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Diminution of the dollar

Live mint | July 16, 2007
V. Anantha Nageswaran

DXY is the US dollar exchange rate index against six other currencies —the Euro, Japanese yen, British pound, Canadian dollar, Swedish krona and the Swiss franc. The index is on the cusp of breaking down below its 20-year low. If it does, experts who analyse charts for patterns suggest that it would open the bottom for the US dollar. We don't know if the event will occur this week or next or even later. The question in my view is one of WHEN and not IF. Of all the things happening in global financial markets, the US dollar outlook is one of the few that are explicable in a rational framework.

There is a risk perception about the health and the healthy foundation of the US financial system that has been created by the extension of mortgage loans to ineligible borrowers and the entire ponzi financing structure built on such shaky underlying loans. This is not the first time. In less than a decade, the world has witnessed in the US, the dotcom boom and bust, the collapse of Enron and WorldCom, lack of integrity in the investment research community, the legislative overreaction that scared investors off from listing in stock exchanges in America and, now, the financing and securitization of housing mortgages that are increasingly in default.

Of course, we are talking about the US, not an emerging economy. Credit rating agencies would not downgrade American treasuries to anything less than AAA investment grade. It is too much to expect them to rationally price the risk of a scandal-prone financial system such as America's. For reasons that are too numerous to be listed here, they were too slow to react to signs of trouble in mortgage-related instruments.
Investors would then turn to the central bank to compensate them with higher yields for the risk of holding the currency. That is what happens to poorer countries. Their systemic shortcomings are mercilessly scrutinized and fussy investors have to be soothed with higher interest rates to the detriment of domestic interests. But, the US borrows in its own currency. Hence, if the US dollar weakens, it is effectively able to default on its debt. The value of the currency is a worry for lenders and not the borrower!

Moreover, investors know that American monetary authorities have a tradition of responding to investors' distress calls. Wall Street is too big to be allowed to fail and America's global superpower status is partially derived from that. That is how the Greenspan Put was born. Bernanke is yet to be tested on his readiness to write a put option for Wall Street to exercise. However, he gave hints of it in a speech in 2002. He said that when faced with the risk of a deflation, any central bank intent on fighting that could, in theory, run the printing presses full time and flood the economy with currency, thus creating inflation. This suggests that he would not hesitate to debase the dollar to preserve growth, jobs and, perhaps, asset prices, too. Arguably, among the central banks of the developed world, the Federal Reserve is the most politically sensitive institution. The preservation of the value of the dollar is easily a matter of lower priority.
The US finds itself in this situation because creative destruction—an intrinsic feature of vigorous capitalism —has been replaced with creative preservation of asset prices and Wall Street bonuses. Briefly, this is the consequence of overzealous and misguided commitment to free markets that has made the financial sector the tail that wags the dog, which is the real economy in the US.

Given such an evolution of the soundness of the US financial system and its practices in recent years, it is a matter of surprise that it has taken so long for the US dollar to begin its decline. Investors are right to expect that other central banks—the European Central Bank in particular— would be relatively more willing to defend the value of their currencies than America's Federal Reserve.

Of course, it won't be easy. Politicians and business lobbies would howl. The newly elected French President Sarkozy has already given enough hints of his intentions to use the currency as a trade weapon, as Japan and China, are doing so at present. Nonetheless, investors should expect to be surprised by the extent to which the euro would strengthen against the US dollar in the coming year or two. Second, precisely because there is a limit to how far it could rise, other currencies such as the Singapore dollar or the Swiss franc should be part of investors' portfolios. Third, “currencies” such as gold and silver which hurt when they fall on the feet should also be picked up at current levels. Theunravelling of the US dollar would be the dominant feature of the financial landscape for the next few years.

 

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