Dollar's fall

In the fast fluctuating forex markets, nerves of steel are prized. In recent months, more so. The gyrations in the forex markets now rival those in the more boisterous equity markets. And leading the volatility is the US dollar—the currency of the biggest economy in the world. The dollar has been on a yo-yo movement in the last year: appreciating almost 20 per cent at the height of the financial crisis, and since March, sliding almost 12 per cent against most currencies.

The current refrain in the forex dealing rooms is that the era of the dollar is over. An imbalanced world economy, where export-driven emerging markets funded the debt-fuelled consumption binge of the developed countries with their savings, is believed to have aggravated the financial crisis.

As the world economy moves slowly to regain equilibrium, currency markets are in flux. Till date the dollar has had a favoured status of the world’s de facto reserve currency. That essentially means central banks across the world stock up their reserves in dollar-denominated assets because they like the liquidity and depth of the US markets. Invoicing of global commodities such as oil, therefore, is also in dollars. In recent weeks, both the International Monetary Fund and the Gulf oil producers have aired thoughts on alternatives to the dollar, sending the greenback into a tailspin. But what has prompted this crisis of confidence in the currency on which the world still relies heavily?

The immediate trigger for the weakness stems from the near-zero US short-term interest rates. Implemented with the intention of jump-starting the economy, these low rates have made the dollar the new funding currency of the world, replacing the yen. Simply put, investors borrow in the US dollar, exchange them to buy risky, higher return assets across the world. Notice the near simultaneous rise in equities the world over.

The impaired fiscal situation of the US does not help. Indications are that the US fiscal deficit will climb to 13 per cent of Gross Domestic Product this year. And the US will need foreign funds to support its enlarged balance sheet. Is it a one-way bet on the dollar then? Says D. Joshi, Director and Principal Economist, CRISIL: “It will be a hard, rocky road ahead.”

That is also because there are no viable alternatives yet. “A global reserve currency should have high liquidity, be a store of value, and should be able to see high fresh issuance of debt. So, despite the rhetoric, the US dollar will continue to remain important,” says Indranil Pan, economist with the Kotak Mahindra Bank.

In any case, a depreciating dollar does not really suit anyone. G-7 economies, many with significant exports, could see a rapid appreciation of their currencies as a result, which could dampen their recovery prospects. Also, central banks holding dollar-denominated assets cannot abruptly move away from the dollar since that will impair the value of their existing dollar assets. Plus excessive dollar depreciation could lead to a surge in commodity prices, raising inflationary pressures.

Economists believe pullbacks in dollar value would coincide with indications of reversal of the policy stimulus. As economic recovery remains feeble, those signs are still a few quarters away. Equity market corrections and mounting risk aversion could also lead to the unwinding of the dollar-carry trade, strengthening the greenback.

Shivom Chakravarti, HDFC Bank economist, adds: “It is in the interest of other major economies to talk down the prospects of the dollar losing its prominence at least till the global economy is on course for a full-fledged recovery.”

However, the long-term trend for dollar weakness remains intact, which broadly translates into a strengthening Indian rupee. Kotak’s Pan believes the rupee could appreciate to 44.50-45.00 against the dollar by end-March 2010 (at the time of writing, the rupee was at 48 against the dollar).

Rupee appreciation would not necessarily be a bad thing, despite exporters hurting. Imports will become cheaper, and global capital flows will increase, which will be attracted as much by India’s stable growth story as for the appreciating currency which improves their returns.

However, “India will have to improve its capacity to absorb these capital flows as also put in place suitable regulations,” says CRISIL’s Joshi. Read: faster financial sector reforms coupled with sharper oversight. Who said shifts in power are easy?

As a recent Standard Chartered Bank report on “Global Imbalances” sums it up: “The dollar’s days may be numbered. Yet, the death of a reserve currency can take a long, long time.” In the interim, nerves of steel are sorely needed.

Wordsmith (new words in business)
Rurban

What: A space that incorporates both rural and urban characteristics — a person or a setting that is rural but with urban aspirations.

Why now: With business seeking fortune at the bottom of the pyramid and aspirations of rural and urban consumers getting less distinct, addressing the Rurban customer is the challenge.

Usage: As companies in India move to rural territories to expand their business—whether it is mobile phones for rural folk or real estate in small towns–the ‘rurbanites’ are rural folk who enjoy some advantages of city life. As a recent article in a national daily pointed out, though: “Rurban development will measure up to its name only when villagers can access all urban amenities without moving out of their villages.”