Dollar redux

Europe and Asia's woes strengthen the greenback

What a tangled web the global financial markets weave! Just as investors and policymakers were getting set for a sustained decline in the US dollar, the gritty greenback seems to be staging a comeback. Dollar strength by definition means weakness in non-dollar asset markets. Thus, if current trends continue, 2011 could see sentiment towards emerging markets like India ebb a little and bullishness on the US and the dollar surge. A number of things seem to drive this reversal in the dollar’s path. For one, the US economy seems to be on a faster track to recovery than was anticipated earlier and may grow at 3.2-3.3 per cent this year and 3.5 per cent or even more in 2011, helped by the Obama administration’s recent fiscal measures.

Eurozone’s fiscal woes, on the other hand, seem to be getting worse and the fear of sovereign default by Spain, a European heavyweight, seems to intensify. Credit rating agencies are fuelling these fears. Moody’s lowered Ireland’s government bond ratings by five notches last week and now threatens to downgrade Spain’s government debt. Financial markets have been wary of Europe for a while now. What they perhaps weren’t quite prepared for is the dismal economic news coming out of Asia. East Asian economies have been rapidly decelerating over the last few months and are likely to slow down further in 2011. Researchers are predicting a relatively tame 7.5 per cent growth in emerging Asia for the year compared to about 9.5 per cent in 2010. Much of East Asia remains fairly export-oriented and dependent on western economies for demand. Despite growing intra-regional trade, a much larger share of final demand for exports (close to 50 per cent going by recent ADB estimates) comes from the developed markets of the West.

Sluggishness in western economies and appreciation in Asian currencies seem to be taking their toll on growth prospects. China continues to grapple with high inflation and is likely to step up the pace of monetary tightening in 2011. Most researchers seem to predict a palpable slowdown next year with the growth rate likely to drop by a percentage point and a half or perhaps even two percentage points. Most Asian economies are struggling with primary product inflation and despite slowing growth, their central banks might be forced to hike interest rates further and compromise growth. In short, while the US seems to be recovering faster than expected (potentially raising the attraction of dollar assets), the sheen seems to be coming off alternative assets, particularly in the Asia-Pacific markets. In this environment, it might not be entirely surprising to find the dollar overcome the drag imposed on it by easy liquidity created by the second round of quantitative easing (QE II) and actually gain against the bulk of currencies. Thus, cheap dollars created by the Fed might get invested in the US market itself and not chase returns in offshore markets. The currency might not gain just as a “safe haven” currency in episodes of risk-aversion. We may find, yet again, that it is too early to write the dollar’s obituary.