Dollar supremacy and lessons to be learnt

The supremacy of Uncle Sam in the global scene can be gauged by how the Federal Reserve’s action on quantitative easing (QE) can cause pandemonium across the globe.

Simply put, the Fed has said that once economic conditions look up in the US, meaning thereby that unemployment level comes down to 7 percent, it will reduce or gradually withdraw the $ 85 billion monthly buyback of bonds.

The prospect of the same has created chaos in the markets as foreign funds have started moving their money back home causing emerging markets currencies to fall as well as stock markets to decline.

Those currencies which are associated with high CAD have declined at a higher rate. Now there are pleas made to the Fed to consider the possible distortions that will be caused to the emerging markets by withdrawing at this stage when global recovery appears quite tenuous. However, the Fed’s view today is that it works for the US and not the world.

Two issues stand out from this development. The first is that the QE programme should be understood a bit more clearly and the second, all developments since 2007 until today tell a broader story of how the US still dominates the global arena and that the hubris around the BRIC(S) nations was short lived and notwithstanding the hype over the euro or the emerging markets getting a stronghold, we are back to the dollar supremacy.

The US still appears to be the superpower in the economic space as well as the political arena, where it has been virtually unchallenged in the last two decades.

Quantitative easing was an outcome of using non-conventional measures to boost the US economy in the aftermath of the financial crisis. When investment banks went down and insurance companies were stymied when they ended up holding plagued assets, the viability and credibility of the financial system was in jeopardy.

Banks did not want to lend to one another as they were not sure of the strength of the counter party. While interest rates were lowered sharply, it still did not quite help as there was trust deficit among institutions. At the same time, the Fed had to invoke its special authority to bail out institutions that it did not regulate. It was here that the QE made a difference.

By buying back bonds, first CDOs, MBS and ABS and later treasuries, the Fed infused liquidity into the system. With the door being open for not just banks but also funds, there was surplus liquidity. But with limited opportunities in the US given that growth was stagnant and declining, these funds looked to the emerging markets which were doing very well and had good valuations given future prospects.

Following the financial crisis in the US, we had the euro crisis which meant that this entire set of nations had their own afflictions. Therefore, money flowed into both debt and equity segments of emerging markets. This helped to shore up forex reserves, boost stock markets, increase investment and hence GDP growth. The main beneficiaries were China, India, Brazil, South Africa, Indonesia, Korea, Thailand and the entire set of eastern European countries.

This is one decision which was opposed by Joseph Stiglitz who had seen the futility of the concept of the QE from the beginning. In fact, his position has been that the QE has not really helped the US and instead diverted funds to other nations leading to other problems such as dealing with forex surpluses in the form of higher liquidity and stronger currencies which have distorted their trade balances.

He has warned earlier, that when the reversal takes place there will be further distortions of high magnitude which we are witnessing today. Therefore, the so called collateral damage we are witnessing across emerging markets that were dependent on these funds has been more severe than the benefits we got when they came in during those difficult years – 2008 onwards. But we must remember that the QE programme was to support the US economy and not the rest of the world, and if it did, then it was more a case of serendipity.

At a broader level, this entire episode has several lessons for us in terms of American supremacy. First, a lot has been made of the financial crisis when the emerging markets got away, supposedly because they were better organised. This was the now famous decoupling theory which says that the world economy can be driven by the emerging markets which was the case for a couple of years. But, today it is clear that the US economy still drives the world economy and the initial economies of scale generated from a relatively lower base in countries of the BRIC group cannot be sustained in the absence of strong growth in the US. The emerging markets are not really a homogenous group, but more a case of classification nomenclature which are not organised to create size due to distance, ideology and relative economic strength.

Second, the dollar still is the supreme currency. The euro was to provide competition to the dollar as the more preferred currency by virtue of being accepted by 17 nations. But the euro crisis has shown how it is difficult to create and conduct a currency based on different aspirations of various nations, howsoever similar they may appear to be. While the world is trying to conjure another reserve currency that is credible and can be accepted by all nations, there is no progress given that the only other currency that is strong today with enough bulk is the renminbi, which, however, is not trusted as it is politically manoeuvred.

Third, while all central banks have said that they conduct their monetary policies based on domestic consideration, which is true to a large extent, they can still not ignore what the US does as the viable reserve currency and its supply across the world still depends on the actions of the Fed. Any change in interest rate stance will have an impact in terms of flow of funds. In fact, this will affect sectors such as stock markets, real estate, and banking. This has already been felt in all the beneficiary countries from the QE.

Fourth, while a lot has been said about the US debt level and the fiscal spending, given that it is the most accepted currency, the government will necessarily have to continue spending and neglect these concerns to provide dollars to the rest of the world. Therefore, ironically for the other countries to grow with a modicum of robustness, the US must be benevolent spender.

The emerging markets have actually tumbled a lot and there is quite a bit of adverse thoughts on the growth models pursued by these nations. The Chinese model of investment-oriented growth has not quite shown sustainability while the Indian model of growth being propelled by higher consumption through subsidisation and not enhanced productivity has its own limitations. Russia is still to match the other nations and minus oil, would probably move into the shadow region. Brazil is not quite a global player in any forum and has tagged along more with the group.

Hence, the US will continue to dominate the global economy and the rest have to get their acts together and embark on a fresh set of reforms to really make an impact. This will hold as long as the dollar reigns supreme. The US still continues to wield clinching power when it comes to helping out other countries through the IMF and World Bank, and if it stops buying, China will have to struggle to find markets. It is doubtful that the Fed will look seriously at the concerns of the emerging markets when it starts withdrawing the QE programme, and the time has really come for them to actually work on models which are more indigenous and less dependent on these flows. That seems to be way things will look like going forward.

The author is chief economist, CARE Ratings. Views are personal.

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