Date:17/11/2004 URL: http://www.thehindubusinessline.com/2004/11/17/stories/2004111701590600.htm

Back Dollar fall overdone?

S. Balakrishnan

TERROR stalks the world. Oil prices are on a tear. Iraq continues to simmer. The twin deficits - trade and fiscal - haunt the US economy. And the Fed is remorseless in raising interest rates.

Everything in place, one would have thought, for a classic global economic slowdown.

Yet things have'nt been so bright for years. America's GDP growth is close to 4 per cent, on average, and the IMF's forecasts are around 5 per cent for the world as a whole for 2004 and 2005.

What's happening? Undoubtedly, it is the increasing integration of markets in goods, trade, services and financial capital that has provided momentum to the global economy and enabled it to overcome the host of negatives. Mobility is the name of the game.

Conditions are ripe for the good times to roll on. Oil prices have started to come down and fears of big shortages seem to be exaggerated, despite the known, increasing energy appetite of China and India. While a return to the teens can be ruled out, crude will probably settle in the $30-40 range - something that the world can live with. (Significantly, even then, real prices would be lower than they were 30 years ago).

Sooner or later, it is likely that terrorist acts will diminish considerably, as security improves, the perpetrators and would- be perpetrators are caught and, most important, a global consensus against terrorism develops. That will remove the risk premium now attached to new investments, both by consumers and businesses and spur growth. The first beneficiary would be stock markets, which, clearly, have better times ahead.

The era of disinflation (falling inflation) and the deflationary threat (falling prices) are over. This has major implications for global interest rates.

As far as the US is concerned, coming inflation numbers are likely to show an uptick in prices, ex-food and energy, beyond the 0.1-0.2 per cent that the market has gotten used to for some time now. Job creation should also be better than in recent months. The Fed can afford to keep its foot on the pedal and go for serial rate increases.

India cannot, of course be unaffected by Fed policy. Despite falling oil, inflation will remain in the 6 per cent range, necessitating a further repo rate hike (or hikes).

Viewed in this background, the dollar's fall against the euro seems overdone - obviously, a very contrarian view at this point in time.

With better growth and higher US interest rates, the coming days and weeks should see a dollar/euro recovery. The euro will also lose ground against the yen, given the China boost to Japan's economy and its continuing exports to the US.

Europe could be a different story. Growth was barely positive at 0.3 per cent in the third quarter. With crude prices coming down, eurozone inflation should drop to the ECB's acceptable level of 2 per cent, allowing it to at least keep interest rates on hold for a good part of 2005.