A V Rajwade: The dollar's fall

It was sometime in the 1970s that I read a financial thriller titled The Crash of 1984 by Paul Erdman, a Swiss banker.

The story starts with the failure of a small bank in Hong Kong, which reverberates across the major financial markets and a crash in asset prices.

One wonders whether the announcement earlier this year by Russia""that the rouble's exchange rate will henceforth track the euro, rather than the dollar""would later get compared to the Hong Kong bank failure in the story.

It could well be, should the dollar crash, and lose its status as the world's reserve currency.

The parallel

There are not many historical parallels to the situation other than the case of the British pound, which was the world's reserve currency in the 19th century.

Like the US today, the UK then was the sole superpower, with its navy dominating the seas and an empire on which the sun never set.

For much of the time when the pound was supreme, the UK was registering regular and large surpluses on the current account and was a huge creditor to the rest of the world.

The pound lost its status after World War I as a result of the huge expenditure of material, monetary, and human resources in the War. The empire remained, for a little more than a generation thereafter, but the pound could not regain its status.

The economic perspective

The dollar took over the sterling's mantle at the end of World War II: the IMF-administered fixed exchange rate system was underpinned by the dollar's convertibility into gold at a fixed price.

But, in sharp contrast to the UK during the pound's heyday, the US has been registering deficits on the current account for almost 40 years now, i.e. through much of the period it has been the world's reserve currency.

A corollary is that the reserve currency nation is the world's largest net debtor ($3 trillion, or 30 per cent of GDP). And, the net indebtedness keeps growing with the current account deficit""$650 billion last year.

The dollar has fallen since its peak of early 2002, by about 40 per cent against the euro and 20 per cent on an REER basis, but this fall has not started correcting, or even stabilising, the current account.

It is customary to blame Asian exporters, particularly China and its exchange rate, for the mounting deficit, which is also the result of very high oil prices.

While these no doubt contribute, there are other and more fundamental factors as well""primarily the low savings rate. The weakest element of the savings investment imbalance is government finances: the fiscal balance has turned adverse by almost 6 per cent of GDP in the first term of Mr Bush, thanks to the huge tax cuts and the sharp rise in defence (offence?) expenditure.

In fact, the dollar would have fallen much more sharply but for the fact that Asian central banks have financed between 50 and 60 per cent of the deficit, by buying dollars in the domestic market and investing them in US treasuries.

How long they will continue to do so is a big question: they know as well as anybody else that, given the economic fundamentals, it is more a question of when (and by how much), rather than if, the dollar will fall.

(When it does, it will be by far the largest "sovereign default" in economic history). True, buying dollars and adding to reserves help sustain domestic economic growth and employment.

But if this means keeping on piling IOUs in a currency with fundamentals too weak to be a reliable "store for value", surely reserves will be diversified.

Data released by the Bank for International Settlements (BIS) last week evidence that China and India are diversifying their reserves into other currencies, and Thailand too has lowered sharply the proportion in the dollar.

The political perspective

Economists believe that a further fall of the dollar, hopefully in an orderly fashion, is needed in order to correct the unsustainable US deficit on the current account.

This would require the kind of global co-operation that underpinned the Plaza Agreement of 1987, which helped correct the dollar's exchange rate over the next couple of years.

In today's environment, such co-operation may involve expansionary policies in Europe and Japan and some revaluation of the Chinese currency. International co-operation seems to be difficult now, both because of the ideology of the Bush Administration and the political capital it has squandered over the last four years.

For the right-wing ideologues, "managing the exchange rate" is a heresy in market theology. This apart, the Administration seems to glory in flaunting its contempt for international co-operation: in Iraq and the Middle East; in keeping away from the Kyoto Treaty and the International Criminal Court; in nominating a new UN Ambassador whose scepticism about the organisation is well-known ("there is no such thing as the United Nations").

In short, too many in Europe, the Middle East, Latin America, and indeed Asia would be quite happy to see the world's lone (lonely?) superpower humbled by the exchange markets.

A possible trigger

What could trigger a further sharp fall? One possibility is Russia pricing oil exports to Europe (80 per cent of its total) in the euro, a change also justified by the trade with the EU.

Iran and Venezuela, to name only two major oil exporters, will be only too happy to follow. Then, the reserves shift out of the dollar would really gather momentum.

The euro

One historical parallel is worth recalling. In the 1960s too, the US was sustaining large (by the standards of those days) current account and fiscal deficits, thanks to the Vietnam War and President Johnson's "Great Society" programmes.

The result was the unilateral suspension of convertibility into gold at a fixed price""and a sharp fall of the dollar. But the currency retained its status as the reserve currency, thanks at least partly to TINA""there is no alternative.

Unlike in the 1960s, now there is a currency with far stronger fundamentals ready to take over the dollar's mantle: the euro, with a strong trade surplus, a huge and liquid bond market, and larger international trade than the US. The EU economy is bigger too.

And, the EU economic model is attracting more members. This is in sharp contrast to what is happening in the western hemisphere: even as the US moves to the right, country after country is moving in the opposite direction""Brazil, Argentina, Venezuela, Uruguay, Bolivia, etc.

To my mind, it is more a question of when, rather than if, the euro will take over. (One pointer: the world's most successful investor, Warren Buffett, has taken a $21 billion short position in the dollar!) But, as Keynes so wisely said, never predict the level and the timing together.

avrco@vsnl.com