A V Rajwade: The dollar's fall: Orderly or disorderly?

WORLD MONEY

The world has too much at stake to let the fall be anything but gradual.

After moving in a narrow range against major currencies for about six months, the dollar has recently fallen sharply against both the euro and the pound, and, to a lesser extent, against the Japanese yen. (There is a measure of stability over the last week or so.) The dollar's fall in the current year, has been orderly: it has dropped by about 12.2 per cent against the British pound, 10.7 per cent against the euro and 2 per cent against the yen (Friday morning). We could see more volatile markets in the coming weeks as traders, busy counting their bonuses, desist from taking fresh positions, and the trading volumes thin ahead of Christmas and New Year. (The recent fall began in thin trading around the Thanksgiving holiday in the US.) Currently, the currency, at $1.3286 to a euro and $ 1.9623 to a pound, is trading at a 22-month low (the all-time low was around $1.36) against the euro, and the last time we saw $2 to a pound was back in 1992.

For some time, the IMF tried to engage policymakers in the US, Europe, Japan and China to bring the ballooning US current account deficit, estimated to reach $ 900 billion in the current year (7 per cent of GDP), to more sustainable levels. (It is politically incorrect to refer to the problem as one of US deficit; the euphemism used is "global imbalances".) The root cause of the US deficit is in the savings investment imbalance in the economy; exchange rate changes may not do too much to correct it. But this apart, there are several factors which could lessen the demand for dollars in 2007:

Signs of a slowdown in the US economy, even as the prospect and growth rate in Europe and Japan improve. The currently prevalent inverted yield curve often presages recessions.

Several central banks, including those in Russia, Switzerland and the UAE, have announced that they would be diversifying their reserves, while others are perhaps already doing so on the quiet. The central bank most vulnerable to a sharp dollar fall is the People's Bank of China, with its trillion dollar foreign currency reserves.

Reversal of the yen carry trades. Based on confidence in the stability of the dollar:yen exchange rate, huge profits were to be, and have been, made by investors and hedge funds in the so-called "carry" trade "" borrow short-term yen, buy dollars and invest in dollar deposits or bonds. The economics is very attractive so long as the dollar does not fall, at least in yen terms. (The carry trade is perhaps the reason for the lower rise of the yen as compared to the euro and the pound.) On the other hand, once a dollar fall gains momentum, the carry trade will reverse, leading to a sharp appreciation of the Japanese currency. (This is exactly what happened in October 1998 when the rate moved from ¥135.53 to ¥114.82, in a matter of 16 days, an episode few of today's young traders would remember.)

The slowdown in the US economy may also mean that the US Federal Reserve would start easing money and dropping short-term interest rates, even though the Chairman's last comments emphasised his continuing concerns about inflation. Financial Times recently carried an article which argued "Falling US interest rates "" or the mere expectations of them "" tends to lower the demand for dollar, as investors seek higher returns elsewhere." This, to my mind, over-emphasises the correlation between interest rates and demand for a currency. Investors in the bond market actually gain by lower interest rates, which are also generally a bullish factor for the equity market. Again, few investors or speculators investing globally would be looking at lower or higher yields, by quarter or half per cent, to make more money! In any case, US interest rates are likely to remain higher than those in Europe and Japan, through 2007; long-term rates could even go up if central banks, which currently hold almost half the stock of US treasury securities, start diversifying reserves.

But this apart, an orderly, gradual fall of the dollar and the US current account deficit are obviously necessary for the world economy. A dramatic and sudden change would be particularly unwelcome to Asian economies, dependent on exports to the US for growth. Managers of reserves in the People's Bank of China, for instance, would also have the unenviable prospect of huge translation losses through appreciation of the domestic currency against the dollar, in the event of a disorderly fall of the US currency. Asian economies and central banks have a great deal at stake in nursing an orderly, gradual fall, permitting the necessary macroeconomic adjustments without a wrenching disruption of domestic economies. As the Americans have often reminded us, it is their currency, but the world's problem.

avrajwade@gmail.com