Published in HBL long ago…
V Pattabhi Ram and A V Vedpuriswar
“The dollar is dead. Long live the dollar.” Only Chatshow, the mercurial professor, could have paraphrased it so chillingly while handling international finance. “What goes up has to come down.” The class did not have to turn around to see who was speaking. Not just the voice but the choice of words too could only be that of Boka. Flowers (because he perennially wore a flowered shirt) realized that if Chatshow was talking about the declining fortune of the dollar, Boka was pointing out to the pounding that the dollar had, years ago, inflicted on the pound. He remembered having read somewhere that it was the legendary speculator, George Soros, who had lead the onslaught.
Chatshow continued. “The dollar has for long been the leading international currency. But over the past three years it has fallen by 35% against the euro and by 24% against the yen. This slide reflects the structural problems in the US economy namely reckless government borrowing, relentless consumer spending and a huge current-account deficit.” The B-School’s in-house magazine had editorially remarked that Americans were shopping as if there was no tomorrow. Flowers had made a penciled note in his copy, “Shop till they drop dead.”
The girl in the middle row stood up. “Sir, globally the central banks of emerging economies are buying dollars to consciously weaken their currencies. That way they are ensuring the price competitiveness of their exports”. Chatshow was glad that the lady was abreast of current developments. He made a mental note to grade her higher in the internals this time. That was when Flowers chipped in. “This huge purchase of the dollar is leading to an expansion of the domestic money supply. This is pushing stock prices and property prices upwards.” Chatshow nodded appreciatively. “If the bubble bursts, as I guess it would, the dollar would race southwards,” said a voice from the rear.
Chatshow wanted to take the discussion to the next level. “There are concerns that central banks of emerging markets might reduce their holdings of American Treasury bonds. For instance, China’s central bank, the second-biggest holder (after Japan) of foreign-exchange reserves, has reduced its purchases of American T-bonds. Both Russia and Indonesia were reducing the share of dollars in their reserves. All this would increase the selling pressure on the dollar,” he told the class swishing his mane.
“Sir, would that mean the dollar would lose its reserve currency status¬?” asked the girl in the middle row. “It could,” said the professor. “Sir, what’s a reserve currency?” asked a backbencher. “Any answers”, asked the professor. “Would it be the currency in which countries like to hold their foreign exchange surplus?” asked the resident quizzer. He had this extraordinary habit of answering every question in every quiz show with a “Would it be?” “Yup”, said the professor and implored the class to read a recent issue of the Economist which had made a strong case for why and how the Euro would soon replace the dollar. A hand shot up. “Yes?” asked Chatshow. “Sir, I read that issue. The piece says that there are four requirements of a reserve currency. One, the economy must be large. Two, it must have open and deep financial markets. Three, inflation levels should be low. And four, investors must have confidence in the value of the currency”. The class said, “Wah. Wah.” The voice continued. “At current exchange rates, the euro area’s economy is not much smaller than America’s. Ever since the arrival of the euro, the European financial markets have become deeper and more liquid. While the euro area has had slower real GDP growth than America, in dollar terms its economic weight has grown relative to America’s over the past five years.”
As the voice slowed down, the girl in the middle row got into the act. “Sir, the dollar is no longer a great store of value. Since 1960, the dollar has fallen by around two-thirds against the pound and the yen. And as far as the fourth condition namely confidence is concerned, the value of the dollar got undermined ever since the US became the world’s biggest net debtor”. There wasn’t a need for the class to read the Economist. These two had hit the nail on the head, summarized it cleanly! Chatshow added, “If the central banks begin selling some of their estimated $2.3 trillion dollar assets, there could be a run on the dollar”.
Was there a way out? Yes and No. He pointed out to America’s huge current-account deficit as the villain. The only way to correct it was by a plunge in the dollar. He continued, “Past evidence indicates that a currency has to undershoot its fair value by a wide margin to reduce a country’s large external deficit”. The girl intervened, “Sir, some economists believe that the dollar has to fall by at least another 30%. And if that happens, the dollar’s credibility will hit a nadir. And the currency would test lower levels.” Flowers remarked, “Do and you are damned, don’t do and you are damned!”
Dipping into history Chatshow suggested that if the dollar had survived in the past it was because of the TINA (there is no alternative) factor. But since 1999, the euro had emerged as a potential rival. Further, in 2004, the current-account deficit was 6% of GDP, almost twice as big as at its peak in the late 1980s. In the 1980s, America had been a net foreign creditor. In 2004, it had net foreign liabilities aggregating 28% of GDP. “The dollar’s days are clearly numbered”, thundered Chatshow. The anti America group in the classroom clapped much to the professor’s annoyance.
All along, Boka had sat like Buddha. Stone silent. But sensing the growing exuberance he decided to speak up. “Sorry, I disagree with the views expressed so far”, he said. The class sat up. 90 minutes into the class and the guy was expressing reservations. “I feel a currency represents a country’s global competitiveness”. Flowers whispered, “Paul Samuelson, speaking”. Boka ignored the barb. “If the economy is competitive, the currency will continue to be credible”. Flowers whispered, “Alan Greenspan.”
Boka’s friend decided to join the fray. “Last night we read Michael Porter’s The Competitive Advantage of Nations. He says macro economic fundamentals do not tell the full story”. Boka took off. “This is the age of innovation. USA is at the leading edge of innovation. This is the age of services. Name any service and the US is the global leader. The US has also shown a remarkable ability to restructure itself. Take outsourcing. US companies are getting things done in India at low costs. In Germany and France, such a possibility evokes strong negative sentiments from the public. I believe the competitiveness of the US can never be equaled by Europe. How many European companies have succeeded in software, biotech or microprocessors? Why is it that the best brains migrate to the US, not to Europe or Japan?” he asked rhetorically.
Boka’s friend said, “The US can afford a budget deficit because it has excess capacity. So inflation will always be under control. And the term current account deficit is a misnomer in today’s context. If Honda USA imports engines from Thailand and exports cars to Europe, it is difficult to identify which country is exporting and which is importing!”
“Hey, there isn’t a snowball’s chance in hell that the Euro would replace the dollar,” said the girl from the middle row quite impressed by Boka and his friend. As the class burst into applause Chatshow waved them down.