The Hindu Business Line : One dollar is one dollar

The US is assumed to have practised a strong dollar policy and presumed to have been content to let the dollar drift down so that exports would become cheaper and imports more expensive.

The policy-makers in Mr George Bush's Cabinet and in Congress should think of each dollar as one dollar. They should stop worrying about what China does with the yuan. Will the US Treasury Secretary-designate, Mr Henry Paulson, continue to support a strong dollar, or will he let it drift down? G. RAMACHANDRAN analyses the scene.

American Senators will want to know how Mr Henry Paulson — the designated US Treasury Secretary to succeed Mr John Snow — plans to set the course for the future value of the dollar. Would Mr Paulson continue the policy of his predecessor in supporting a strong dollar? Or, would he let it drift down?

Mr Paulson's answer will not come in the way of his confirmation as Treasury Secretary. First, his confirmation is regarded as a done deal. Mr Paulson is Goldman Sachs' incumbent chairman and chief executive. Goldman Sachs is regarded as the most influential company in the world. Its understanding of economic issues is assumed to be perfect.

Second, Mr Paulson has bigger responsibilities that dwarf concerns pertinent to the dollar. Taxes, budgets, spending and funding demand his attention. They will determine the future course of the US economy as also employment, incomes and the purchasing power of the dollar.

Mr Paulson should explain to policy-makers in Mr George Bush's Cabinet and in Congress that the right way forward is to assess the value of the dollar against itself. Mr Paulson should urge them to think of each dollar as one dollar. In particular, he should urge them to stop worrying about what China does with the yuan.

The possible trinity

Nobel laureate Robert Mundell postulated an axiom known as the `impossible trinity'. Capital mobility, fixed exchange rates and interest rate autonomy cannot coexist simultaneously. Countries that desire capital mobility and interest rate autonomy have to choose floating exchange rates or peg their currencies. This explains why the euro floats, why the Indian rupee is in dirty float, and why the Chinese yuan is pegged. This also explains why the British pound crashed out of Europe's Exchange Rate Mechanism (ERM) in 1992 (Business Line, March 29).

But the `impossible trinity' does not apply to the dollar. First, it is not part of any ERM. The US Federal Reserve System is not obligated to participate in multilateral interventions by central banks aimed at maintaining the relative values of two or more currencies. Second, the dollar is not pegged to any other currency. Consider the yuan. It is pegged to the dollar but the latter is not pegged to the former. The onus of maintaining the peg is on China.

Third, the dollar appears to float against other freely floating currencies such as the pound and the euro. The truth is that these currencies float against the dollar. It is up to the currencies to float at whatever values the market thinks is appropriate relative to the dollar.

More degrees of freedom

This descriptive view of the dollar liberates Mr Paulson and Mr Ben Bernanke, Chairman of the US Federal Reserve Board, to regard the dollar as a currency that is fixed against itself. This provides the Bernanke-Paulson duo the freedom to work the monetary levers and the fiscal platform to carry the US economy through a little slowing down and a transition.

Economic growth in the US has been extraordinarily robust in the past three years. The systematic re-employment of under-utilised human and physical resources has driven growth. Productivity and labour force have grown significantly. In his candid comments at the International Monetary Conference on June 5, Mr Bernanke has pointed out that the productive slack in the system has been reduced substantially after three years of `above-trend growth'.

Contradiction and ambivalence

The three years of above-trend growth could not have been sustained in a non-inflationary economic environment without the outsourcing of manufacturing to China. The US added 5.2 million new jobs since August 2003. Average unemployment declined to 4.7 per cent. Hourly compensation rates grew at over 4 per cent annually. Mr Snow deserves significant credit for the handsome, non-inflationary growth. But he chose to apply pressure on China to loosen the yuan's peg to the dollar. He supported a strong dollar in public but insisted that market forces should determine the dollar's value.

Should Mr Snow have worried about the value of the dollar when the world invoices trade in dollars and central banks hold dollar assets?

`Market forces' is actually the code for pushing the yuan into a floating system. Market forces already determine the value of the euro, the pound and the yen vis-à-vis the dollar.

The assumption underlying the code is that the yuan's floating value vis-à-vis the dollar would rise above its pegged value.

The contradiction and the ambivalence are obvious. The US is assumed to have practised a strong dollar policy for the past 15 years and presumed to have been content to let the dollar drift down so that US exports would become cheaper and imports — from China — more expensive.

Pegged yuan is anchor

American exports have neither become cheaper nor have imports from China become more expensive. The aggregate US-China trade rose by a whopping 93.7 per cent between 2002 and 2005 to $285.3 billion.

US exports rose by 89.1 per cent to $41.8 billion. Imports from China increased by 94.5 per cent to $243.5 billion. The growth rates appear balanced.

But US imports have exceeded exports by $201.7 billion. About 50 per cent of the adverse trade balance is on account of import of electrical machinery and power generation equipment. Without these, the US would have exhausted its productive slack a while ago.

The other 50 per cent of the adverse trade balance is on account of import of consumption goods such as apparel, toys, furniture and footwear. Without these affordable imports, the US would have had inflationary growth. Mr Snow would have lost his job a long while ago.

Mr Paulson should explain to the US Senate that the pegged yuan has anchored economic growth in the US. It has added certainty to consumption and investment and to corporate, municipal and household budgets. And to top them all, hedging costs have been borne by China.

(The author is a financial analyst. Feedback may be sent to indiagrow@yahoo.com and pari@thehindu.co.in)

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