A V Rajwade: Asia's dollar dilemma

WORLD MONEY

Or, why policymakers prefer resisting an appreciation of domestic currencies.

There were some indications over the past couple of weeks that the dollar's fall on the international currency markets may have ended. It has marginally bounced from its recent lows of $1.345 a euro, and ¥102.1 a dollar, to $1.33 and ¥104.5.

To be sure, the description of the recent lows against the euro as "all time" ignore the history of the DEM/dollar exchange rate and the German currency's role as the European single currency's anchor.

Less than a decade back, the dollar was fetching just DEM 1.35 ($1.45 per euro at the mark's euro parity), and ¥80.

Even otherwise, it is arguable that, on fundamentals, the dollar could well fall further: the estimated deficit on current account in 2004 is $660 billion (5.6 per cent of GDP), and analysts predict a rise to 7 per cent in 2006 and 8 per cent in 2008, unless the dollar falls further sharply.

Its fall so far does not seem to have led to an increase in the price of imports. Inflation in the US remains modest, permitting the Federal Reserve to continue a generally easy monetary policy, and still negative short-term rates.

Meanwhile, even as the US' net external liabilities grow rapidly to finance the deficit on current account, one curious feature of its external account is that the investment income is still net positive.

While the Europeans are worried about the impact of the currency appreciation on exports and GDP growth, the European Central Bank is probably happy that this will have a positive impact on inflation "" jobs and growth are not its worry.

The central banks that have intervened heavily to stem the rise of domestic currencies against the dollar, are all Asian "" from Japan to China to South Korea to India to south-east Asia.

And as of now, the fate of the dollar, and a correction in its external deficit, hinge on what Asian policymakers do. They are in a dilemma:

Allow domestic currencies to appreciate and accept the negative impact on employment, exports and growth. This is not easy for large countries like China and India, what with the paramount need for job creation.

A corollary would be that the central banks will stop adding to their stock of US government paper and dollar interest rates could go up. The double whammy of rising domestic currencies and dollar interest rates will lead to losses of hundreds of billions of dollars for the Asian central banks through mark-to-market of the reserves in the domestic currencies.

Asian reserves are now in excess of $2 trillion and a 10 per cent rise of the domestic currencies, even without a fall in dollar bond prices through rising interest rates, would lead to losses of over $200 billion.

Under the circumstances, it is no wonder that the Asian policymakers prefer the option of resisting an appreciation of domestic currencies and maintaining relatively-high GDP growth "" even if this involves having to buy more and more US government bonds, knowing fully well that, sooner or later, the dollar may well fall further, and so would the value of reserves measured in other currencies.

In many ways, the unwritten pact between Asia and the US is that we will keep exporting and use the funds to buy your government bonds. It suits both, if only for the time being, and obviates the need for any major changes.

A rough parallel to what is happening is that of a seller continuing to sell to a buyer with no money to pay, accepting his cheques, and not cashing them. How long will this last? Nobody really knows.

Amongst the Asian countries, China and Malaysia are holding the exchange rates stable but the other currencies have appreciated against the dollar by lesser or higher percentages.

The Korean Won, for instance, is almost back to the pre-crisis level and seems to be clearly worrying policymakers. Export growth is expected to slow dramatically from 30 per cent in the current year, to 7 per cent in the next. Successive forecasts have lowered the GDP growth number to 4 per cent for 2005.

While the Asian policymakers continue to resist the rise of local currencies by intervening heavily, there is some evidence that they are diversifying the reserves "" or at least reducing the percentage held in the US currency. For instance, OPEC countries have reduced the dollar assets in their reserves from 75 per cent to 60 per cent.

China's reserves have grown by over $110 billion in the first three quarters of the current year, but US treasury holdings are up only about $16 billion.

The numbers perhaps exaggerate the percentage of surpluses going into non-dollar investments: the reason is that the rise of $ 110 billion is itself the result of a combination of actual addition to reserves, and an increase in the dollar value of traditional non-dollar reserves.

In short, India's dilemmas are not very different from those of many other Asian countries "" surplus on current account, large and growing capital inflows, and upward pressure on the exchange rate. A possible solution to the Asian dilemma is the much-talked about bond fund and an Asian monetary fund. But these developments deserve a special article.

Tailpiece: Some time back, there were reports that the government lost Rs 40,000 crore in 2003-04, on account of various export promotion schemes, particularly, duty drawbacks and concessions.

While I have no reason to doubt the arithmetic, one very questionable assumption underlying the calculation is that all these imports, on which duty concessions were given to exporters, would have taken place even in the absence of exports.

Email: avrco@vsnl.com