A V Rajwade: The riddle of the dollar's value

WORLD MONEY

Everything points to it falling, but it keeps appreciating.

In recent years, several riddles about the US dollar have continued to puzzle me "" its external value and its time value, to start with. As for the first, most observers and students of the exchange market, including me, were of the view that the dollar's fall, which started in May 2002 (34 per cent against the euro by December 2004, 14 per cent against the Japanese yen, and 26 per cent against the British pound), would continue through 2005, since despite the depreciation against major currencies, there had been no correction in the deficit on the current account. These expectations were belied last year "" from December 2004, it has appreciated by 15 per cent against the euro, and 12 per cent against the yen and the British pound "" and shows few signs of weakening in the near term.

The rise in 2005 was at least partially attributed to two, one-time factors "" the tax concession available to US corporations repatriating profits from subsidiaries abroad, and the continued widening of the interest differential in favour of the dollar. Of this, the first factor has substantially come to an end "" and so would the second factor, sooner rather than later. Surely, the series of increases in short-term rates, engineered by the US Federal Reserve, are at, or nearing, the end of the cycle, even as the European Central Bank and the Bank of Japan would be looking to tighten money. And, with the deficit on current account expected to go up further sharply in the current year (2005 "" $813 billion, or 6.5 per cent of GDP), on fundamentals the dollar should fall. In the mid-1980s, deficits of less than 4 per cent of GDP had led to a 40 per cent fall in the real trade weighted value of the dollar. History can, of course, repeat itself. But would it?

The second riddle is about the time value of the dollar, that is, interest rates. The long term bond yields have hardly moved despite the rise in the fed funds rate from 1 per cent in June 2004, to 4.5 per cent now, resulting into a practically flat yield curve right up to 30-year maturity.

The simple answer to both the riddles is net capital inflows well in excess of the deficit on current account. Foreigners' purchases of dollars tend to strengthen the currency, and their investments in the bond market keep yields low. More than 50 per cent of US government debt is now held by foreigners, in particular, Asian central banks that have been adding to their reserves and investing a significant portion of the additions (70 per cent?) in the US. So also oil exporters may be keeping a lot of money outside the US for political reasons, but probably still in the American currency.

There is yet another riddle in connection with the dollar. The country's balance of payment data continue to report a surplus on investment income despite net external liabilities estimated at $2.5 trillion! It was as high as $ 36 billion in 2004 (but dropped to $4 billion in the first three quarters of 2005). One reason could well be that while much of US investment abroad is by way of FDI, more of foreign investments in the US are in bonds: the income on the former is much higher than on the latter, explaining the riddle. Other ingenious and imaginative explanations have also been offered, but none are satisfactory. Like most reporting and indeed what passes for analysis of financial markets, these look like rationalisations rather than explanations. (In practice, most such rationalisations give way to others when market sentiment changes.) The fact is that nobody really knows what quirks of data compilation lead to the continued positive investment income.

But coming back to Asian central banks, China did announce that it is revising its reserve investment policy in order to "optimise the currency and asset structure" and "actively boost investment income". The statement could mean several things "" investments in corporate bonds rather than government paper, a higher proportion of reserves in non-dollar currencies (overall or, as is more likely, the additions to reserves) and so on. But, perhaps, not too much should be read into the statement. A sharp fall of the dollar against the yuan would inflict huge losses on the central bank. Again, in terms of the sacrificed domestic jobs and growth that an appreciating currency would imply, the Chinese have too much at stake to change their policies dramatically. Nevertheless, it should not be forgotten that the dollar's exchange and interest rates are highly vulnerable to Asian monetary policies "" and while the current relationship can go on, it can also end suddenly. Political developments should also not be ignored "" for instance, sanctions against Iran and its switching oil pricing to another currency.

As for me, despite the experience of 2005, I remain bearish on both the external value of the dollar and the bond prices.

Email: avrco@vsnl.com