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Rebalancing the Dollar

Dollar depreciation will continue unimpeded, as long as the domestic US savings rate does not go up. And till this stays secular, you'll see nominal changes in rupee-dollar rates on the upside

Most people tend to link the current wave of Dollar depreciation to the much-expected 'global rebalancing', a term attributed to Stephen Roach, Chief Economist of Morgan Stanley. The simplistic argument was that if the US continued to run the current twin deficits (current account and fiscal), it would erode the value of the dollar. The resultant depreciation would make imports expensive and exports cheap, thereby correcting the current account deficit till the balance is restored.

Roach argues in a recent article that there is more to it. Growth patterns across the world are changing. The relative weight of PPP-adjusted growth is changing. On the one hand, developing countries now account for 70 per cent of the 4.5 per cent (projected) world GDP growth, i.e. 3.2 per cent of the 4.5 per cent. Even among developed countries, the US is losing market share to both Europe and Japan; while the US with 2 per cent would add just 0.4 per cent to global growth, Europe would now add 0.5 per cent to global growth and even Japan was at 0.2 per cent.

The developing world now accounts for 48 per cent of world PPP-adjusted GDP and its share is rising. Relative growth (to developed countries) is not slowing down. This is as it should be. What is more important is that the new “global growth engines” (a term long appropriated by the US, which seems to have led the world by consumption growth, not savings/ investment growth) do not have the structural problems that the US had.

Roach argues that the 'excess consumption' in the US needs to be cut back, if the US itself is to 'rebalance', i.e, start to live within its means. But this has long been feared in Asia, as it was expected to cause an industrial and export slowdown. If the new 'growth engines' in the developing world were to take up the slack, it would give the US some breathing space, allowing it to slow down without causing much pain on the other side of the world.

If the earlier argument that currency movements alone can correct the structural imbalances embedded in the world economy was to be true, we would not have the following situation: the wildest estimate was that a 30 per cent correction in the Dollar would correct the current account deficit. Well, we have already seen a 15 per cent correction in the trade-weighted value of the dollar, without any correction in the size of the current account deficit. So obviously, a nominal correction in the dollar alone will not do it. The real cause of the US current account deficit is the savings gap, the difference between capital needed for investment/ consumption and the money accumulated through domestic savings. The latter was down to 2 per cent of GDP (India is at a shade above 30 per cent). If you buy this argument, then the real global rebalancing will not happen because of some currency adjustment, but when the supply of savings in the US turns predominantly domestic. So the place to watch is not the currency markets, but the savings and personal consumption data. For the first time in world economic history, a drop in personal consumption in the US is a matter of celebration… How can you justify a record 71 per cent personal consumption rate, co-existing with a negative (income-based) savings rate? Here in India, we don't even break up our savings rate into two segments: one, what proportion of our income did we save and two, what proportion of our asset appreciation did we save?

In India, given our low asset base relative to our income, we are still building assets. So asset appreciation (except, perhaps in the metros of late) remains a small part of our Savings. We remain a net supplier of savings generated in product markets, which are then channeled into asset markets. In simple terms, we make and sell things (product markets), save money from salary, etc and we invest in houses or stocks (asset markets). Indians will find it difficult to think of any other way of life, Well, on the other side of the world, it seems they do the opposite. They (used to) extract 'equity' from housing by refinancing their ever-appreciating houses at ever-lower interest rates, which gave them a profit, with which they bought things and services made by the Asians. This odd situation, which the ordinary Indian cannot comprehend, has created the global imbalance I am referring to above.

For example, even the anaemic American savings rate of 2 per cent mentioned above, includes the “home equity” that Americans have extracted from the famed housing Boom. Net of such equity extraction, their Savings Rate is actually negative. To confirm this, look at their record personal indebtedness, even as Interest rates hit record lows during the last years of Greenspan's reign. In actual terms, while equity extraction has dropped with falling house prices, the income-based Savings Rate remains in negative territory.

My sense is that the average American is caught in a 'behaviour trap' (see a previous article where I recounted instances of this). Human beings have 'comfort zones', to which we gravitate as our circumstances get better. Then, even as circumstances change, we cling to our old behaviours, hoping that 'things will work out'. There is 'stickiness' to our behaviours. As incomes rise, we are quick to go from bicycles to bikes and then cars, but we do not retrace our steps with the same alacrity. This behaviour pattern is evident in all financial markets. It is a variant of 'pain aversion' that I have often talked about. Roach avers that the 'breakout' will come with a sharp surge in Unemployment rates, which could happen as the construction sector starts to lay off people, after the Housing slowdown. This should finally push up the savings rate.

In short, dollar depreciation will continue unimpeded, as long as the domestic (income-based) US Savings Rate does not go up. And as long as this stays secular and across-the-board, you will see nominal changes in rupee-dollar rates which are on the upside. As currency traders and corporate strategists, we should be looking in the right direction if we really want to know where the dollar is headed.

And why, prey, is all this appearing in an equity investment magazine? Because, dear reader, small parts of India are in the same (American) behaviour trap. I ask you, whether your savings rate is calculated on your Income, or your net worth. Readers of this magazine are most prone to a 'feel-good' that comes from asset markets, ignoring the reality of their financial situation. Remember that wealth is nothing but 'accumulated sweat'. Sweat can only be generated from product markets and saved through asset markets. In the early stages of development, we save from what we earn and put our savings into assets. Sometimes we lose the link and start to do the reverse. The sharp explosion in asset prices in India have been caused by a sudden increase in leverage. The 'wealth effect' generated by this, in turn, leads to an increase in consumption. This (effect) should not be confused with the cause. In some markets, I find this relationship gets confused.

Like in real estate recently. Real estate prices, and the wealth generated through their appreciation comes from industrial development, not the other way round. There will be a lot of pain even in India, every time we forget this.