STORY OF THE US DOLLAR – A TRAGEDY IN MAKING?

By | May 26, 2009

When the UPA Govt took charge, the stock markets surged and so did the Indian rupee vis-à-vis the US dollar. And after a run up of almost over a week, the rupee slipped yesterday. And even today, the rupee depreciated 24 paise to 47.52/53 a dollar in the early trade. The word on the street is in the short term, the rupee will remain weak but in the long run, after August – September, once US stops buying its own Treasuries, the rupee will once again show some strength through the year. Though there are various versions saying that the money pouring into Asia has now cooled off, with some blaming this rupee fall of yesterday on the North Korea nuclear test, which is scaring off everyone from investing in Asia. Now that’s too far fetched a reason but what really ails the rupee?

To understand the behaviour of the rupee, one has to keep an ear to the ground and watch out for some key international happenings. India can say that it is decoupled to a large extent when it comes to the stock markets, what with Indian economy being more resilient and all. But the movement of currency is necessarily dependent on international happenings. So what are the key things which could dictate the movement of the rupee?

US Rating downgrade?

Standard and Poor’s has put the U.K.’s Sovereign Debt rating on negative credit watch. This has raised fears that the ratings of US might also be downgraded as both US and UK have more or less followed the same policy of injecting billions of dollars into their economies by buying assets from banks. A downgrade in the rating would not bode well for the US economy which could weaken the dollar, if and when it happens.

It is unlikely that US or UK would be downgraded but surely will be put on a credit watch. Why? Because tinkering with the dollar, which is the global currency could once again send the entire world into a tailspin. India’s rating was downgraded by S&P on concerns of mounting fiscal deficit. But downgrading the US is not so easy. Hence it will not happen. No one, be it Moody’s or S&Ps or Fitch; no one would have the courage to downgrade US. The fear of another recessionary reaction worldwide is enough to keep these rating agencies from being proactive. So downgrade seems ruled out but being put on a credit watch seems more likely.

Ballooning deficit of US?

If we in India thought we had a problem with our fiscal deficit, take a look at the figures of US. Big deficits mean the government has to borrow more, which could put its credit rating at risk. They can also put upward pressure on inflation, thus cutting the purchasing power of the dollar.

S&P has presented a report wherein it has stated that debt in the U.K. could hit 100% of GDP in the near term. IMF released a report in April which stated that U.K. debt load will be at around 67% of GDP compared to 70% for the U.S. and 69% for the Eurozone. So clearly, the highest debt risk weighs on the US.

Why eye on US economic figures?

Now all these assumptions of deficit estimates are made on the basis of economic estimates like GDP growth rate, unemployment and these have not been too good in reality. In the first quarter of 2009, GDP was at – 6.1% and as against this, the estimate for the deficit is based on the assumption that the GDP growth in 2010 will be 3.8%. Unemployment at the end of April was at 8.9% while estimate is at 8.8% for entire 2009. So based on this, we now need to keep an eye on the figures of unemployment and growth rate of US GDP as it will indicate whether deficit would go up further than estimates or be around same levels.

So from whom will US borrow?

It is not like borrowing money directly as we do from a bank – how this works is that countries buy the financial securities issued by the US govt. Hence when we read news of China, Japan buying US Treasury it means US is actually borrowing. To now get over this deficit, US needs more money, the estimate is borrowing to the tune of $1 trillion by September. The government has said it will need to borrow $2 trillion, or 14 percent of the country’s total economic output, in 2009 alone. The Federal Reserve will be buying back $1.5 trillion in mortgage and agency debt issued by Fannie Mae and Freddie Mac and is making direct purchases of U.S. Treasury bonds to the tune of $300 billion. This week the US Treasury is selling up $101 billion of fresh government securities.

China has purchased $23.7 billion dollars of US treasuries bringing their total to $768 billion. 70% of the estimated $1.95 billion dollars of China‘s reserves is in US treasuries. With countries not having enough to buy more from the US, the US Fed now plans to buy back mortgage- backed securities to the tune of $1.25 trillion this year. The Fed is in the process of buying $300 billion of long- term Treasuries through September. So this means that the dollar will remain up, at least till then.

Story in the long term?

With more and more money getting printed and pumped into the market to buy back these securities, it is estimated that more money supply will get more money into the hands of people, who in turn are expected to spend more. Right now, no one is really spending but once they do start spending, money supply will be more than the goods and that will lead to inflation. And at that time, to control the inflation and curb money supply, interest rates would have to be hiked and securities will have to be sold. When so much gets sold, the value of money will go down. And if China is one of the biggest buyers today, won’t it sell when the value goes down? So at that time, all would sell dollar into their currencies. And that is the time when US will have to come with another rescue plan to stem the crash of the dollar and thus save the world, as they do in all Hollywood movies!

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