Greenback's comeback

A year ago, skeptics of United States Dollar (USD), were talking about alternative to USD as a global reserve currency. Due to the slide of the USD, which has been a default reserve currency over the last 60 years, vis-à-vis Euro, Sterling Pound and other emerging market currencies during 2004-2007, dollar skeptics were questioning the viability of the USD as a global reserve currency. Because of their huge dollar reserves, China and Russia, two of the largest holders of USD reserves, were floating the idea of introducing an alternative form of global reserve currency to diversify their foreign currency holdings and protect their respective foreign reserves wealth amidst declining USD. In the United States, officials were concerned that if the central banks of countries with huge dollar reserves start selling dollar, then it would lead to huge decline in USD and undermine dollar’s role as global reserve currency. The tables have turned now and how!!! Since the start of 2008, the USD has appreciated by over 16 percent against the Euro and by over 23 percent against the Indian Rupees (INR). In 2009 alone, the USD has appreciated by over 9 percent against the Euro and by over 7 percent against the INR. And this is in spite of that fact that US economy is crippled with soaring unemployment, projected budget deficit of USD 3 trillion over the next two years, and total debt of over USD 10 trillion.

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What’s leading to dollar’s rise?

Massive economic contraction around the world:

Due to the ongoing economic crisis, major economies all over the world are contracting sharply. According to a recent Bloomberg report, Japan’s economy, second-largest in the world, tumbled 3.3 percent in the fourth quarter of 2008 from the previous one, while Germany contracted a seasonally adjusted 2.1 percent and the economy of euro area shrank 1.5 percent during the last quarter of 2008. Meanwhile, the International Monetary Fund forecasts the U.K. economy to contract by 2.8 percent this year. Though the US Gross Domestic Product (GDP) contracted by more than 6 percent during the fourth quarter, because of high economic uncertainty, investors are pulling away their money from risky assets in developed countries and emerging markets and investing in relatively safe US treasuries. This is reflected in the yields of US Treasury bonds, which have come down significantly during last one year, due to high investors demand for these risk-free securities. Reports from Indian also suggests that Foreign Institutional Investors (FII) have with withdrawn more than USD 2 billion in 2009 are taking home USD 13.5 billion in 2008.

Narrowing inter-country Interest rate differential:

One of the sources of the last dollar slide was high interest rate differential in United States and other major economies around the world. During much of last five years, interest rate in United States has been relatively low compared to rates in other countries. However, due to the current contractionary pressure, central banks around the world have been cutting interest rates drastically to stimulate the economy. In July 2008, according to Bloomberg, the European Central Bank’s (ECB) borrowing costs were 225 basis points more than the Federal Reserve’s federal-funds rate and the Bank of England’s benchmark was 300 basis points higher. Other things equal, higher interest rates attract overseas investment and leads to appreciation of the country’s currency with high rate. Currently, rates in UK are only 75 points more than the respective rates in the US. Similarly, the ECB’s rates are only 175 points higher. The narrowing interest-rate differential has also helped the USD to gain against other currencies. Furthermore, given the current economic distress and possible deflationary risk, central banks around the world are expected to cut their benchmark rates, which will further help dollar in the short run.

Implications for domestic economy:

With the Nepali Rupees (NPR) depreciating vis-à-vis USD, in tandem with the depreciation of INR against the USD because of our fixed exchange rate system with INR, there will be implications for our domestic economy. Because of our weak currency, USD denominated imports will be expensive while foreigners will find our exports cheaper. If one assumes the “J-Curve” phenomenon then, in the short run, imports will cost us more while exports will sell for less leading to temporary worsening of our current account, which will reverse later as costly imports are expected to decline and exports to surge as effect of currency deprecation seeps into foreign trade. However, much of this depends on exchange-rate elasticities of our export and import products (For example, we will not drastically reduce our petroleum product consumption because of depreciating currency). Remittance income will increase as a dollar now is worth more in local currency. Though the global oil prices have come down substantially in recent times, we will not be able to enjoy low oil prices (to the extent in the international market) because the Nepal Oil Corporation (NOC) has to pay more, in local currency, to buy oil in international market. Furthermore, the USD denominated foreign loans and their respective interest will cost more.

Published on The Kathmandu Post on March 16 2009

Link: http://www.kantipuronline.com/columns.php?&nid=184846