A V Rajwade: The dollar's fall

WORLD MONEY

McKinsey estimates the dollar needs to fall 30 per cent for the US current account to balance in five years.

The dollar has been falling globally for the last five years or so "" its fall has been particularly sharp against the euro, the British pound and the Canadian dollar. Recently, even the yen has started appreciating despite the continued attractions of the "carry" trade. In index terms, the dollar has slipped from around 125 in 2002 (Bank of England trade weighted index) to approximately 85 now.

So far, the fall has been gradual and seems to have started correcting the external imbalance. The August trade deficit, at $57.6 billion, is the lowest since January: exports rose about 13 per cent, while imports inched up just 3 per cent. As a percentage of GDP, the deficit was as high as 6.7 per cent last year, but has come down to 5.5 per cent in Q2 of the current year. The improvement can be expected to continue as clearly the dollar is more competitive now "" and, the crisis in the housing market may well reduce consumer spending and demand in the US economy. To be sure, bilateral deficits against Japan and China are continuing to grow, even as China treads its path of gradual appreciation. But, thanks to higher domestic inflation and the exchange rate, China's export prices have started going up. And, this has inflationary implications for the US "" perhaps in anticipation, the dollar yield curve has steepened.

But to come back to the dollar's exchange rate, a recent McKinsey study has estimated that a fall of 30 per cent from the January 2007 levels would be needed for the current account to balance in five years. A smaller fall of 20/25 per cent would be enough to bring the deficit down to between 2 to 3 per cent of GDP, over the same period.

Is there a possibility of a sharp, disorderly and abrupt fall? In an unusually frank statement, Rodrigo Rato, the outgoing IMF managing director said last week, "There are risks that an abrupt fall in the dollar could either be triggered by, or itself trigger, a loss of confidence in dollar assets, ... that exchange rate appreciation in countries with flexible exchange rates "" including the euro area "" could hurt their growth prospects." As stated by Rato, one development that would trigger a sharp fall is the possibility of private investors and central banks becoming unwilling to hold dollar assets, at least on the existing scale "" in August, for example, there was an outflow of $ 163 billion of foreign capital from the US. On the other hand, the US needs almost $ 3 billion of inflows every day, just to balance the current account! Continued outflow of capital, or even a sharp fall in the inflows, is capable of dramatically changing the exchange rate: don't rule out the possibility although dollar investors have a lot to lose should the currency fall sharply.

A more likely scenario perhaps is the possibility of major commodity producers changing the currency of pricing. Political pressure on Iran from the US is mounting with the neo-conservatives' lobby calling for an invasion of Iran. Would the cornered Iranians be tempted to start pricing oil in the euro, as a measure of retaliation? Should they do so, Russia and Venezuela would be only too willing to follow suit "" and so would other commodity producers. Not even the G7 would then be able to arrest a sharp fall of the dollar.

The rupee's rate
As regular readers may recall, I have been criticising the monetary policies followed over the past year or so. But few ill effects are discernible at least so far. This, of course, should not be very surprising "" monetary/financial excesses do take time in impacting the real economy. To quote two specific cases, Alan Greenspan cautioned about the "irrational exuberance" in US equity markets in 1996: it took four years for the bubble to burst, and bring on a recession. Again, while going through a collection of best business stories published between July 2002 to June 2003, I found references to the likelihood of a crisis in the sub-prime mortgage market; it took more than four years for that bubble to burst earlier this year. It is unlikely however that the current high real interest and exchange rates will take that long to start affecting the real economy. Large-scale layoffs in garment and other industries have started, and they could gather momentum at an awkward time for the UPA's election prospects.

Tailpiece: "Imperfect though they may be, REERs have signaled large exchange rate overvaluations in the run-up to many financial crises, making it important for the IMF and others to monitor bilateral RERs and multilateral REERs," says Luis A V Catão, "Why real exchange rates?", Finance and Development, September 2007. In our case, the RER against the US dollar, the currency in which more than 85 per cent of our current account transactions are invoiced, evidences even more egregious overvaluation, than the REER.

avrajwade@gmail.com