No Nonsense
Saga of the sagging dollar
The once mighty US dollar does not appear as mighty after all -- at least lately. From June 2002, the greenback has taken a nose-dive, tumbling nearly 65% against the euro (then, 1 EUR = $0.89, now 1 EUR = $1.48 ). The Canadian and Australian dollars have also gained steep increases versus the US dollar (approximately 55% and 72% respectively) over the past five years.
Why is the dollar falling so fast? What does this fall mean? Who gains and who loses as the buck sucks wind? Why isn't Washington thwarting the dollar demise? How does the dollar debacle affect Bangladesh?
The culprits are the huge twin deficits -- the growing US trade deficit, exports minus imports (September deficit was running at an annual rate of $703.4 billion, down 7.4% from last year's $758.5 billion, amounting to nearly 7.0% of the US economy), and the large Federal budget deficit ($498 billion or 3.6% of GDP).
The ballooning budget deficit is the result of President George Bush's promised tax cuts for the richest Americans and his war in Iraq.
Much of the trade gap has culminated from US commerce with China, Japan, and Korea. The Americans' yearning for "living beyond means" was financed by foreign debt -- and today, these countries together have amassed forex reserves of nearly $1 trillion -- much of it held in dollar denominated US Treasury bonds.
The typical economic prescription for correcting trade imbalances is to let the forex rate adjust downward, making exports cheaper relative to imports. But the Chinese yuan isn't market determined -- it's pegged to the dollar -- which makes the yuan and the dollar move in tandem, and Washington is pressuring China to revalue its currency.
Now the markets have began to enforce the law of parity, steering the US dollar down against major foreign currencies. This has made US goods cheaper in foreign markets, boosting exports and narrowing the trade deficit while punishing China and other currency manipulators.
For example, the US trade deficit for September dipped 0.6% from August to $56.5 billion. This resulted from a 1.1% boost in US exports, reaching a record $140.1 billion.
The trade imbalance with the EU countries dropped a sharp 37.1% to $6.4billion; with America's biggest trading partner Canada, it dropped 3.2% to $4.9 billion, while the imbalance with Mexico fell 9.3% to $6.3 billion.
The tumbling dollar may seem to be a panacea to narrow the trade deficit -- but it is fraught with risks and uncertainties, which is worrying the IMF and international financial markets.
The sharp fall in the stock markets, especially in Asia, is a response to this fear, making electronics and car manufacturers like Sony and Toyota especially vulnerable. And that, in turn, could affect the export driven growth of countries like China.
Additionally, the unabated dollar dive makes the dollar reserves of these countries vulnerable -- loss in value -- as do the yields on the US bonds held by their central banks. This vulnerability may force the governments and investors of these countries to sell-off many of their dollar holdings, inflicting a further unintended weakening of the dollar .
Can central bank interventions prevent all this? Not really -- not at all. Instead of eliminating market forces, interventions essentially hold them back.
The desertion of the Bretton Woods Gold standard and the fixed foreign exchange rate regime in 1973 for the freely-floating forex rates was motivated to avoid frequent forex market interventions while letting the market determine the value of a country's currency by the "law of one price" -- that is, equality of prices of all goods and services across national borders.
Any deviations from this paradigm will allow arbitragers to make profits by buying currencies from cheaper markets and then selling them where they are dearer.
This law of one price, when applied to currencies, is translated to the purchasing-power-parity (PPP) theory. As in the goods market, currency traders eliminate arbitrage profits by buying currencies where they're cheap and exchanging them where they're priced higher.
As an example, if $100 buys more goods in Japan when exchanged for yen than it does in the US, then currency traders will exchange dollars for yen until the dollar is depreciated enough to bring the currencies in parity. This process makes some currencies appreciate or depreciate against others.
Consider a case where PPP requires a devaluation of the dollar vis-a-vis the yen. Suppose, the US Federal Reserve (Fed) intervenes to foil it by buying or, better yet, persuading the Bank of Japan to buy dollars that arbitragers are supplying in exchange for yen. Since this intervention is necessary for relieving the underlying disparity, it doesn't impede the arbitraging.
Moreover, intervention not only requires intervening central banks to have large stocks of foreign currencies, it also imposes on them huge arbitrage losses when the intervention is overwhelmed by market forces and traders devalue the dollar.
The Fed's buying of dollars with yen cannot continue indefinitely. However, the Purchasing Power disparity can be remedied by any of the three options, (a) exchange-rate fluctuation, (b) reducing the supply of dollars relative to the supply of yen, and (c) inducing the Bank of Japan to increase its inflation of the yen.
The on-going fiasco with the dollar is reminiscent of what happened in the 1980s -- then it was the Japanese yen doing the threatening. The major industrialised countries worked in concert for a managed currency float under the Plaza Accord and succeeded in bringing the dollar to a stable and a more sustainable level.
This time, Washington is opting for the market to play it out, instead of initiating any interventions similar to the Plaza Accord -- possibly because of Beijing's past intransigence in revaluating its yuan to the market level. Besides, given the colossal size of the foreign currency markets today, it's uncertain and unlikely that central banks could repeat an effective intervention again.
Surprisingly though, the battered dollar, so far, hasn't dampened imports much. In September, imports rose 0.6% to $196.6 billion -- second highest on record. The deficit with China rose 5.5% to $23.8 billion, second only to $24.4 billion in October 2006.
Historically, currencies exhibit a six-to-seven year cycle of adjustments -- February 2002 seems to be the peak in the cycle. The easing of the dollar may still continue with the adjustment process that began nearly seven years ago.
The fallout of the falling dollar would boost inflationary pressures on countries which depend on imports, such as the US and Bangladesh.
That would worsen inflation in Bangladesh since many daily essentials such rice, wheat, edible oil and so on are imported. Domestic producers would also push up the prices of their produce to maintain price parity and affordability of imported goods.
Although, increasingly higher foreign remittances build forex reserves -- a much desired asset to avert financial crisis -- they fuel domestic inflation through their monetisation in local currency. Building such forex reserves through increasing exports wouldn't have such an inflationary effect on the economy.
One rewarding policy would be to use up a hefty amount of dollar reserves by importing industrial and agricultural equipment, power plants, and other heavy machineries from the US at current bargain prices, thus preserving dollars purchasing power in US markets. That would generate employment and income through increased production and exports -- thus setting a non-inflationary growth trajectory.
Dr. Abdullah A. Dewan is Professor of Economics at Eastern Michigan University.
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