An important concern is the future of the dollar. The value of the dollar has been falling since March, and it has lost around 15% against all major currencies. This is partly due to the near-zero short-term interest rates that make investors borrow cheaply, then sell them to buy currencies of countries whose stocks and bonds promise better returns. Another force driving down the dollar is the continued US trade deficit. The question is whether the decline is part of a cyclical adjustment, or whether we are witnessing a major structural change.
Economists here and even overseas argue that in the long term, a continued fall in the dollar would not happen. While a cheaper dollar would help US exports and foreign tourism, it would make imports costlier, and given the current account deficit, there would be significant inflationary pressures. Abroad, other nations would find it more difficult to export to the US, hurting their growth. Several economists argue that this will self-correct, and that the dollar rallied strongly in the worst of the economic crisis. They point out that simple monetary correctives could reinfuse faith in the dollar. Further, a weaker dollar would make Americans poorer by cutting their purchasing power, which would be unsustainable as a policy.
There are, however, experts who point out that we are perhaps witnessing a major structural shift in the value of the dollar. They point out that while US current account deficit is shrinking due to better exports, there is no let-up in the fiscal deficit. Further, the Fed budgetary figures published every Friday indicate that the Fed’s liabilities are continuing to grow week after week. During the last eight weeks, there has been an investment flow of at least $500 billion into emerging markets, as investors flee the dollar. US currency in circulation is growing every week as deficits are getting monetized, and this adds to the pressure on the dollar.
The worry is that the bearish case for the decline in the dollar takes on a life of its own—already, several central banks that attempted to defend the dollar are diversifying their foreign exchange reserves into other currencies. Even though China is keeping the stock of dollar reserves the same as before, there is a distinct decline in the addition to stock as it diversifies into physical stock of commodities and other currencies. China is also increasingly using its currency as a currency of trade, and the Chinese banks operating in Indonesia, Africa and South-East Asia are using export letters of credit in Chinese currency. China perceives US policy as a well-calibrated strategy to push its fiscal problems to the rest of the world.
The impact on the Indian economy of a crash in the dollar would be quite severe. The economic outlook published last week indicates a trade deficit of nearly $120 billion for the current year— this would grow as export earnings in dollars decline, and as imports become cheaper. Commodities will cost more. Invisibles flow would be worth less. There would be significant flow into secondary markets, without the necessary fundamentals, creating an asset bubble once again. As flows increase, the Reserve Bank of India (RBI) would attempt to sterilize through market stabilization bonds that would worsen the fiscal deficit. If we think of the dollar at Rs35, then exports would collapse. Already, our debt papers are costing 400-500 basis points above the London Interbank Offered Rate (Libor)—China’s are 100-150 basis points—and this would get worse.
Several countries are already planning disaster mitigation strategies. In the case of China, it includes reduction of additional exposure to dollars, converting trade and aid into its own currency wherever possible and to attempt to pass on the impacts of the bubble to other emerging economies—most notably India and Indonesia, which are growing, and are significant importers. I am not sure whether RBI and the finance ministry have similar strategies—they appear rather to be expecting to manage through currency support measures, which will possibly fail this time.
There are alternatives that we can adopt. One would be to ensure that accretion to reserves is parked in currencies other than the dollar—say, the euro, which is strengthening, or the yen. Another approach would be to look for exports in currencies other than the dollar—China is introducing its own currency in several markets, which we may not be able to do, but we should explore euro and yen trade areas. For example, trade with Singapore could well be switched to Singapore dollars—a currency that is likely to remain strong. We could even consider China trade in renminbi. Third, this is the time to use dollar funds heavily to invest in infrastructure projects—increase our dollar liabilities, in effect, go short on the dollar. Fourth is to invest in purchases of commodities—increase our strategic stocking. Of course, there is the alternative of allowing the currency to float—an alternative unlikely to be politically acceptable.
It would be short-sighted for RBI and the finance ministry not to have a strategy for a dollar crash and to assume that cyclical trends will prevail.
S. Narayan is a former finance secretary and economic adviser to the prime minister. We welcome your comments at firstname.lastname@example.org