The dollar?s slide: an unsettling campaign

Last fortnight this column sought to deconstruct what the policy prescription might be to fix the great imbalance?the US current account deficit?and had concluded that a sustained tightening of monetary conditions in the medium-term was likely to persist. And by extension to much of the rest of the world, insofar as it would define the backdrop of monetary policy worldwide. We had begun with the G7 statement of

April 21 and gone on to discuss Chairman Bernanke?s testimony to the US Congress some days later. But for want of space, we had not dwelt on the other leg of the management issue?namely exchange rates.

The G7 said it reaffirmed that ?ex-change rates should reflect economic fundamentals. Excess volatility and disorderly movements in exchange rates are undesirable for economic growth. We continue to monitor exchange markets closely and cooperate as appropriate. Greater exchange rate flexibility is desirable in emerging economies with large current account surpluses, especially China, for adjustments to occur.?

What those ?economic fundamentals? are is perhaps crystal clear to the enlightened political leaders of the developed world, though perhaps less so to lesser mortals. But the second part, on countries with ?current account surpluses? to undertake ?necessary adjustments,? is clear. The need to ?reaffirm? rested perhaps on some unpublicised understanding in the February 10-11 Moscow meeting, the official communiqu? of which was pre-occupied by things like avian flu, energy security and terrorist finance.

In any event, exchange rates made a great about-turn in the week ending February 17, 2006. Since the low point of the US dollar at the end of December 2004, exchange rates while following their usual meandering course had moved inexorably to push up the dollar. Between December 31, 2004 and February 17, 2006, the euro had gained 13.7%, the yen 15.3%, the British pound 10.1%, Swiss franc 15.0% and the Australian dollar 5.7% The Swedish, Norwegian and Danish currencies also followed suit.

During this period?that is, 2005 and early 2006?the US current account deficit continued to expand. In the face of relatively much stronger economic outcomes in the US, and the sharp increase in US interest rates, the greenback could not be kept down.

However, some currencies did gain vis-?-vis the US dollar even during this period of general dollar strength?Canadian dollar (4.3%), South Korean won (6.1%), Chinese yuan (2.7%), Malaysian ringgit (2.0%), Mexican peso (6.3%) and Brazilian real (20.3%). Malaysia had come off the fixed peg on July 21, 2005, and in Canada, both the economy and government finances are getting stronger. The currencies of Brazil, Mexico, South Korea and China were responding to their current account surpluses?the Latin Americans in a fashion that matched their schooling, China quite reluctantly and Korea somewhere in between.

Since February 17, 2006, all currencies seem to have locked step against the host of the great imbalance, even those with sizable current account deficits like Britain. Between February 17 and April-end, the euro gained 5.7%, yen 3.9%, British pound 4.5%, Swiss 5.4% and Australian dollar 2.7%. The Scandinavian currencies rose by even more, with the Norwegian krone up by 8.9%. Korean, Canadian, Malaysian and Brazilian continued to rise by 1.3% to 3.0%, while the Chinese currency moved up in a characteristic micro-step of 0.4%. The Mexican peso was unable to keep up and lost 6% against the dollar. New currencies however joined in, and they included the Singapore dollar (3.2%), Thai baht (4.6%) and Taiwan dollar (1.5%).

Up to May 12, the march continued with the euro up 2.0%, yen by 2.9%, pound by 3.7%, Swiss franc by 3.2%, Australian dollar 1.7% and the Scandinavian currencies up by 1.3% to 2.4%. The currencies of Korea, Canada, Malaysia, Singapore and Taiwan also kept up the good work and the Chinese yuan moved up by 0.1%. The huge sell off in Brazil?s stock markets last week has caused the currency to drop vis-?-vis the dollar and the baht also slipped a bit.

There is still a long way to go if that is the way the great imbalance is to be set right and balance restored in the world. Already the global dollar weakness is causing plenty of collateral damage, and the worldwide sell down in equity markets last week is being placed at the door of this campaign.

A leading international financial newspaper on its front page quoted an investment banker working with an institution believed to have been associated with the family of President Bush, ?precisely what officials feared would happen from the large global imbalances is now taking place in reaction to their clumsy attempt to ?fix the problem?. Volatility in the capital markets is rising. Global equities are tumbling.? The ?clumsy attempts? surely pertains to the currencies? lock-step march.

Whether fixing the current account deficit of the US is an urgent global need that needs co-ordinated action by officialdom is another issue. As long as there is huge excess demand in the US, net suppliers to that economy are willing to hoard IOUs, and there is little choice in the market for reserve assets, the problem will remain. Common sense informs us that for a problem to be fixed, the source has to be attended to?namely the excess of domestic demand in the US and its low rates of savings.

There is nothing wrong in the old prescription?fix government finances and raise interest rates, thereby curbing domestic demand. Working on current account surplus countries to adopt exchange rate flexibility is a good idea, for that is the only means to achieve an outcome similar to unilateral devaluation. But this is a second-order issue. If nothing is done on the primary problem, merely working on exchange rates will cause plenty of pain with very little gain.

?The writer is economic advisor to Icra