Business

The dollar continues to reign supreme

For most of the past six years the U. S. dollar was losing its value in relation to three other major currencies — the euro, the British pound and the yen. That seemingly secular trend called into question certain assumptions regarding the dollar.

The first assumption related to the dollar’s continuing status as the world’s reserve currency. The advent of the euro in 1999 raised speculation about the emergence of a genuine rival to the dollar. However, it was only recently that the clamour for replacing the dollar as the reserve currency became intense. The reasons have had as much to do with politics as economics.

It was not just the growing strength of the euro as a currency but its acceptability in a political sense that weighed in those arguments. Some oil producers, notably Venezuela and Iran, wanted to switch to the euro for invoicing their petroleum exports.

The dollar, however, remains the currency of choice in the oil trade. Even those who are politically opposed to the U.S. see some substantial benefits in continuing with the dollar.

Among central banks of the world too, there have been debates over the existing practice of deploying forex reserves in dollar denominated assets. The bulk of India’s $300-billion plus reserves continues to be invested in U.S. government securities by the Reserve Bank of India. Those who wanted to move away from the dollar centric approach cited the low yield from such investments. However, investment decisions by central banks are based on a number of other considerations including, of course, safety and liquidity.

The whole point is that the dollar reigns supreme dismissing all prophesies of disappearing from centrestage. A more recent development seems to reinforce the dollar’s position in the hierarchy of currencies.

Since the beginning of August, the dollar has staged a comeback against other major currencies, moving up more than 5 per cent against the euro, 7 per cent in relation the pound and 2 per cent vis-a-vis the yen.

Although it is not known whether the dollar’s recent rally will be sustained, in the world’s foreign exchange markets, its bounce back is certainly big news. One view attributes it to a long overdue correction. After remaining under pressure for so long the U. S. currency had to assert itself. This essentially a technical explanation does not do justice to the economic fundamentals behind the exchange rate movements concerning the dollar and other major currencies.

There are basically two overlapping explanations covering the long as well as the short terms.

The dollar’s weakness over a fairly long period has been attributed to the twin deficits of the U.S. economy — the fiscal and the current account. These meant that the U.S. could spend much more than its own savings. The shortfalls were met by a liberal influx of foreign money.

As long as central banks and other global investors continue to pour money into the U.S. and hence bridge its deficits there was no particular cause for worry.

Yet the levels of global imbalances — as the phenomenon of overseas savings making up the deficits in the U.S. has come to be called — were clearly unsustainable.

The process of winding down those imbalances was never expected to be smooth as it required unprecedented co-operation among major central banks.

The great turbulence in the world’s financial markets is attributed to the beginning of the process of winding down imbalances at the global level. The dollar has been under pressure ever since global imbalances were seen to threaten global financial stability.

A second and more specific reason for the weakness of the dollar is, of course, the housing market collapse and the serious credit crunch it has created.

Add to this record fuel and other commodity prices affecting all the principal economies and fuelling inflation, you have the phenomenon of the global economy slowing down while simultaneously battling inflation.

The IMF has lowered its forecast of global GDP growth to 4.1 per cent by the end of this year from 5 per cent last year.

While the U.S. economy has been battered by the financial crisis, other major economies seem to be suffering more. That at any rate is the considered opinion of central banks of those countries.

The euro area economy has shrunk in the second quarter. Japan’s GDP fell and the Governor of the Bank of England has prophesied a long period of stagnation for the U.K.

In contrast, the forecast for growth in the U.S. is distinctly upbeat: according to latest reports, its economy expanded at 3.3 per cent rate in the first quarter, much faster than previously thought. But the outlook for the remainder of the year remains grim.

The message is that in the era of globalisation no country is spared the pain of a major financial crisis even if it had originated elsewhere. And currency movements are quick to latch on to economic fundamentals including GDP growth rates and inflation and expectations of them.

In India too the dollar has been on the rise breaching the Rs. 44-mark on August 26, its highest level since March last year.

Apart from its recent strength in relation to major currencies certain other factors explain the dollar’s rise in terms of the rupee.

These include an outflow of money from the Indian stock markets pushing up the dollar demand.

Oil prices might have softened but India’s import bill for petroleum is still high.

C. R. L. NARASIMHAN

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