Fenil's Library

That's mainly because the other currencies aren't doing any better

Vivek Kaul. Mumbai

The heat was clearly getting to me, as I kept tossing and turning around, unable to sleep. Just then, I heard the door bell ring. "Hello, I am Aruma, your new neighbour. You must be Vivek and I have run out of coffee," she said as I opened the door. I asked her in and went into the kitchen to get some coffee. 

"You know, so many people have been talking about the US dollar crashing these days. But what has been happening is the exact opposite. Over the last six months, the US dollar has gained value against other currencies, which means other currencies have lost value (see table)," she said, dropping The Economist on the table, as soon I got back with some coffee for her.

It felt rather odd to have her in my room at this hour; more so, talking economics. It must be the heat, I thought, trying to waive off the intrusion.

"Basically, the US has a debt pile of around $54 trillion and is printing dollars left, right and centre to rescue their biggest financial institutions and to pump-prime the economy by spending on government sponsored projects," I started.

"Well then its currency should lose value against other currencies, shouldn't it?" she asked. "But that's not happening."

"You are right. The major reason for that is the fact that the financial contagion has spread worldwide. Take the case of United Kingdom, where the government has rescued the biggest banks by printing the pound sterling. Or Japan, where the economy has shrunk 12.1% between October and December. Eastern Europe has borrowed around $1.7 trillion, largely from Western European banks, and needs to repay or roll over around $400 billion this year, which is around one-third of the entire gross domestic product (GDP) of the region. The Austrian banks for one have lent $289 billion to Eastern Europe. A large portion of this lending is in Swiss francs, which these Austrian banks have borrowed from Swiss banks. The Austrian finance minister, Joseph Proll, recently said that even if 10% of this lending goes bad, the Austrian financial system will go broke. Closer home, South Korea has debt of around $194 billion to repay by the end of this year. Currently, its foreign exchange reserves stand at around $201 billion. The country will have a tough time getting anywhere close to repaying all this debt," I said.

"So what does that tell us?" 

"It tells us that investors are now realising the whole world is in trouble and have been moving their investments into securities issued by the US government and thus by default into the US dollar. When they do this, they need to buy the US dollar and sell other currencies, increasing the demand for dollar and thus its value. This has helped the dollar hold up against other currencies. Also, the US dollar is the international reserve currency, and most countries still have a majority of their reserves in it. Thus, the hope is that in spite of the huge debt it has on its hands, the US will survive and so will the dollar." 

"Is there any other reason?" 

"Yes. See, the US is the largest importer of goods and services in the world and it is not importing as much as it used to. Now, many countries are dependent on exports. South Korea, for example, gets more than half of its gross domestic product from exports. In January, the country's exports to the US fell by around 22% and to Europe by 47%. This, too, is helping the dollar hold up."

"I didn't quite get that," she said.

"See, when countries export, they usually get paid in dollars. When they repatriate this money, they sell the dollars and buy their local currency. When you sell a currency and buy another, the value of the currency sold falls and the value of the currency bought goes up. With exports falling big time, dollars are not being sold as before, which is another reason it has held up. Take the case of Mexico. In August, one US dollar was worth around 9.9 Mexican pesos; today it is worth 14 pesos. This is primarily because 85% of Mexico's exports are to the US, and the export volumes are falling. Thus, investors who bet on the peso continuing to go up in value against the US dollar are selling out, leading to a fall in the value of the currency." 

"Any other major country that's going through this?" 

"Yeah, Russia too. Energy and metal constitute around fourth-fifths of Russian exports. Alexei Kudrin, the deputy prime minister and finance chief recently said exports can fall by $200 billion from $469 billion this year. This is primarily because the price of oil has fallen from a high of $150 a barrel to around $49 a barrel currently. Confidence in the Russian economy is down because of these reasons and this has led to the rouble crashing against the dollar by 35% since the beginning of October." 

"What about gold. Why is it rising? I am told the price of gold and the dollar are inversely correlated. I would understand investors moving towards gold if the dollar was perceived as a weak asset. But dollar's holding firm. How come gold is still rising?" 

"If you look at the prices of gold since October 1, it has risen around 3.5% to $911 an ounce (one troy ounce equals 31.1 grams). However, the dollar has appreciated much more against other currencies. So the theory does hold." 

"Maybe it does. But where do you think the dollar will go from here?" 

"Well, once the dust settles down, the dollar should fall and gold continue to rise." 

"You have a fair sweep of the issue, don't you. I was planning to make some coffee. Want some?" 

(The example is hypothetical) 

k_vivek@dnaindia.net

References: Gold is a Safe-HavenAmid Global Depression, Gary Dorsh,February 3,2009, www.safehaven.com;US Dollar Shines in a Depression, China buys Metals by Gary Dorsch, www.safehaven.com, March 5, 2009;The whiff of contagion, Economist,February 28th -March 6th, 2009;Articles by Puru Saxenaon www.safehaven.com.