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The underperforming dollar

As USA has been importing much more than what it has been exporting leading to a huge trade deficit, causinf weakening of dollar, writesDH Pai Panandiker.

india Updated: Apr 27, 2007 16:41 IST

The US dollar has been hit rather hard. For the first time in 15 years the pound exchanged for two dollars, the euro rose to a record high and the rupee crossed 41 to the dollar.

The dollar has been tottering for quite some time. After all, the value of a currency depends largely on the state of external trade and foreign investment. The United States has been importing much more than what it has been exporting leaving a huge trade deficit to be funded from foreign resources. In the last one year this deficit climbed to $829 billion. As long as other countries were willing to invest in US there was no problem. Now there are second thoughts.

In the last three years the Federal Reserve had raised the interest rate far more than the European Central Bank (ECB) or the Bank of England. The US economy is now in the reverse gear and most likely the Fed will have to cut its interest rate. On the contrary, the ECB is only too eager to put up the rate once again. As a result, the spread between the US and EU three-month rates has reached the lowest in the last two years and may shrink even further. That makes private investors cagey about investing in US securities.

The more important investors in US, however, are the central banks of other countries. The dollar is the bulk currency in their reserves primarily because the dollar is the most accepted currency in the world. With the weakening of the dollar, the euro has emerged as a partial substitute. Japan, it is reported, will invest its $888 currency reserves in a more diversified range of assets rather than US treasuries alone; so too the oil exporting countries. The international currency market will consequently be over-supplied with dollars and there is a good chance that the dollar will fall further against the euro, the pound and even the yen.

The hardening of the rupee against the dollar is a different story. In the first 25 days in the month of April the rupee hardened 6 per cent. That was mainly because of the huge inflows of foreign capital. With this sudden burst of dollars in the market the dollar dropped. The RBI is not buying those dollars because that would weaken its efforts to soak out liquidity which is necessary to hold down inflation. It has therefore preferred to encourage outflow of dollars by liberalizing overseas investment by mutual funds and companies and early repayments of foreign loans.

The present international currency realignment will not be short lived because it reflects the more fundamental trends in major world economies. The EU and the Japanese economies are on the bounce while the US economy is cooling down. Almost all currencies are readjusting to these developments. The rupee, however, will not remain as hard as it is now but is also unlikely to go back to the earlier rate of 45 to the dollar.