From the third quarter of 2008, the dollar, which was sliding against almost all currencies, suddenly found itself on an escalator. Policy mechanics, and not market economics, explains the greenback’s rise, says S. GURUMURTHY.  

Here is a fascinating story. It was the US, in the early 1970s, that had redefined the rules of currency pricing and made it rest on economic fundamentals and free market mechanism. But today its currency is defying the very rules the rest of the world has adopted from it. Here is the curtain-raiser for the story. With its annual GDP growth averaging 3.3 per cent from 2003 to 2007, the US economy went a high growth curve. Indeed, the growth was driven by toxic sub-prime home loans and credit, yet it was high growth nevertheless.

Despite this, and because of high external and internal deficits, the US dollar depreciated by over 50 per cent against the euro and other European currencies, as also against crude and gold. The toxic sub-prime subterfuge came out in the open in end-2006 and turned into a financial tsunami by end-2007. By early 2008, the sub-prime tsunami and its giant waves began battering the US and the global financial system.

With the assets and liabilities of the investment banking firm Bear Stearns becoming part of the US Fed balance sheet in March 2008, and some six months later, the fourth largest investment bank Lehman Bros turning bankrupt and the US insurance giant AIG becoming the subsidiary of US Fed, the US economy, finance and the dollar are all in a spin.

Today the market consults astrologers on the fate of the US financial system, and its annexe, the global financial system. Yet the dollar, instead of crashing, has, after a 5-year fall, started appreciating – stunningly. Why? Read on.

More hard facts

First, a look at more hard facts that weigh the dollar down. The US is already heavily indebted – by over $12 trillion, almost a quarter of the global debt – to the rest of the world.

More, it still borrows at the rate of over $2 billion a day for its day-to-day expenses – comprising its internal and external deficits. The figure is more – $4 billion, says the EU Digest, published by Europe House, a non-profit organisation of Euro-US interests.

Commenting on the article “US Fed Needs Global Watch” which had appeared in this newspaper last December, the EU Digest said: “The global current account deficit of the US is now larger than it has ever been, nearing $800 billion, almost 7 per cent of its GDP.

To finance both the current account deficit and its own sizeable foreign investments, the US must import about $1 trillion of foreign capital every year, or more than $4 billion every working day.

The situation is unsustainable in both international financial and domestic political (i.e., trade policy) terms.”

The EU Digest commended that the dollar depreciate further to correct the drift: “Correcting it must be the highest priority for US foreign economic policy…… The foreign exchange value of the dollar has to substantially decline to make a serious dent in the record US current account deficit of nearly $800 billion.” This was the state of the US economy as the year 2007 ended. The dollar fall continued as 2008 turned disastrous for the US economy.

The dollar seems to have obeyed the rules of economics till about the first quarter of 2008. The annual GDP growth in the first two quarters of 2008 was just 1.9 per cent, against the average of 3.3 per cent for the earlier five years.

This, The Guardian (of UK) said, was disappointing as the tax rebate of $93 billion given to boost the economy itself amounted to an annualised pace of 4 per cent!

Yet, from the second quarter of 2008, more significantly from the third quarter, the greenback, which was sliding against almost all currencies for the last five years, found itself on an escalator all on a sudden.

Sudden rise

In the last few months, it has appreciated by 13 per cent on a trade-weighted basis. It has gained 5.4 per cent against its main rival, the euro, and 2.2 per cent against the GBP. As this article is being written, the dollar has gained further against the euro, and also reversed its loss against the yen.

The excuse for the latest rise: the rescue of AIG by the Fed at a cost of $85 billion. Applying here the laws of market economics, the dollar should fall, not rise, as the market mechanism has failed.

The US’ economic fundamentals show how precariously the dollar is otherwise placed. The different indicators normally applied by the Fed for judging where the nation’s economy is heading and to decide whether to raise or to cut the Fed rate, demonstrably show, as of September 10, 2008 that the US economy was continuing to deteriorate.

In addition, some 13 of the 18 critical market and financial indicators, which also show deterioration, are: three credit market indicators of Dow Jones – credit default swap, credit card delinquencies, and mortgage delinquencies; six stock market indicators – DJ Industrial Averages, DJ Real Estate, DJ Financial Index, DJ Retail Index, S&P volatility, and market breadth; and three economic indices, including manufacturing, services, and services employment.

With these hard facts showing up at a click, it is not just the rules of economics, but also common sense, that would call for a fall, not the rise, of the greenback.

How, then, has a weak dollar turned strong in defiance of both economics and commonsense? The Financial Times wrote, on August 19, that ‘the timing of the dollar’s appreciation’ is ‘hard to call’; it ‘may prove short-lived’ . Its comeback, the Times said, is ‘not based on US fundamentals’ , ‘but on weaknesses elsewhere and weakening oil prices’.

The newspaper went on to add: “A faster appreciation of the Asian currencies still makes a lot of sense.” Obviously, the paper had not noticed that one of the important Asian currencies – the Indian rupee – far from rising, has lost almost 20 per cent against the dollar in the last eight months!

The real reason

A week later, on August 28, the Financial Times came out with an intriguing report that gave out the clue. It reported that, according to Japan’s Nikkei Online, the US, Europe, and Japan had discussed the possibility of “co-ordinated currency intervention to support the dollar” at the time of the Bear Stearns crisis in March 2008.

The US Treasury, said the Times, refused to comment on the report. The report recalled how the US-European policy-makers were concerned at the persistent dollar weakness, and also how a crisis at the individual institutional level could trigger a disorderly plunge in the US currency, that could lead to disastrous consequences for the US and Europe.

Consistent with this view, at its regular meeting (April 11, 2008), the G-7 expressed concern “about the sharp fluctuation in major currencies” and “their possible implications for economic and financial stability”, and added that “we continue to monitor exchange markets closely and co-operate as appropriate” . This, the Times commented, “marked a shift in international currency policy.”

Following the April meet, the US-EU officials told the Financial Times that they were united in their support for a stronger dollar. It was then that the US Fed chief, Mr Ben Bernanke, joined the US Treasury Secretary, Mr Henry Paulson, the Times said, in talking in public about the US currency. Till then, they would not, and did not, dare talk about the dollar.

Thus, policy mechanics, not market economics, explains the unexplained, and otherwise inexplicable, rise of the dollar now. It is from the April meeting of the G-7 and thereabouts that the dollar, that was on the ventilator, was put on the escalator and began rising without any economic rationale. Can anyone credibly claim that its appreciation is ma
rket-determined?

On the contrary, as the Financial Times story indicates, it is “international currency policy” directed; perhaps, more appropriately, “international currency policy” rigged – rigged by those who have high stakes in the value of the dollar that mediates the global economy. This is the dollar that the world has in trillions as its stock and investments!

Post-Script: No seer is needed to tell us how the rigged rise of the dollar has hit the Indian economy, and greatly neutralised the 35 per cent fall in crude prices with a 20 per cent fall in the rupee value, from Rs 39 to Rs 47 to a dollar. That is the subject for another story.

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