An orderly adjustment

The rupee has been hitting fresh five-month highs against the dollar, appreciating by 2.5 per cent in two months. The rise is part of a global hardening of currencies against the dollar, which has been attributed to the large US fiscal and current account deficits, and to President Bush's victory in the US elections.

The latter has been interpreted to mean the continuance of the administration's policy of tax cuts at home and war abroad. The surprise is that the dollar weakness has occurred when the US trade deficit has been lower than expected, and when the US Federal Reserve has raised interest rates by another 25 basis points.

Ordinarily, these factors should have led to a stronger dollar; its continued weakness is an indication of the longer-term structural problems in the US economy.

A devaluation is the old solution to a structural trade deficit. It boosts exports and stimulates the economy, while making imports more expensive and thus allowing the current account deficit to correct itself.

Experts have been talking of a dollar decline for years, and a substantial drop has happened from $0.90 per euro a couple of years ago to $1.30 today. Recent reports also suggest what has long been forecast, that there has been some diversification by Asian central banks, which have moved away from investing in US treasuries.

Nevertheless, the interests of Asian countries dependent on US markets are too closely intertwined with the American economy to allow them to accept a destabilisation of US markets.

So far the brunt of the dollar's depreciation has been borne by the euro, partly because China's yuan is pegged to the dollar, so other Asian countries' central banks have been forced to try and minimise their own currency appreciation.

However, the recent upsurge in inflation across the world, and in oil prices in particular, has led to central banks allowing their currencies to appreciate, in order to lessen inflationary pressures.

That has been true of the Reserve Bank of India as well, which is why the rupee has been appreciating. As a matter of fact, a dollar depreciation, if managed properly, may be good for emerging markets.

That's clearly seen from soaring stock prices in emerging markets, as dollar depreciation makes assets denominated in other currencies more attractive.

Investors have been dumping dollar assets for emerging market assets, the dollar depreciation being an added bonus to the high growth of some of these economies. And so far as exporters are concerned, a stronger US economy is more important than a stronger dollar.

The problem is that the yuan's dollar peg makes it difficult for the central banks of other Asian countries to allow their currencies to rise.

However, the Chinese central bank has recently raised interest rates, which has been seen in some quarters as foreshadowing a weakening of the dollar-yuan peg.

If the Chinese government decides on a revaluation of the yuan, it will reduce the pressure on the euro and other appreciating currencies, and allow a readjustment of some of the imbalances in the global economy.