The re­turn of the Dol­lar

Financial Mirror (Cyprus) - - FRONT PAGE -

The US dol­lar is on the move. In the last four months alone, it has soared by more than 7% com­pared with a bas­ket of more than a dozen global cur­ren­cies, and by even more against the euro and the Ja­panese yen. This dol­lar rally, the re­sult of gen­uine eco­nomic progress and di­ver­gent pol­icy de­vel­op­ments, could con­trib­ute to the “re­bal­anc­ing” that has long eluded the world econ­omy. But that out­come is far from guar­an­teed, es­pe­cially given the re­lated risks of fi­nan­cial in­sta­bil­ity.

Two ma­jor fac­tors are cur­rently work­ing in the dol­lar’s favour, par­tic­u­larly com­pared to the euro and the yen. First, the United States is con­sis­tently out­per­form­ing Europe and Ja­pan in terms of eco­nomic growth and dy­namism – and will likely con­tinue to do so – owing not only to its eco­nomic flex­i­bil­ity and en­tre­pre­neur­ial en­ergy, but also to its more de­ci­sive pol­icy ac­tion since the start of the global fi­nan­cial cri­sis.

Sec­ond, after a pe­riod of align­ment, the mon­e­tary poli­cies of th­ese three large and sys­tem­i­cally im­por­tant economies are di­verg­ing, tak­ing the world econ­omy from a multi-speed tra­jec­tory to a multi-track one. In­deed, whereas the US Fed­eral Re­serve ter­mi­nated its large-scale se­cu­ri­ties pur­chases, known as “quan­ti­ta­tive eas­ing” (QE), last month, the Bank of Ja­pan and the Euro­pean Cen­tral Bank re­cently an­nounced the ex­pan­sion of their mon­e­tary-stim­u­lus pro­grams. In fact, ECB Pres­i­dent Mario Draghi sig­naled a will­ing­ness to ex­pand his in­sti­tu­tion’s bal­ance sheet by a mas­sive 1 trln euros ($1.25 trln).

With higher US mar­ket in­ter­est rates at­tract­ing ad­di­tional cap­i­tal in­flows and push­ing the dol­lar even higher, the cur­rency’s reval­u­a­tion would ap­pear to be just what the doc­tor or­dered when it comes to catalysing a long-awaited global re­bal­anc­ing – one that pro­motes stronger growth and mit­i­gates de­fla­tion risk in Europe and Ja­pan. Specif­i­cally, an ap­pre­ci­at­ing dol­lar im­proves the price com­pet­i­tive­ness of Euro­pean and Ja­panese com­pa­nies in the US and other mar­kets, while mod­er­at­ing some of the struc­tural de­fla­tion­ary pres­sure in the lag­ging economies by caus­ing im­port prices to rise.

Yet the ben­e­fits of the dol­lar’s rally are far from guar­an­teed, for both eco­nomic and fi­nan­cial rea­sons. While the US econ­omy is more re­silient and ag­ile than its de­vel­oped coun­ter­parts, it is not yet ro­bust enough to be able to ad­just smoothly to a sig­nif­i­cant shift in ex­ter­nal de­mand to other coun­tries. There is also the risk that, given the role of the ECB and the Bank of Ja­pan in shap­ing their cur­ren­cies’ per­for­mance, such a shift could be char­ac­terised as a “cur­rency war” in the US Congress, prompt­ing a re­tal­ia­tory pol­icy re­sponse.

Fur­ther­more, sud­den large cur­rency moves tend to trans­late into fi­nan­cial-mar­ket in­sta­bil­ity. To be sure, this risk was more acute when a larger num­ber of emerg­ing-econ­omy cur­ren­cies were pegged to the US dol­lar, which meant that a sig­nif­i­cant shift in the dol­lar’s value would weaken other coun­tries’ bal­ance-of-pay­ments po­si­tion and erode their in­ter­na­tional re­serves, thereby un­der­min­ing their cred­it­wor­thi­ness. To­day, many of th­ese coun­tries have adopted more flex­i­ble ex­change-rate regimes, and quite a few re­tain ad­e­quate re­serve hold­ings.

But a new is­sue risks bring­ing about a sim­i­larly prob­lem­atic out­come: By re­peat­edly re­press­ing fi­nan­cial-mar­ket vo­latil­ity over the last few years, cen­tral-bank poli­cies have in­ad­ver­tently en­cour­aged ex­ces­sive risk­tak­ing, which has pushed many fi­nan­cial-as­set prices higher than eco­nomic fun­da­men­tals war­rant. To the ex­tent that con­tin­ued cur­rency-mar­ket vo­latil­ity spills over into other mar­kets – and it will – the im­per­a­tive for stronger eco­nomic fun­da­men­tals to val­i­date as­set prices will in­ten­sify. This is not to say that the cur­rency re-align­ment that is cur­rently un­der­way is nec­es­sar­ily a prob­lem­atic de­vel­op­ment; on the con­trary, it has the po­ten­tial to boost the global econ­omy by sup­port­ing the re­cov­ery of some of its most chal­lenged com­po­nents. But the only way to take ad­van­tage of the re-align­ment’s ben­e­fits, with­out ex­pe­ri­enc­ing se­ri­ous eco­nomic dis­rup­tions and fi­nan­cial-mar­ket vo­latil­ity, is to in­tro­duce com­ple­men­tary growthen­hanc­ing pol­icy ad­just­ments, such as ac­cel­er­at­ing struc­tural re­forms, bal­anc­ing ag­gre­gate de­mand, and re­duc­ing or elim­i­nat­ing debt over­hangs.

After all, global growth, at its cur­rent level, is in­ad­e­quate for mere re­dis­tri­bu­tion among coun­tries to work. Over­all global GDP needs to in­crease.

The US dol­lar’s resur­gence, while promis­ing, is only a first step. It is up to gov­ern­ments to en­sure that the on­go­ing cur­rency re-align­ment sup­ports a bal­anced, sta­ble, and sus­tain­able eco­nomic re­cov­ery. Oth­er­wise, they may find them­selves again in the un­pleas­ant business of mit­i­gat­ing fi­nan­cial in­sta­bil­ity.

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