Personal Finance

Dollar can claw back

Jyoti Roy | Updated on January 17, 2011 Published on January 17, 2011

The rupee would be more impacted than other emerging market currencies by capital outflows.

Ever since the Bretton Woods system got abolished in 1971, there have been numerous occasions when a dollar crisis had been predicted. The dollar, as measured by the dollar index, last peaked during the heydays of the dot com bubble and has been in a prolonged downtrend since then.

This has sparked off the debate as to whether the days of the dollar as the reserve currency of the world are numbered. The significant fiscal and current account deficit that the US has been running, quantitative easing by the US Fed, are leading to the depreciation of the currency. However, a gradual weakening of the dollar is beneficial for the US at the current juncture given the current slack in the economy. A weak dollar would make US exports more competitive and at the same time discourage imports, helping reduce the current account deficit.

Emerging markets, including India, are witnessing massive capital inflows on account of loose monetary policy by developed economies. This has led to a sharp appreciation in emerging market currencies. Exports are one of the key growth drivers for most emerging economies including China. Any sharp appreciation of the local currencies relative to the dollar would reduce their export competitiveness. Also as most of these economies run a current account surplus, additional capital flows complicate the central bank's job as it can lead to asset inflation. India, unlike other emerging markets, has a current account deficit which makes the job of the central bank much easier. For FY2010, the current account deficit stood at $38.4 billion or 2.9 per cent of GDP as compared to $28.7 billion or 2.4 per cent of GDP in FY2009. India's current account deficit masks the massive trade deficit which stood at $ 102.1 billion in FY2010.

Deficit concerns

Though the Indian rupee has appreciated on the back of the capital flows, the large current account deficit has prevented a sharper appreciation as witnessed during the fag end of the last equity bull run in late 2007. The rupee had appreciated sharply from 44/dollar to Rs 39 within a short span of time which had forced the Reserve Bank of India to intervene in the currency market. This led to an increase in liquidity in the system which had to be sterilised by the central bank. However, sterilisation has its own costs and is not desirable as it imposes an additional burden on Government finances.

Post-the financial turmoil, the Indian economy has bounced back strongly on the back of strong growth in domestic consumption. However the key risk for the Indian economy lies in the external sector due to an increasing current account deficit which is being financed by short term FII flows into equities. Any reversal in outflows would lead to a sharp depreciation in the rupee which could have an adverse impact on companies with large dollar-denominated liabilities due to higher interest outgo as well as mark-to-market losses. However, depreciation of the rupee relative to other exporting nations would increase India's export competitiveness which would be beneficial for the economy.

In the short run, the dollar is likely to depreciate some more on the back of fresh dollar supply due to the second round of quantitative easing by the Fed which would expand the Fed's balance sheet by another $ 600 billion. However, if the current debt crisis in the Euro Zone which is now restricted to some smaller peripheral countries such as Ireland and Greece spreads to larger euro zone economies such as Spain, then one can build a case for increased risk aversion. Also, lower than expected global growth can also lead to a sharp increase in risk aversion.

Increased risk aversion would lead to a sharp reversal of capital flows from risky assets including emerging market equities to safer avenues such as US treasuries. Such reversal of capital flows would lead to a general strengthening of the dollar. The rupee would be impacted more than some of the other emerging market currencies due to the large and expanding current account deficit which is currently being financed by capital flows.

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