The Dollar Conundrum

While the US financial system and the stock market have seen unprecedented loss and volatility in recent months, the United States Dollar (USD) has been making strong rally against major world currencies. Against Euro, the USD has gained from 0.62 to 0.74 - 19 percent rise in last six months. Similarly against the Indian Rupees (IRs), the USD has gained from 38.40 to 48.53 - a whopping 26 percent increase in last one year. Since the Nepali Rupees (NRs) is pegged to the IRs, the USD has also appreciated substantially against our national currency - from a low of NRs 63.5 in January to NRs 77.75 on Oct 17.

Against the Japanese Yen, the USD has mixed fortune - while the USD appreciated against Yen for the first half of the year, it fell during the recent global financial crisis as international investors and speculators started buying Yen to unwind their carry-trade position. The fall of Euro against the Yen further underscores the point that investors worldwide are unwinding their carry trade position. In the light of recent global financial crisis and liquidity crunch, the rise of Yen is understandable as international investors currently don't find carry trade's prospect attractive.

One of the major reasons for the recent rise of the USD against currencies of emerging market like India and Brazil is increasing level of risk aversion among international investors. For major part of this decade, Foreign Institutional Investors (FII) had been pouring money into high-growth emerging markets such as Brazil, Russia, India and China (so called BRIC countries). The unprecedented level of capital inflows into these countries led to the appreciation of their domestic currencies against the USD. However with the recent global financial crisis, major FII such as hedge funds and mutual funds are liquidating their position in these emerging markets and selling their foreign assets for the USD. It is worthwhile to note that the decline of the IRs against the USD, which started roughly a year ago, tentatively coincides with the unraveling of the mortgage crisis in the United States. In India, the recent wave of selling in Bombay Stock Exchange (BSE) has been predominantly led by the FII. According to a Securities Exchange Board of India's (SEBI) report, the net FII outflow crossed USD 1 billion during the first half of September. With the continuing volatility in the global market and the existing uncertainty about global financial system, it is plausible that major FII will stay away from the emerging markets like India for a while.

The larger question amidst all these recent fluctuation in the dollar value and the ongoing global financial crisis is the long term future of the USD. Though the greenback has risen substantially in recent months, to understand the contours of the USD in future one must analyze the fundamentals that influences currency value in the long run. Following are few facts and observations that might help one understand the course of the USD in coming days. The US economy is headed for a recession. How long and how painful the downturn will be depends on how soon the credit crisis eases and how early banks start lending to businesses. However, irrespective of the length and the breadth of the downturn, the image of the US economy will receive a severe battering in months and years to come. Henceforth there are two dangers to USD from this front. First with a dwindling economic growth rate, the USD will see its value decline because the long run value of a country's currency is tied to its economic growth. Despite the current financial crisis, the overall prospects for countries like India, China and Brazil are still bright and they will continue to grow at a much healthier rate than US economy in coming years. Hence their currencies should, in theory, appreciate against the USD. Second danger comes from a potential undermining of the image of US economy and its financial system. When the US economy last went to recession in 2000-2001, the USD held its ground against other currencies because foreign investors continued to buy US assets. At that time, United States was still regarded as, according to international finance expert Catherine Mann, "an oasis of prosperity" because of its high productivity and ability to innovate. However, because of the ongoing global financial crisis, which has its root in the United States, the image of US economy and its financial system will be tainted.

Furthermore, the recent surge of greenback doesn't bode well with the argument that dollar needs further weakening to manage high level of current account deficit in the US. As early as January 2007, weak dollar advocates and respected economists like Martin Feldstein and Kenneth Rogoff argued that the USD needs to decline by 8 to 25 percent against other currencies to manage the spiraling current account deficit in the US. The depreciation of the dollar in first half of 2007 was seen as a right direction - one that could help bring down the US current account deficit to more manageable level. However the recent rise of the USD could further strain the US current account deficit, which stood at approx USD 740 billion for the year 2007. With a weakened economy and decreasing consumer confidence, US imports is expected to fall substantially in coming months. However, the stronger dollar coupled with a weaker global economy will hurt US exporters more and is expected to further widen the US current account deficit.

Another aspect is the monetary policy of the Federal Reserve "Fed" of the United States vis-à-vis actions of other central banks. The recent rise of the USD is noteworthy when we compare the difference in interest rate policies of the Fed and other central banks during the first half of 2008. When the Fed started cutting interest rates in early 2008, central banks in Europe and emerging market were raising rates to tackle inflationary pressure. For example, during first half of 2008, the Reserve Bank of India (RBI) raised interest rates while the inflation-hawkish European Central Bank (ECB) avoided rate cuts because of rising inflation figures. In a normal scenario the USD should have lost value against the Euro and IRs. But the recent crisis and the massive capital flow across the globe have undermined normal economic linkages. With oil prices coming down sharply, inflation is expected to ease in coming months. Already the central banks around the world have cut interest rates to ease the liquidity problem. These rate cuts around the world should help the USD to maintain its recent gains.

Overall, despite the recent gains, the future of the USD depends on the health of the US economy and its ability to attract foreign investors. Both aspects seem vulnerable right now. The recent USD 700 billion bailout plan of the US banks has put additional pressure on the mounting level of US national debt, which stands over USD 10 trillion. This rising national debt level undermines the future of the USD because emerging doubts about the US debt level could spur selling off of dollar reserves in China, Russia and India, whom hold over trillions of dollars as official reserves.

Published on The Kathmandu Post October 23, 2008

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