| First, he argued, even appreciation would impose a domestic cost that could potentially be as high as the cost of sterilisation. Second, the economic costs of appreciation could also well be higher than the costs of sterilisation. |
| In a recent paper*, Michael P Dooley, David Folkerts-Landau and Peter Garber also ask why central banks are accumulating so many dollars and whether they have any choice in the matter. At last count, Japan had $ 750 billion, China, Hong Kong and Taiwan 700, the Euro Area 230, South Korea 180 and India 110. |
| They write, "accumulations of financial assets and liabilities, in particular, international reserve assets and domestic currency liabilities that appear to be suboptimal when viewed in isolation, make sense when viewed as a part of a development strategy." |
| There are two forces driving this strategy. One is the labour surplus. The other is the assessment that this surplus can only be absorbed in export industries, whose competitiveness can be maintained only through a stable and low exchange rate vis-à-vis the dollar. |
| Being Westerners, and, therefore, not at the receiving end, they omit to add the third driving force. This is simply the determination not to be held to ransom by the US via the International Monetary Fund. |
| You have to be naïve not to be able to understand just how powerful the US is and how ruthlessly it can treat a country, even to the point of manufacturing a payments crisis for it. |
| In the third quarter of 1990, for instance, India's macroeconomic fundamentals were not all that worrisome, really. Yet suddenly, dollars started to flee the country. To date no one knows what caused it. |
| Be that as it may, the authors say that thanks to employment reasons "intervention in exchange and financial markets has (and will) continue to be large and persistent enough to generate predictable deviations of exchange rates and relative yields in industrial country financial markets from normal cyclical patterns." In other words, there is really no substitute for the dollar. |
| The authors further argue that even if the composition of the reserves changes, so that central banks switch a little bit into the euro, the fact of reserve accumulation will remain. Then comes the real news. |
| The authors conclude that "diversification is inconsistent" with the policy imperatives of the developing countries. "An attempt to diversify and maintain dollar cross-rates would generate an increase in gross reserve assets and the gross domestic assets required to sterilise the reserve increase." |
| In other words, switching from dollars to euros will necessitate an increase in the holdings of euros as well, to sterilise which will impose a further cost. It would be far cheaper to stick to the good old dollar, which seems to be turning out to be as good as gold. |
| This is an important conclusion because economists and journalists are now no longer asking whether the dollar will fall, but when it will do so. |
| What Dooley, Folkerts-Landau and Garber are saying is that it will not fall precipitously because even though it seems like a one-way bet to sell dollars, it is not. To quote, "Our guess is that even if such a portfolio adjustment is attempted it will be cautious, small and quickly reversed." |
| What does this mean for the financial markets? Real interest rates will remain low and perhaps by as much as one percentage point, say the authors. "If Asia does not blink first and inflation stays low because of the supply of cheap foreign savings, we expect to see lower short and long interest rates, with short treasuries well below other short rates." |
| What if inflation returns to the US anyway? "Then the rise in US rates would be mitigated by Asian intervention." |
| *The Revived Bretton Woods System: The Effects of Periphery Intervention and Reserve Management on Interest Rates and Exchange Rates in Center Countries, NBER Working Paper No. 10332, March 2004 |
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