Abheek Barua: Where is the dollar headed?

Those building in a scenario of gains in the rupee over the next few years could perhaps build in the risk of reversal over the medium term.

On Wednesday, November 7, the government upped the limit on market stabilisation scheme (MSS) bond issuance by Rs 50,000 crore. This came in the wake of an increase in the cash reserve ratio (CRR) on October 30. The two measures put together allow the RBI to impound Rs 65,000 crore additionally from the monetary system. With this enhanced capacity to manage liquidity, the central bank has to worry a little less about the (potentially inflationary) money it releases into the system when it buys dollars to stem rupee appreciation. The implication is obvious "" expect sustained intervention in the currency markets.

Despite this addition to its weaponry in managing liquidity, it is unlikely that the rupee will see any signs of softening against the US dollar. For one, it might be against the RBI's interest to try and engineer any significant depreciation of the rupee. Oil prices are rising every day and while the administered price regime artificially protects domestic consumers from its consequences, the quantum of "suppressed inflation" is growing exponentially.

One distortion breeds another and the policy of cushioning domestic consumers has to take a toll somewhere else. The victims of this policy of holding the oil price line are the oil-marketing companies and the exchequer, which might want to subsidise the oil companies for their losses. The best that the RBI can do in these circumstances is to allow some rupee appreciation so that each dollar increase in the price of oil translates into a smaller increase in the rupee price. To cut a long story short, the RBI might want to reduce the pace of the rupee's rise against the greenback but is unlikely to try and reverse the trend.

Besides, the RBI's ability to engineer depreciation is limited. Globally the dollar remains heavily oversold both on fears of a recession in the US and the US central bank's (the Fed's) strategy of trying to get the US economy to export its way out of a slump. Thus, the Fed is tacitly encouraging the sharp fall in the dollar hoping that a softer dollar will encourage US exports and rein in imports. This is not without basis. The relentless fall against the dollar has put American exports back on track. Third-quarter GDP for 2007 posted a healthy 3.9 per cent growth rate, on the back of scorching 16.2 per growth in exports. Much of this bounce in exports reflects the dollar's relentless fall against the currencies of its major partners over the year.

Surprisingly, this strategy has not come across any resistance from the US's major trade partners, who, potentially, stand to lose. The European Central Bank (ECB) has neither intervened by buying dollars or by trying to talk down the euro. The recent monetary policy statement from the ECB released on November 8, for instance, tried its best to avoid any references to the dollar. Ditto for the British Central Bank, the Bank of England.

There could be two reasons for this. First, these central banks share the RBI's concerns about the inflationary impact of rising oil price and are consciously using currency appreciation as a shield against this. Second (and this is a little strange), the appreciation in their currencies is yet to manifest in an impact on their exports. The German trade balance for September, for instance, printed at a six-month high. While exports to the US have perhaps slowed a little, euro-zone economies have found succour in a rising exports to high-growth emerging economies such as China and Russia.

How much more will the US dollar slide? Economists are broadly split into two groups on this issue. There are those who believe in a brave new world where the rising role of the high-growth emerging markets will act as an offset to the dwindling fortunes of the US. The corollary to their argument is that the US dollar will continue to weaken in the foreseeable future. The imbalance in the demand and supply of fossil fuels will keep oil at these elevated levels. Central banks will bank on exchange rate appreciation to stave off these price pressures.

The more conventional view is that the world is far more dependent on the US than financial markets are currently factoring in. Assumptions of permanent decoupling of any economic bloc (including Asia) from the US are unrealistic. If the US economy sags a little more, two things are likely to happen. Export growth in the rest of the world will take a beating and softer external demand will begin to hamper growth rates. Non-US central banks will then have to focus back on the competitiveness of their currencies. They will be helped by the fact that as their growth rates show signs of vulnerability, investors will pull their money out from these markets and pump cash into conventional safe assets like US treasury bonds. As demand from the US softens, oil prices will also slip back into lower ranges and give the central banks more headroom to push their currencies down.

Going by what is happening in India at the moment, there appears to be some meat in this line of reasoning. If all the anecdotes about the export drop in diverse sectors like textile and auto-components add up to something more substantial, growth could dwindle going forward, and with falling growth, the euphoria about Indian assets could die down. If indeed capital flows decline and the trade gap widens, the rupee could take a beating.

However, this is certainly unlikely to happen in the near future and the rupee is likely to appreciate a bit more. But those building in a scenario of continued gains in the rupee over the next few years could perhaps build in the risk of reversal over the medium term.

The author is chief economist, HDFC Bank. The views here are personal