FE Editorial : Dealing with dollar

Jan 01 2009, 00:56 IST
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SummaryFinancial instruments were the most important question of 2008. Currencies could well get that ‘honour’ in 2009. And the two most important questions for India, of course, are: what will happen to the US dollar, and what will happen to the Indian rupee.

Financial instruments were the most important question of 2008. Currencies could well get that ‘honour’ in 2009. And the two most important questions for India, of course, are: what will happen to the US dollar, and what will happen to the Indian rupee. The dollar presents a paradox. The US was the epicentre of the crisis. Yet, massive capital flows came to the US in the aftermath of the crisis, driving up the dollar to unprecedented levels. These were related to a ‘flight to quality’. Investors worldwide were uncomfortable with holding credit risk and chose to buy US government bonds, driving down the interest rate on the 90-day treasury bill in the US to zero. In 2009, that flight to quality is likely to subside. Already, there are many signs of stabilisation in the financial system. The VIX, which measures the uncertainty of the S&P 500 index, has dropped by almost half to levels which would be considered high but not unbelievable in 2007. The 90-day Libor has dropped to 140, reflecting greater comfort on the part of the financial firms about each other. Interest rates in the US have dropped dramatically. Investors are itching to get out of US government bond investments. Once the panicked flight to quality is out of the picture, will money leave the US? While this is likely, it is important to keep the gloomy picture for the rest of OECD in mind. In continental Europe, Japan and the UK also, growth prospects are gloomy. In dollar terms, these countries would have normally absorbed very large investments; the paucity of investment opportunities there thus leaves spare capital in the world economy.

The US (and the UK) has a big edge when compared with continental Europe in supporting entrepreneurship, immigration, a hire-and-fire culture on the labour market and thus the rapidity with which the downturn will be absorbed. The only sparks of optimism, other than the US, are some emerging markets like China and India. But in dollar terms, these cannot absorb large amounts of capital. Hence, there is a good possibility that even after the financial panic has subsided, the strength of the dollar may continue, owing to weaknesses in other OECD countries. As a side effect, the strong dollar adversely affects the ability of American firms to export to the rest of the world, and complicates the recovery in the US.

Turning to India, there

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