As Republicans and Democrats bickered over the US “debt deal”, investors dumped the dollar across the board over concerns that the impasse would continue and the US government would be forced to default on some of its debt service commitments. Mercifully, an agreement arrived at the eleventh hour to raise the debt ceiling and pass a long-term fiscal consolidation programme that gave the markets a chance to, at least temporarily, breathe easy. The dollar gained thereafter from the “safe-haven” trade as attention shifted to weaker global growth prospects that pushed equity markets lower.
Though the new debt deal has averted a crisis and a possible default, it has not been able to prevent a downgrade. The size of the fiscal consolidation programme ($2.5 trillion over a ten-year period) is deemed to be somewhat inadequate in bringing about a structural improvement in the US public debt-to-GDP ratio over the longer term. It is for this very reason that Standard & Poor’s (S&P) has chosen to strip the US of its prized AAA rating and put it in the AA+ category as it was looking for fiscal compression of around $4 trillion over the next decade. Markets are expected to react adversely to the latest developments that could see the dollar lose support in the near term. However, mass dumping of US treasury securities are unlikely in the immediate future. For one, S&P’s competitors Moody and Fitch have committed to retaining the highest rating for US sovereign debt and are not expected to make any revisions in the immediate future. Second, global investors are mandated to hold Tier-I assets that would include AA paper.
The more important implication of the debt deal is that fiscal consolidation could slam the brakes on US economic growth and slow it over the long term. Incidentally, the US economy appears to have hit a “second soft” patch since the recession ended in 2009, even in the absence of sustained fiscal consolidation. With fiscal consolidation on the horizon, the public sector is expected to contract and the private sector is unlikely to grow at a strong enough pace to make up for the loss in output. The net result could be a period of very flat growth of around two per cent for the next few years driven primarily by fiscal rectitude. That could ultimately compromise its debt-service capability further, yet another instance of the notorious vicious cycle of austerity.
From a currency market perspective, the only real support for the dollar over the medium term could come from continued buying into US treasury securities driven by risk aversion. Over the last few months, the dollar has ceded some ground to the Swiss Franc and the Yen as the “safe haven” currency of choice. The big question is whether recent developments in the US will speed up the dollar’s demise. The jury, we think, is out on this. While the dollar weakened in response to an awful 2Q2011 US GDP release, subsequent adverse data flow (on both the US economy and global region) and renewed anxieties over European debt positions led to a rally in the dollar. Thus, despite the problems that beset the US, the dollar has not lost all its sheen.
The fate of the dollar seems to hinge on whether or not a slowdown in the US economy is treated as a bellwether of a global slowdown. Asian economic performance will remain the key. A downturn in both the US and Asian region could force investors to pare positions in riskier Asian assets into the safety of US treasury securities that could result in dollar strength. If, however, Asia gets away with a soft landing and the markets believe that the two continents have yet again decoupled, the dollar could keep depreciating.
Thus, Asian currency performance could be used as a yardstick to measure whether the global investor community is expecting a slowdown across the board or a dip just in US’ economic fortunes.
For much of 2011, the perception that Asian economies, despite their inflation woes, are likely to get away with a temporary soft patch rather than a hard landing has driven a rally in Asian currencies despite growing concerns about US and Europe. A favourable interest rate differential has of course helped.
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The rupee has not been an exception and has appreciated over the last few months driven by a cocktail of factors: the persistence of the anti-dollar trade in the global markets, the Reserve Bank of India’s surprise aggression to hike rates and a favourable onshore and offshore (Non Deliverable forward, NDF) differential that encouraged speculative inflows. However, the rupee erased recent gains in response to the capitulation in global equity markets.
The future of the rupee depends on whether financial markets price in a global slowdown and run back to the safety of the dollar or ride the decoupling wave into Asian markets. Some mild depreciation seems due irrespective of the way the global market mood swings. A bulky oil payment is still due to Iran and hefty repayments on external borrowings are due (44 per cent of external debt of $305,892 million at the end of March 2011 was “short term” and need to be repaid or rolled over this year). Watch this space.
The writers are with HDFC Bank. These views are personal