Strong currency in a weak economy!

Even as the US financial markets continue to get battered and the economy slips deeper into a recession, in defiance of all conventional theories, the dollar has continued to strenghten against all the major currencies. While some analysts have attributed this to the essential resilience of the US economy, the real reasons may lie elsewhere and the rise may be a temporary phenomenon.

As Brad Setser explains, referring to recent studies by Sophia Drossos and Yilin Nie of Morgan Stanley, foreigners unwinding their positions on dollar denominated US debt, built up during the sub-prime bubble, have put strong upward pressure on demand for dollar. The natural sellers of US Dollar in the global markets, American banks with their large dollar depsosits, have suddenly become tight fisted and wary of any lending, thereby driving up the premium on USD LIBOR.

For example, the appreciation of the dollar with respect to rupee has been driven by the massive withdrawal of funds by foreign portfolio investors, repatriating their profits back home to shore up the finances of their belaguered parent firms.

Another dynamic has been the emergence of a USD denominated carry trade, fuelled by the low interest rates in the US. Investors have been borrowing at the low rates in the US markets, thereby increasing the demand for dollars, and investing in foreign currency markets having higher interest rates. A weaker dollar has accentuated this trade, as it meant that the borrowers could also profit from the exchange rate weakness of dollar.

But all these are temporary phenomenon, and cannot sustain the appreciating dollar, especially given the over 5% current account deficit. The stronger dollar will hurt the competitiveness of the US exports, and widen the trade deficit even more. It is therefore inevitable that the dollar fall down considerably in the coming days if the structural imbalances in the economy are to be remedied.

Update 1
The Economist, quoting an NBER paper by Kristin Forbes, thinks that the size, liquidity, safety, efficiency and transparency of the US financial markets, relative their under-developed financial markets, makes emerging economy Central Banks and their investors, channel their monies into US financial assets. Further, as the graphic below shows, despite all the recent turmoil, dollar continues to be the favored reserve currency.