Topic: Article
Contrary to what many believe, the dollar depreciation will hardly see the global imbalances get better
First hit – a buy order for an overseas fund goes through. Second hit – long positions on Gold futures and Gold ETFs is ensured. And a last hit to add some foreign currencies to the portfolio. Well, this seems to be one of the off -beat workouts being performed with amazing perfection and haste, across many trading terminals, as the dollar continues its free fall. Now, everybody is scampering for a hedge against the dollar and the question whether the dollar downfall trend will continue or reverse in future holds tremendous significance. Many vouch for the fact that the dollar will and should fall for the global imbalances to balance out. Well, perturbingly, reality begs to differ! What is happening recently is proving all the dollar doomsayers right. Over the past few days dollar has slipped against major currencies at a pace that would push the greenback to oblivion in no time. The dollar fell to $1.97/pound against the pound; a level that’s 23% down compared to January 2006 levels and has never been seen in the past 14 years. Similarly, the dollar against the euro plunged to $1.33/euro, which was at a 20 month low. And this inhospitable situation of the dollar has been a courtesy of some dedicated mismanagement of the US economy. According to Naomi Fink, Currency strategist, BNP Paribas “Support for the dollar has fl own in the face of a continued deterioration of US fundamentals.” It’s not only about debilitating deficits today as growth woes are taking toll on the dollar. With housing continuing to lose steam, a screeching halt of the economy is getting more and more predictable. The NAHB/Wells Fargo Housing Market Index has fallen from 57 points in January 2006, to 33 in November. Moreover, the manufacturing sector is also showing signs of slowing down. The PMI index, which measures manufacturing activity in the economy, published by Institute of Supply Management fell below 50% to 49.5% for the first time since April 2003.Going by the fact that a falling dollar will help in balancing out the imbalances is not appealing as it would have been in the past. Today we live in a globalised era and the curtains have come down significantly between economies and markets are far more deregulated. And this has narrowed the scope for correction in the trade balances through an exchange rate window. Conventionally, a depreciation in the dollar would help American exports and make imports costlier (discouraging imports) thereby, bridging the trade gap. But in the present context depreciation in dollar would hardly affect imports today as pricing power of producers have fallen significantly due to commoditisation. So, we generally do not experience any shock due to depreciation of currency thereby imports stay unfettered, subsequently having a minimal corrective effect on the current account balances. And if at all such a thing has to happen, then it would require the dollar to fall more than what it should have in the past; and this variation which is not considered might be quite high and bring the whole global financial system to its knees. Well, there can be a less violent solution to this imbalance problem.
Moreover, the dollar depreciation against the euro and pound would never address the global current account imbalances. If we look at the US deficits, to a large extent it reflects the surpluses of Asian economies. Interestingly, there hasn’t been any marked depreciation of dollar against the major Asian currencies. Rather, major Asian currencies like the yen and the yuan have actually depreciated by 0.8% and 2.9% respectively, against the dollar during the same period (Jan 03, 2006 – Dec 01, 2006). So, till the time dollar doesn’t depreciate against the Asian currencies, hoping the imbalances to improve is actually being too optimistic. And as far as the current course of the dollar against the pound and the euro is concerned, the chances that this depreciation would continue for long also seems quite unlikely. First of all today many developing countries have locked their reserves in dollar and they won’t let the dollar to depreciate for the sake of their own reserves. Secondly, there are vested interests of other countries to keep their own currencies down against the dollar in order to support their own exports. Many argue that interest rates are rising elsewhere and Fed has stopped, which is driving this depreciation. Furthermore, a look at the interest rate differentials, which is currently 2% between US and Europe, shows that the dollar is as attractive as it was in the past. Well, for the imbalances to improve, fiscal discipline – cutting expenditures and broadening the revenue base – on the part of US is a more desirable option and of course, a less costlier one, rather than a dollar depreciation.
