Falling Dollar and Chinese Jitters

These are no longer Chinese Whispers, but Chinese jitters resulting from a weakening US dollar. The markets may have been happier if these were Chinese Whispers, which essentially is a distortion of a message, when whispered from ear to ear amongst a chain of people. The reason why China is feeling the pinch is because it holds a huge amount of national saving in US government treasuries and any fall in the US dollar means, a fall in the value of their national savings. China has become the largest holder of US paper, with investments of nearly $768 billion. The dollar index has weakened nearly 8.6% since February this year, making the Chinese jittery about their savings.

But, why is the dollar falling? A number of reasons seem to be leading to a depreciating dollar. The most obvious is the perception of a stabilizing global economy and investors returning to stocks and riskier securities. For this they need to sell their dollar denominated government holdings and convert it into various currencies for investing. The selling of the dollar leads to a fall in its value and the present scenario appears to be related to this phenomenon. While, this may be considered the short term cause of a falling dollar and may be viewed as a positive development as the underlying cause is an improvement in the global economic scenario, the medium term reasons seem to negative. The medium term reasons that seem to be dampening the dollar is related to the US fiscal deficit.

The damages caused by the economic storm that ravaged the US, seem to need a lot of money to fix the damages. The damages took the shape of bust banks, bad home mortgages, looming unemployment, closing businesses, the latest being GM and other several such damaging developments. To repair these damages, the US government announced a number of bailout packages. The money for these bailout packages can come from two sources. The government can either print money or borrow money. The first recourse is highly explosive and can lead to runaway inflation. The wiser recourse is to borrow money. However, the wiser approach comes with a price. A high level of government borrowing, leads to crowding out of private investment and a general rise in the interest rates. It may be noted that this increase in the interest rate is not induced by the Fed to fight inflation, but is a result of worsening economic conditions. Hence, investors may take a negative view of the US economy, which is likely to keep the dollar subdued.

However, how this unfolds remains to be seen. Obama has already made tall promises of curtailing the deficit to 3% of GDP. However, Obama’s plan needs to be analyzed more closely before one can jump to any conclusion. Reining in the fiscal deficit requires alternate sources of funding the fiscal deficit. One of the ways to reduce the deficit is by increasing taxes. However, an increase in taxes has an impact on disposable incomes of consumers. Lower disposable incomes can slacken demand and reduce production. This in turn can again slacken growth of GDP, leading to a negative investor sentiment, which further can exert a downward pressure on the value of the US dollar.

Thus it appears that the US dollar may face some downward pressure in the medium run and its long term performance will depend upon how the economy shapes up during this period. In  any case we can be happy to note that the talk is now more about economic recovery and the recession seems to be fading into the past…..and let’s hope that this isn’t just a Chinese Whisper, but a real and sustainable recovery.