I have been an avid reader of AV Rajwade’s columns. His last column (‘Money and exchange markets’,October 20) says the ‘flight to quality’ explanation is not sufficient to explain why the dollar remains so strong. The key reasons lie elsewhere, in my opinion
The dollar strength is not a positive vote for the American economy but an overwhelming negative vote for European economies. The key factor underpinning the dollar’s strength was the assumption that policy response from Europe would be neither quick nor sufficient in a crisis. This assumption has been proven to be correct over the past four weeks.
The interest-rate differential between the dollar and the euro finally looked like it would come down. We were at a level where interest-rate cuts looked to be more likely in Europe than in the US (not least because the US had cut early and cut deep). In deep recessions, real rates need to turn negative before the central bank can rest easy. The US was pretty much in negative real rate territory. Europe and UK have some way to go still.
US current account deficits are highly correlated to oil prices and should therefore narrow in a recession. On valuation grounds, the euro and sterling were overvalued.
Also, the big factor moving currencies now is probably the risk-of-breakdown rather than the classic current-account linked arguments. This is the primary reason why the higher the bail-out package, the stronger the currency. I don’t think the world viewed the $700 billion plan as a prudent fiscal move from the US government. Investors sat back and said “If things are this bad and Europe is still living in denial, God save euro-land”. Subsequent events in the UK, Ireland, Germany, Iceland have suggested that currency investors got their assumption right.
Rajesh Balasubramanian, on email
