The dollar dilemma

The euro is the best alternative to the dollar, but its rising strength is posing a problem for Europe.

The credit market is not the only thing worrying central bankers right now — so is the external value of the dollar, which recently fell as low as $1.50 to a euro. At its lowest, the euro was worth just 83 cents (October 2000); from that point, it has appreciated about 80 per cent, and is currently even higher than the all-time peak of the legacy German currency, the Deutsche mark, at DEM 1.35 (April 1995). The dollar has also fallen sharply against the currencies of other major trading partners like Canada and Britain, but not very much against the two major Asian currencies, the Japanese yen and the Chinese yuan. The yen has strengthened as a result of the unwinding of carry trades, but remains susceptible to the extremely low domestic interest rates persuading residents to invest abroad in higher yielding currencies. The yuan continues its deliberately slow, managed appreciation, so as to keep the economy competitive and increase employment opportunities.

The dollar’s movements against individual currencies apart, its steady depreciation in recent years in trade-weighted index terms was perhaps inevitable given the huge and unsustainable deficit on the current account. From its peak in 2002, the dollar index has dropped around 40 per cent and the result is being seen in an improvement in the current account deficit — from 6.5 per cent of GDP last year, it is likely to fall to about 4 per cent of GDP next year. This improvement, coming when the oil price remains near $100 per barrel, would suggest that at the current level of the dollar’s exchange rate, the US economy has become much more competitive globally and a further fall may not really be needed for bringing the external deficit down to sustainable levels. While this may be so, one should not forget that market prices are driven far more by liquidity (that is, demand and supply) than by fundamentals.

The big two Asian central banks (China and Japan), as also the central banks of the oil exporters, have a major interest in a stable to strong dollar. China’s reserves are within handshaking distance of $1.5 trillion and any further fall of the dollar would mean significant translation losses while measuring the reserves in any other currency. No wonder Wen Jiabao, the Chinese premier, told a conference in Singapore a couple of weeks back: “We have never been experiencing such big pressure...We are worried about how to preserve the value of our reserves.” (Presently, something like 65 per cent of the reserves held by central banks worldwide are in the US currency, as compared to 71 per cent five years back.) Successive US Treasury Secretaries have always claimed that a strong dollar is in the interest of the US; at a G-20 meeting in South Africa recently, the Chinese whole-heartedly supported the avowed American policy!

The OPEC countries, with their growing hoard, are not only worried about maintaining the global purchasing power of the reserves, but also about another factor: since the currencies of many of them are pegged to the dollar, the American currency’s fall is “importing” inflation in these countries since they import a lot of goods from Europe and other countries. To mitigate this problem, Kuwait has de-linked its currency from the dollar, and others are considering alternatives at a Gulf Cooperation Council meeting today. Political opponents of the US like Iran and Venezuela are actively advocating the pricing of oil in non-dollar currencies. Saudi Arabia, the largest OPEC producer and an American ally, is opposed to changing the pricing currency. However, for countries like Iran and Venezuela (and even Russia), the change would have obvious political attractions. The next big downward move for the dollar could well depend on this.

There is, of course, another imponderable: will central banks start diversifying reserves into non-dollar currencies to protect their value? Surely, the answer to the question has to be in the affirmative. However, it is most unlikely that the diversification would take the form of changing the present composition of the stock of reserves: done on any scale, even 10 per cent, this would surely precipitate a sharp dollar fall. Chances are, therefore, that the diversification would be achieved gradually, over a period, through investment of the fresh flows of reserves. In the present state of the global financial markets, the only possible alternative to the dollar, for holding a large amount of reserves, is the euro. The EU is a bigger economy than the US; the euro-denominated international debt issues now exceed those denominated in the dollar; and there is a deep and liquid bond market in the euro. But European economies are finding it difficult to cope with the existing strength of the euro; any further appreciation would surely worsen growth and employment prospects.