Kaushik Das: Global recession in the New Year?

If interest rates in the US increase further, the property and retail bubble could burst, leading to a major turmoil

The dollar has strengthened more than 14 per cent against almost all the other major global currencies in the past two months. Even the Indian rupee fell below 46. A strong dollar has various implications.

A strong dollar means that it is cheaper for Americans to import, leading to a further widening of their trade deficit. Their current account deficit will also widen. The current account deficit of the US currently stands at 6.1 per cent of GDP. Clearly, further increase in the current account deficit would be unsustainable and, hence, it is in the best interest of the US economy to follow a weak dollar policy.

The dollar's strength is mirrored as a depreciating trend in other, especially Asian, currencies. An appreciating dollar will have a two-fold effect on forex reserves of Asian central banks: First, it will enhance the capital value of the existing forex reserves held with the US treasury. Second, it will increase the current account surplus in Asian countries, thus adding to more forex reserves.

Thus, with an appreciating dollar, the present trend of global imbalances (see chart) will continue with the US running a frightfully high current account deficit and the Asian central banks funding this deficit by lending their surplus forex reserves in return for US Treasury Bills, earning a paltry 2 per cent on them.

The current appreciation of the dollar comes on the back of narrowing interest differentials between US and the other countries as a result of the successive Fed-Fund rate hikes in the past 17 months (from 1 per cent in June 2004 to 4 per cent by November 2005), which is making the US market look more attractive for short-term investors. This has led to increased short-term capital inflows into the US and a resulting appreciation of the dollar. Any appreciation of the dollar on the back of short-term capital flows will increase the current account deficit further.

The US has a twin deficit problem: the budget deficit and the current account deficit are linked. The causality is as follows: A budget deficit reduces the national savings of a country and pushes up the interest rates which crowds out private investment. As investment falls, the capital stock accumulation decreases, leading to lower productivity and a fall in GDP. The higher interest rates also lead to increased capital inflows, which lead to an appreciation of the domestic currency. With imports cheaper than exports, it ultimately culminates into a current account deficit.

Despite running a budget deficit, US interest rates were at an all time low of 1 per cent, thanks to Alan Greenspan. This artificially low interest rate fuelled bubbles in the retail and mortgage markets as people went on a consumption binge without having adequate savings. The negative savings rate of both the government and the private sector meant that the shortfall in savings is met by importing foreign savings from mainly Asian central banks. How long can this continue? What can the US do now?

Fiscal policy: The US should forthwith tackle its budget deficit by cutting government spending. There is no other way. However, the retiring of the baby boom generation and a projected alarming rise in the health and the social security expenditure makes the viability of reducing budget deficit looks pretty bleak in the near future.

Monetary policy: Raise interest rates even higher. But the question is how much more? The general consensus among economists is that fed rate is expected to go up to a "neutral" level (a level at which real interest rate is positive) of 4.5 per cent by the end of January 2006 and then stop as Ben Bernanke replaces Greenspan as the new Fed chief from February 1, 2006. Raising interest rates any higher will lead to widespread bankruptcy as the property and retail market bubbles will burst. Raising the interest rate too much would also lead to temporary appreciation of the dollar (as witnessed currently) and adversely affect the current account deficit.

Currency route: The third option is to let the dollar weaken against other currencies rather than appreciate. This will help to bridge the deficit to some extent. But how much should the dollar fall? According to some economists, it needs to fall another 30-40 per cent to bring the problem of deficit under control. However, if that happens, the central banks that are holding US treasury bills will shift their reserves from the dollar to the euro or any other stable currency to avoid capital loss and, thus, cause a collapse of the dollar.

External adjustments: The current financial mess that the US is in today can be partly attributed to the mercantilist policies of the Asian countries who kept sterilising forex reserves to stop their currencies from appreciating. In fact, the ideal policy for Asian countries (excluding Japan) to attain a long term sustainable growth should be to run a current account deficit rather than running huge current account surpluses (with a caveat that fiscal deficit in these countries should be low) and financing the deficits through long-term capital flows such as FDI and FII. Although China has revalued the yuan against the dollar by a small 2 per cent, the currency is still grossly undervalued and, therefore, China should take the lead among Asian countries and push for further revaluation of the yuan. But the "prisoner's dilemma" problem transpires, where each country tries to predict how the others will behave and, therefore, all end up choosing a sub-optimal policy: sterilisation!

None of the policies in isolation can help the US to get out of the terrible mess it is in at the moment. All the policies have to be undertaken in the right proportion taking into account the problems associated with each of them. But the sooner policymakers take a pro-active step towards fixing this global economic imbalance, the lesser would be the pains of adjustment.

The author is an economist with SBI Capital Markets Ltd. Views expressed are personal