The pace of the dollar?s slip and slide will quicken in coming months. Expect a further 10-15% devaluation of the greenback to come. This may help to take the edge off inflation in India but it will pose problems for rupee-based exporters competing against, or selling into, the dollar area, and of course China is a de facto member of the dollar area. The trigger for the latest round of dollar weakness will prove to be recent comments from Fed officials suggesting that they are not worried about dollar weakness. And while Fed chairman Ben Bernanke has tried to offset this impression, the markets always start off from a position of scepticism about the ability of policymakers to do anything. The question on traders lips is what can the Fed do about a falling dollar? Would it raise interest rates with the economy still mired in recession? Traders will conclude that this is unlikely and push some more on what they see as an open door.
Indeed, the clear impression is that the US wants a weaker dollar. Monetary policy is deliberately loose. Commentators chastise President Obama for not insisting on a dollar devaluation versus the renminbi during his recent Asia trip. We have often argued in this column that the US authorities?looking to appease their angry, relatively youthful, indebted voters, who are busy trying to rebuild their balance sheets from the drop in house prices?will opt to take risks with inflation rather than growth. A 12% deficit-to-GDP ratio and the brushing off of dollar worries are a testament to that.
The first rule of foreign exchange is currencies will go to that point which provokes a policy response. When US officials say they are not worried about dollar weakness, the dollar will fall until they are worried. The lesson for sceptical traders is that all of the turning points of the dollar in the past, 1985 (Plaza accord), 1987 (Louvre accord), 1992 (EMS crisis), 1995 (Tequila crisis) and 2002, are defined by points of policy intervention. On each of these occasions, dollar weakness or strength had reached a point of market or economic dislocation where the US and other countries were united in trying to stop it.
When Fed officials say the US is not overly concerned about a weak dollar, it reminds me of the late and first ECB president Wim Duisenberg explaining in 1999 that as the euro area was a more ?closed? economy than individual European countries?because of the heavy intra- European trade?he was not overly worried about the weakness of the euro. The foreign exchange market took the euro down until he was worried. The ECB, US Fed and others engaged in co-ordinated intervention to stop its slide in 2002. Where will the euro?s peak be? Where is the point of pain that will provoke the ECB and the Federal Reserve being provoked into a monetary policy and intervention response? This is relevant to those outside the US and Europe because the euro is the main counterpart to the dollar in foreign exchange markets and so the euro?s peak will coincide with the dollar?s trough.
In looking for this point of pain, a young economist may start off by examining trade elasticities and the euro area?s current account position. The euro area does not have a large current account deficit?though to be fair this is an average made up of big deficits in Spain and large surpluses in Germany, for instance. But the point of pain, like almost all issues in economics lies along a political nerve. The pain that matters is that being experienced by voters, and this is better summarised by the level of unemployment in the mix of countries that carry weight at the ECB, than anything else. Given the already high level of unemployment caused by the fall-out from the global financial crisis, this point of pain is probably closer to current exchange rate levels than it would have been before the crisis. I would hazard a guess that this point of pain is above $1.70 for the euro, just shy of 15% away. Assume a similar appreciation of the rupee. Although the rupee is a managed currency, dollar weakness will be associated with strong capital inflows into emerging markets and RBI will find it a heavy challenge to get the right balance between internal and external stability. That said, RBI is no stranger to challenge.
Why do exchange rates do that? Why do they act like a vindictive creature moving to points of pain? The best explanation I can give after a lifetime of personal experience in the currency markets is that the fundamental forces that act upon exchange rates to push them towards fundamentally sustainable levels are weak, and so the market is dominated by short-term players, which makes the forces of momentum strong.
The author is chairman of Intelligence Capital Ltd, chairman of the Warwick Commission, and member of the UN Commission of Experts on Financial Reform
