A V Rajwade: External value of the dollar

WORLD MONEY

The problem of external deficit is unlikely to be solved without a sharp fall of the dollar.

"If something can't go on forever, it won't." "" Herbert Stein, Economist

If there is one major macro-economic variable to which the quoted remark applies, it is the current account deficit of the US. The deficit in the current year will amount to about 6 per cent of GDP.

The US needs net capital inflows in excess of $ 2 billion every working day just to finance it! And this for an economy whose net external liabilities already amount to a quarter of its GDP.

How long will the rest of the world, particularly Asia, keep buying dollars to finance the deficit? And if it stops, will the recent slide in the external value of the dollar turn into a rout?

Some parallels come to mind. In the second half of the 1960s, the US started incurring increasing deficits on the current account, partly as a result of the war in Vietnam.

Remember, that was the era of fixed exchange rates, with the US dollar freely convertible into gold at a fixed price of $35 an ounce. The surplus countries were happy to hold dollars, which earned interest, rather than converting them into gold, which did not, as long as the commitment to gold convertibility was credible.

With US external liabilities exceeding the available stock of gold, however, countries like France started converting dollars into gold. The US first devalued the dollar to $42 per ounce of gold and when that did not halt the pressure on the currency, it suspended convertibility in August 1971, and the dollar slumped. Since then we have been effectively living in an era of floating exchange rates.

The parallels to today? The problem of external deficit is unlikely to be solved without a sharp fall of the dollar; Paul Volcker, former Chairman of the US Federal Reserve and currently one of the more respected economic statesmen, recently quantified the possibility at 75 per cent within the next five years.

Again, like the French converting dollars into gold, China, one of the largest accumulators of dollars in the world, has gradually started shifting reserves from the dollar into the euro, which is one of the proximate causes of the recent euro strength and dollar weakness.

The second example is from the mid-1980s. The problem, once again, is the rising US deficit on the current account, thanks to an unsustainable exchange rate.

With US goods increasingly unable to compete with imports from Germany and Japan in particular, unemployment was growing and trade protection measures were gathering political support (Today's parallel is the backlash against BPO).

So much so that the US, setting aside all its market theology (despite Reagan being in power), took the lead in convening a meeting of the G-5, which promised to take concerted action to bring the external value of the dollar down, in what became known as the Plaza Agreement.

This had the desired effect and the dollar fell about 30 per cent in trade weighted terms over the next couple of years. The current account deficit, which was 2 per cent of GDP in the mid-1980s, started narrowing.

It actually turned into a surplus in 1991, thanks also to the moneys paid by non-combatants like Saudi Arabia, Kuwait and Japan to the US for fighting the first gulf war to evict Iraq from Kuwait.

The present current account deficit is three times as large in GDP terms as the one in mid-1980s, which had prompted the Plaza Agreement. Does this mean that another similar G-5 (now G-7) action is possible? Unlikely. The spirit of international co-operation has weakened.

Treasury Secretary John Snow keeps talking fatuously of a continued "strong dollar" policy. Again, over the past couple of decades, market theology has so mesmerised policy makers that nobody dare utter the heresy of managing the exchange rate. But the macro scenario is surely tempting enough for a Soros to short a few billion dollars!

If, as the above analysis suggests, a sharp correction in the dollar's external value is likely, should the reserve Bank of India stop accumulating reserves and allow the rupee to rise? The answer is no. The central bank should, however, shift reserves from dollars to other currencies as the Chinese are reported to be doing. But more about the domestic exchange rate policy next week.

Tailpiece: Most of us have been so brainwashed by the mantra "markets right, governments stupid", that it leads to all kinds of funny arguments being made on the subject of exchange rate policy, to avoid admitting that the rate is being managed.

I, for one, have long argued that there is nothing wrong whatsoever in managing the exchange rate; after all, if the domestic value of the rupee is managed by the central bank (through keeping inflation under control), what is so holy about the external value of the currency, namely the exchange rate, that it should be outside its purview?

The provocation for the above thought was provided by the reported comments of the South Korean finance minister after the central bank bought $ 2 billion on a single day to stem the rise of the won against the dollar: "The Bank of Korea was not intervening, this was just part of ordinary operations...But the Bank of Korea would not like to give the market the impression that it is just sitting back while the dollar/ won rate goes up."

In other words, the bank neither intervenes, nor sits back! Incidentally, the won has appreciated about 9 per cent against the dollar in the current year, and a third of Korea's domestic economic activity consists of exports.

Email:avrco@vsnl.com