What Will Happen Next to the U.S. Dollar

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Last Friday, U.S. President George W. Bush lost no time in signing into law a highly flawed but seemingly inevitable $700 billion bailout package and $110 billion of add-on spending. Now, we all will have to live with the unintended consequences.

It may seem incongruous in current circumstances, where the U.S. dollar has strengthened prodigiously since mid-July, to expect the currency to be among the obvious victims. Russian policymakers could again be subject to the whipsaw effects of Washington's benign neglect.

Ironically, Russia's policy dilemma as recently as the second quarter of this year was how to neutralize the massive upward pressure on the ruble exchange rate stemming from capital inflows coming on top of an oil-driven current account surplus. The cost for Russia was a worrying spike in inflation to more than 15 percent in an effort to manage the ruble appreciation. Even so, the ruble rose in dollar terms by 6 percent in the first six months of 2008. This came on top of a 12 percent increase in the previous three years.

For almost three months now, the pressure increasingly is in the opposite direction. Capital outflows more than offset the continuing trade surplus, and the Central Bank lost reserves as it tried to brake the depreciation of the ruble, which fell by 12 percent in dollar terms between July 15 and Oct. 6. Reserves, including valuation effects, have declined by more than $33 billion, to about $560 billion, over roughly the same period.

Certainly, Russia-specific issues weighed on the ruble, such as the tensions over TNK-BP and then Mechel, and especially the brief Georgian war in early August. However, Russia was in good company as other emerging markets and developed countries caught the financial contagion coming from the United States. The euro tanked. It fell from an all-time high of $1.60 in May to a low of $1.35 this past Monday, a 16 percent depreciation.

In the context of the biggest financial meltdown in almost 80 years, fear predominates in financial markets. The resulting flight to safety has overwhelmed all concerns with profits as global investors -- fleeing from emerging markets, oil and almost all categories of assets -- sought the ultimate safety of U.S. treasury bonds, driving their yields almost to zero and strengthening the dollar in the process. So far in 2008, the dollar has whipsawed the ruble. What's next? Could it be a double whipsaw as the dollar again plummets? In the immediate period, this seems unlikely. If the financial pandemonium continues and especially if the Europeans are unwilling to imitate U.S. Treasury Secretary Henry Paulson's bailout, then the euro could continue to weaken. The flight to safety would reinforce the dollar. The Central Bank should use this opportunity to float the ruble and minimize the domestic impact of a strengthening dollar, especially if the euro should fall to $1.15, as predicted by at least one mainstream but possibly foolhardy analyst.

How long though could the dollar defy economic gravity? It probably will last as long as fear remains the primary factor driving world markets. And then, when that time comes, economic fundamentals are likely to assert themselves. At that point, the basic fundamentals could be so glaringly obvious that not even the concerted efforts of China, Russia and Saudi Arabia would prevent a dollar collapse. This is not an idle scenario. Let's come back to the bailout. A few days ago, one of my students asked about the conundrum -- how can yields on U.S. Treasury bonds be falling if the debt is increasing so massively?

He hit on a key point. Once things start to stabilize and the perennial flight to the safety of U.S. Treasury securities and the dollar based upon overwhelming fear of a total systemic meltdown start to subside, the proverbial search for return will reassert itself. Risk perceptions in finance all too often seem to have a short memory span. Greed is a powerful force and investors will start to worry about their massive holdings of low-risk but almost zero-return U.S. securities.

Moreover, they will worry even more about the growing fiscal deficit and the colossal sums that will be needed to finance those deficits for years to come. And it is hard to imagine that a new U.S. president and a heavily Democratic Congress would refrain from spending even more than current commitments to ease the economic pain of the recession even if taxes are raised on the more affluent.

Already, before the bailout package, the federal budget deficit was projected optimistically at $438 billion in the fiscal year that began on Oct. 1. I have seen some fairly mainstream estimates of more than double that amount. But who is going to buy all of that Treasury paper? Already last week, U.S. public debt hit a record $10 trillion. Debt service is set to absorb an increasing share of U.S. government spending. For Russians with a long memory, the inexorable dynamic of debt financing will be reminiscent of the events leading up to the August 1998 default on GKOs.

Here is where it gets interesting. Even abstracting from how the external current account can be paid for, primary reliance on U.S. domestic financing is totally unrealistic as it would entail a massive increase in bond yields and prolong the recession for possibly years. So almost invariably, the U.S. Treasury will be in the unenviable position to make those bond sales attractive to Russia, China and oil producers -- the main sources of the world's savings.

Until now, these countries have considered it to be in their own national interest to keep their savings in U.S. Treasury bonds. Each had its own reasons -- in Russia's case, in order to prevent a massively inflationary injection of liquidity from oil sales and a sharp ruble appreciation. However, emerging from the financial turmoil, the circumstances may be different.

The United States' financing needs will be far greater then anything imagined. Until now, the rest of the world needed to purchase almost $2 billion of U.S. treasuries on a net basis every working day. What about more than $4 billion though? And with lower commodity and oil prices, the excess savings will be lower. Moreover, in the case of Russia, especially with higher interest rates, savings could be efficiently deployed to finance truly huge domestic investment needs. In any case, there is now a preference to develop further the local market and the use of the ruble so as to be less vulnerable to contagion the next time a hegemonic financial power destabilizes global markets.

So, the U.S. Treasury will face the unpalatable option of selling its bonds at much lower prices (another bubble waiting to burst) with much higher yields to entice the rest of the world to fork over that $4 billion to $5 billion each day -- but then it's back to the problem that U.S. households and companies would face sharply higher interest rates in the midst of a recession -- or the dollar must drop to make U.S. assets attractive to foreigners.

There really may not be too much choice. Russia should use the breathing room before this happens to pursue and implement the pro-private business policies supporting diversification and higher productivity.

Otherwise, the risk of another whipsaw could be considerable.

Martin Gilman, a former senior representative of the International Monetary Fund in Russia, is a professor at the Higher School of Economics in Moscow.