The diminishing dollar and its consequences for our economy

The London Economist used to say before the financial crisis of last year that foreigners would tire of holding Dollars given the US’s gaping hole in its external account. It thought foreigners would move out of the dollar and send the dollar slumping. Fortunately, the dollar did not crash during the financial crisis.
In fact the opposite happened when the financial crisis began in the USA. The deeper the crisis became the more the dollar strengthened as fearful investors sought safety in the dollar. Between September 2008 when Lehman Brothers failed and March 2009, when US stock markets hit the bottom, the dollar rose by almost 13% on a trade weighted basis. But this made it impossible for the USA to take remedial measures to correct its external deficit by increasing exports. So the US and EU governments have been urging China to allow the Yuan to appreciate. From a long term perspective the US external deficit is unsustainable and it is worsening the global macro-economic imbalances. If these imbalances unravel the world would once again sink into recession.
So in recent weeks the dollar has been depreciating against all the other major currencies like the Euro, the Pound Sterling and the Japanese Yen. China since it pegs the Yuan to a fixed value of the dollar, does not allow an appreciation of the Yuan. A country’s exchange rate cannot be a concern for it alone, since it must also affect its trading partners. This is particularly true for big economies. So, whether China likes it or not, its heavily managed exchange rate regime is a legitimate concern of its trading partners. Its exports are now larger than those of any other country. But these currencies do not wish to see their currencies appreciate because it damages their exports. A similar situation in the 1930s led to competitive devaluations and ended in breakdown of the world multilateral trading system. Naturally, the Chinese resent the pressure exerted on them to appreciate their Yuan. At the conclusion of a European Union-China summit in Nanjing last week, Wen Jiabao, the Chinese premier, complained about demands for Beijing to allow its currency to appreciate. He protested that “some countries on the one hand want the renminbi to appreciate, but on the other hand engage in brazen trade protectionism against China. This is unfair. Their measures are a restriction on China’s development.” The Europeans would reply that the policy of keeping the exchange rate down is equivalent to an export subsidy and tariff, at a uniform rate – in other words, to protectionism too.
What is the impact of the dollar depreciation on us? We like China peg our currency to the U.S dollar at a fixed rate. Many economists argue that although this will benefit the consumers by keeping down the rupee equivalent of imported goods particularly food prices, yet the policy is not sustainable given the high inflation which prevailed in the years 2006-2008. During this period the Rupee became over-valued and no attempt has been made to correct for it by pegging the Rupee at a lower rate for the dollar. Recently there was a massive wage increase in the tea plantations. This has pushed several tea plantation companies into the red, judging from the third quarter results of the listed companies released so far. What is the alternative to a depreciation of the Rupee. The government cannot give export subsidies as its too cash strapped and also has to keep to the IMF targets for the budget deficit and for domestic borrowings. So are we not distorting our domestic economy by pegging the Rupee to an unfavourable rate of exchange, harmful to exports? It is not possible to improve productivity on the tea plantations as suggested by some. The only other way is to reduce workers real incomes by allowing prices to rise again. Inflation was brought down partly by the fall in private sector credit draw-off, partly from the stability of the Rupee and partly from the fall in world food prices. Fortunately there are no signs that the oil price will go up. But with the revival of the developed countries a commodity price rise is predicted by analysts. They also predict a rise in oil price next year. So we cannot afford an attitude of business as usual.
As for the dollar we find that it has a special status as a safe haven. But when the dollar weakens the price of gold goes up. So central banks in several countries have diversified their Foreign Exchange Reserves by moving into other currencies or gold. The Central Bank has bought 10 tons of gold from the IMF. But gold does not provide a return until it is sold and a capital gain realised. Critics point out that our Official Foreign Reserves are borrowed not earned. Although the Central Bank doesn’t incur any cost when it buys Dollars for Rupees in the local market and uses them to buy gold yet since the Dollars came into the bond market the country as a whole has to pay interest on these bonds while not getting any return from investing them in gold.
But what about our external deficit? The Central Bank has reported a current account surplus as likely for this year. But a current account surplus is benign only if the goods required for private sector growth have been imported. But because the economy is still in recession we cannot say the current account surplus is benign. To say that we must wait for the outcome of the recovery of growth next year. Our concern is how to lower fiscal deficits without tipping the economy back into recession. That will be impossible unless we are either able to restore the private sectors spending and borrowing as before, or if enjoy rapid expansion in net exports. Of the two, the latter is the safer route to economic health. But that in turn, will only happen if surplus countries expand demand faster than potential output. So our economic health depends on the recovery of the global economy.