The Hindu Business Line : With the exit of a reluctant guru... Will mantra of strong dollar go?

Now that the US Treasury Secretary, Mr Paul O'Neill is gone, the million-dollar question is if the mantra of the strong dollar will follow him. Some say it already has. There is, however, compelling logic for the dollar to fall, as the US' eco nomic fundamentals do not justify its high valuation, says V. Anantha-Nageswaran.

THE resignation of the US Treasury Secretary, Mr Paul O'Neill, came when speculation over his fate had subsided. However, it was not a surprise. Somehow, neither he nor the Wall Street warmed up to each other. It is unfortunate but true that the competence of a US Treasury Secretary is determined in Wall Street and not on Main Street. However, it is not apparent that Mr O'Neill did anything that would make Main Street regret his departure.

It is claimed that he opposed the President, Mr George Bush's omnibus tax cut last year which had little by way of short-term economic stimulus. It is also claimed that he opposed the imposition of tariffs on steel imports. If so, then it is sad to see him leave.

He was also working on simplifying the tax code in the US. Any Finance Minister or his official who works to make the tax system simple to understand and implement deserves support and not criticism. That is why this author believes that some of the criticisms directed at Dr Vijay Kelkar appear to be missing the woods for the trees. Let us get back to Mr O'Neill.

History of myth of strong dollar policy

He largely operated in the shadow of his predecessor's predecessor, Mr Robert Rubin who was immensely popular with Wall Street. He originated there. When the dollar was at its weakest in 1995, he restored faith in the currency by coining the phrase that a strong dollar was in the interest of the US. It was much needed at that time.

His predecessor, Mr Lloyd Bentsen, had worked on the basis of a mercantilist approach and talked the yen up against the US dollar, sending the currency to around 79 yen against the US dollar. It is not that Mr Bentsen was single-handedly responsible for it. He had a large role, nonetheless.

However, Mr Rubin began to make a virtue out of necessity. He repeated the policy ad nauseam that it became a mantra and mostly an empty one at that. The US really did not have a strong dollar policy. Only small, open economies have exchange rate policies (for instance, Singapore) since they cannot use interest rates as a tool of monetary policy. With domestic demand a small component of the national economy, interest rate becomes a blunt instrument.

If the US government really wanted to encourage/maintain a strong dollar, it must have actively encouraged national savings, reducing the reliance on foreign savings to finance its appetite for foreign goods. Foreigners not only produced the goods and services US wanted and but also gave the US consumers loans to purchase them.

During Mr Rubin's tenure, he did not really have to encourage domestic savings since foreign investors were really enamoured of US assets. Impressed by technological innovation, strong productivity and rising profitability (we now know that a lot of it was generated by accountants aided by auditors), direct and portfolio investment flooded into the US.

The US government, on its part, ran fiscal surpluses, thus slowing the runaway current account deficit train. Frankly, the government did not maintain a deliberately austere fiscal stance. Economic boom made its task easier by boosting tax receipts and governments are usually quick to claim credit for popular results, even if policy did not intend them.

Nor did the government propose any measure to sequester the surplus for rainy days. There was some loose talk of paying down national debt. Before it could become a policy decision, entered Mr George Bush. The discussion changed to tax cuts from retiring national debt.

The Federal Reserve Chairman, Mr Alan Greenspan, who had earlier favoured paying down national debt, changed his stance. He now favoured returning the public its money claiming that it was a moral duty of the government to do so. The only credible source of objection to a tax-cut that grossly favoured the rich had melted away thus without a fight.

The tax cuts were duly enacted and, within a few months, projections of budget surpluses in the years to come that were used to justify the tax cut, had disappeared. The government thus gave back the money it did not have. Not to be discouraged, there is talk of fresh stimulus to the economy through additional tax cuts, making the tax cuts of 2001 permanent (they are now scheduled to disappear in 2010) and abolishing estate tax. Mr Bush decided to pay for his tax cuts by reducing the annual salary increase for Federal employees for 2003 by a percentage point, to 3.1 per cent.

In the meantime, US households have, largely, continued to spend as though nothing has changed. Rising house prices have lulled them into a false sense of complacency about their net-worth. It has offset the decline in the value of corporate stocks they held. However, they do not seem to be either willing or capable of reckoning that their liabilities too have increased along with the value of their home equity. Thus, the current account deficit continues to rise with both the domestic private sector and public sector now merrily living beyond their means. It is one thing for the Federal government to step up to the plate and spend during economic slowdown. It is another thing to use that as a pretext for enacting tax cuts for the rich. We do not seem to have a counter-cyclical fiscal policy in the US. On offer is a policy of favouring the rich with tax breaks by cutting back on social spending. The New Deal is fast metamorphosing into a raw deal. Well, it is a problem for the US. Or, is it?

This elaborate preamble was necessary to demonstrate the intellectual vacuity of the fictitious strong dollar policy. Not only was there no such policy but also the government was actively undermining the pillar that would support the currency. On top of that, the Federal Reserve had lowered the yield on dollar debt by reducing the Federal funds rate since January 2001 from 6.5 per cent to 1.25 per cent. It is not certain that we have seen the last of the rate cuts.

Despite the steady erosion of support from both the fiscal and the monetary side for the strong dollar, the departing Mr O'Neill repeated the mantra of his predecessor. His earlier attempts to suggest that the emperor really had no clothes were met with consternation on the Wall Street.

The reaction is par for the course for Wall Street, more than Hollywood, is a make-believe world. It believes that fiction could be made into fact by sheer dint of repetition and the edifice is, mostly, built on that premise. Hence, Mr O'Neill's candour was ill-suited to the world of modern finance. He reverted comfortably to the rhetoric of the strong dollar.

Fundamentals do not justify a strong dollar

Now that he is gone, the million-dollar question is whether the mantra of the strong dollar would follow him. Most bet that it would. Some say that it already has. I am not so sure. However, there is a compelling logic for the dollar to fall. It is an overvalued currency and US economic fundamentals do not justify its valuation. The currency's overvaluation is evident in the Chart. Its decline since the beginning of the year hardly registers on this chart because the currencies of two of its major trading partners — Canada and Mexico — have weakened against the dollar. Hence, in terms of trade competitiveness, the dollar remains significantly uncompetitive. This has resulted in a steady rise in the current account deficit even during a recession.

Goldman Sachs and Morgan Stanley project the deficit reaching six per cent of GDP by end-2003. In addition, in terms of bilateral purchasing power parity against major world currencies, the dollar is considerably overvalued.

Further, in a portfolio context, returns to capital in the US have declined with excess investment in the nineties eroding the profitability of capital. With weak economic growth and excess leverage, the Federal Reserve has engineered lower yields on debt instruments too. Returns to holding dollar assets are thus lower and are set to remain lower. Thus, economic fundamentals do not underpin the currency as they did in the 1990s.

If the dollar begins to weaken — whether or not the incumbent US Treasury Secretary sanction it — will it solve all problems for the US and for the rest of the world? That is a tough one to answer since every economic solution imposes costs on some while conferring benefits on others.

(To be concluded.)

(The author is a Director with Credit Suisse Asia-Pacific, in charge of global economics and asset allocation. The views are personal. Address feedback to nageswar@singnet.com.sg)

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