1.40. The pound’s peak in euro terms occurred in early 2007 (¤1.53). It has since dropped to ¤1.25, a fall of 18 per cent. One reason for the softness of the pound, apart from a weak economy, is the fact that the supplies of oil from the North Sea are running out and the UK is increasingly becoming an oil importer. Coming back to the dollar, some analysts believe that a level of $1.47 to a euro is probably needed to reduce the current account deficit to a sustainable level; surely, the deficit has started falling in recent months. Meanwhile, China seems to have suspended its gradual appreciation of the yuan in dollar terms: This is perhaps a response to the dollar’s appreciation globally, the high domestic inflation, and stabilising trade surplus.

The rupee too has depreciated against the dollar in the current fiscal year. Interestingly, as the accompanying graph will evidence, the rupee depreciated much before the fall of the euro and the pound in the last six weeks. While the fall would give some relief to exporters, there still are concerns about the balance of payments — but more on this in a later article.

avrajwade@gmail.com