Karela Fry

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The dollar as a probe for faults in economies

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The root cause of the biggest news in the last two days is analyzed by Financial Express:

Indian rupee crashed to a record low and the Indonesian rupiah hit a 4-year trough on Monday, as the expected withdrawal of US monetary stimulus prompts investors to shun emerging markets burdened by weak external balances, slowing economies and inflation.

It followed a slide on Friday in Brazil’s real, a currency that, like the rupee, has been hammered by investor doubts that actions taken by monetary authorities last week will prove effective in stemming the sell-off.

More details are given in an article in BS which explains much:

The Indian rupee plummeted to a record low against the dollar on Monday, leading a rout by Brazil’s real and other emerging market currencies seen by investors as the most vulnerable to an exodus of foreign capital.

A fierce selloff in many emerging currencies shows no sign of abating as the expected withdrawal of US monetary stimulus prompts investors to shun markets seen as riskier because of funding deficits, slowing economies and inflation.

The rupee fits that bill, as do the Indonesian rupiah, the South African rand and the Brazilian real. The rupiah plunged to four-year troughs on Monday while the rand lost another 1% to bring year-to-date losses to almost 17% against the dollar.

Brazil’s real extended last week’s fall of more than 5% fall to trade at its weakest level since March 2009 even as the central bank sold nearly $3 billion worth of currency swaps, which are derivatives that mimic an injection of dollars in the futures market. Like the rupee, it has been hammered by doubts over the efficacy of policy actions to stem the rout.

The rupee and the real, respectively, have been the worst performers in Asia and Latin America since late May when the Fed first signalled that it may begin winding down its monetary stimulus this year. India’s currency has lost 13% against the dollar this year while the real has plunged 15% in the same period.

A decline in the Fed’s bond purchases will push government debt yields higher, which should raise the attractiveness of the dollar and dollar-denominated assets.

The finance newspapers make more sense on many complex issues than the large-circulation political newspapers. The article above allows us to take a look at a recent opinion piece in the Hindu and progress beyond the usual political conclusions drawn there:

Of course, to be fair to the central bank, it can only do what is within its powers and that is using monetary policy tools; these cannot substitute for resolute action from the fiscal side, which is the government’s prerogative. Indeed, the comments of Prime Minister Manmohan Singh on Saturday at a RBI function couldn’t have been more apt. Dr. Singh spoke of the “possibilities and limitations of monetary policy in a globalised, fiscally constrained economy.” He may or may not have meant it as a dig at the central bank but the truth unfortunately is that there are indeed limits to what monetary policy can achieve in the absence of support from fiscal policy.

First, a quick brushing up of this crucial difference from a clear explanation in Economics Help:

  • Monetary policy involves changing the interest rate and influencing the money supply.
  • Fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy.

If the finance newspapers are correct, then the analysis of the news gives us the following story. The US Federal Reserve’s stimulus package was the US domestic monetary policy response to the sub-prime crisis. Due to the global reach of the dollar, this money spilled in to investments in emerging markets, so buoying up the Indian market during the lean months of 2009.

At about the same time oil imports started costing more. During this time of dollar inflows, the oil price rise could been passed on to the consumer. However, political compulsions, such as the uncertainties arising from the Raja racket and Didi tantrums, meant that this sensible step was not taken. Instead the deficit was absorbed into the budget in a mistaken fiscal policy.

After a point this became unsupportable, and the price rise was eventually passed on to consumers. As a result, we have a major deficit as well as a rise in prices. This happened just before the US money supply began to dry up, causing the stock market to take a beating.

Manmohan Singh would then be right that the solution was not in tweaking monetary policy. However, it turns out that the Reserve Bank is not a caged parrot, and so can sing its own tune. The government has held office during a period of real growth, when economic benefits did trickle down to a large section of the population. Some would contest this, others would say that it arose from the same mistaken assessment of the Indian economy which led the government to try to absorb the oil price deficit. But this seems not to be the main cause of the present triple crisis: deficit, inflation, market uncertainty. These are of the government’s own making, and can hit it hard in the upcoming election.

Should we blame this on the US sub-prime crisis? Not really. The crisis was certainly an external force probing the strength of our economy. But, if the above analysis is correct, then the Congress’ inaction on corruption and the opportunistic politics of its regional political partners were the real fault lines along which the the economy collapsed. The era of coalitions is bound to continue, since the two big parties are no longer big enough on their own. The cracks in the economy cannot be healed unless it becomes important for regional parties to become more responsible.


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