Will The US Dollar Decline In Value?

In theory, because of the huge amounts of dollars printed by the US Fed the US Dollar should weaken against all currencies. To some extent it has already happened. In the last 3-4 years as the US Trade and Fiscal deficits increased, the dollar did weaken.

From 2000 to 2007 the USD lost half its value with respect to the Euro. Refer the Euro-USD chart below:

This is exactly as per theory. But in the short run when investors seek to avoid risk they move into safe assets. So currencies like US Dollar, Swiss Franc appreciate in value. Similarly Gold gains when investors seek safety over returns. So in the last 6 months the dollar strengthened against other currencies.

In many respects India and US are remarkably similar. India has a huge fiscal deficit and is a net importer of goods. Last year India's Trade Deficit was over $100bn which as a percentage of GDP is worse than America !! This trade deficit was financed by foreign investors who bought Indian stocks and bond by the truckload. So, the rupee remained stable, when the stock market declined, the inflows dwindled and the rupee weakened.

India does not have Capital Account Convertibility. The Reserve Bank of India's official is to prevent sudden volatile movements in the currency markets. The RBI does not try to fight the trend; it tries to smooth out the volatility.

There was an article in the New York Times weekend edition about the US Dollar. Read the article here

Debt Monetization & Inflation

Mr Anonymous in response to my post "Asphyxiation By Forex" wished to know how Governments are going fund their fiscal deficits - Will they borrow the money or just print it?

The answer - bit of both actually. The technical term for Governments printing the money they need is 'Debt Monetization' or 'Quantitative Easing'. It works in the following manner: When the Government can’t find domestic or foreign buyers for its debt (usually because the interest rate is not high enough to attract lenders), the Central Bank buys this debt by printing new money. The government spends this money and in turn debases all the currency outstanding. Essentially the Central Bank "creates" money.

This is a sophistication of a process first used by the Roman empire. They would shave some gold off the edges of gold coins, remelt the shavings and mint them into more coins. The new coins would then be recirculated !!

Coming back to the present, the US Federal Reserve has "created" nearly $1.3 trillion dollars since October 2008. See the chart below:

Source: Wikimedia Commons

Is It Useful?

The size of a nation's economy is the total value of the spending on goods and services in the nation in a year.

The formula for GDP (Gross Domestic Product) is:

GDP = C + I + G + (Ex - Im)

where “C” equals spending by consumers,

“I” equals investment by businesses,

“G” equals government spending and

“(Ex - Im)” equals net exports, that is, the value of exports minus imports. Net exports may be negative.

The Global Economy is in the midst of a severe recession. Demand from consumers and businesses has dropped sharply. Economic theory suggests that the Government should increase spending to cushion the blow. By spending borrowed money Governments are trying to get the economy moving again.

Is there any risk?

The problem created by Quantitative Easing is that more the money in the economy less is its value. So it buys less over time. The prices of goods and services increase .leading to inflation. Inflation s a problem because it lowers the real value of wages and salaries and hurts people like retirees with a fixed source of income whose standard of life reduces due to inflation.

To sum up, Quantitative Easing is aimed at increasing the supply of money into the economy. Once the economy shows signs of recovery Central Banks will have to reduce the supply of money. If left unchecked the excess money can lead to high inflation, but managed well will soften the downturn.

Asphyxiation By Forex

India's phenomenal growth of the last five years was powered in large part by huge injections of cash and investment. Investment accounted for about 39% of the country's gross domestic product in the 2008 fiscal, up from 25% five years ago. At its peak, more than a third of investment came from abroad. At its peak, more than a third of investment came from abroad.

But in the last three months of last year, foreign loans and direct investment fell by nearly a third, to their lowest level in more than two years.

Source: Reserve Bank of India

The decline in foreign investment has taken a big toll on sectors like real estate, manufacturing and infrastructure. In the last quarter of 2008, the economy's growth rate plummeted to about 5.3%, the lowest in five years.

For 8-9% growth rate, private investment and low cost of capital is essential. The Government's Fiscal Deficit has ballooned to 10% of GDP. The Government is expected to borrow Rs 300000 crore this year compared to Rs 120000 few years ago. Such large borrowings will crowd-out the private sector and lead to an increase in interest rates.

Cutting subsidies, reducing the fiscal deficit and attracting foreign investment should be top of the 'To Do' list for the Government.