2012 is the year of the dollar: it's a mixed bag for India

The US dollar (USD) will make a strong comeback this year as the US economy strengthens and grows at a faster pace relative to its peers in the developed world.

The USD index, which tracks the dollar against a basket of six currencies (euro, Japanese yen, UK pound sterling, Swiss franc, Swedish krona and Canadian dollar), is trading at around 80, up by 8 percent in calendar year 2012 to date. However, the index is down over 30 percent from levels seen in 2002. The dollar index can well regain its losses seen over the last 10 years, with a good portion of the losses made up in calendar year 2012.

A strong US dollar will have major repercussions for markets and economies across the world. The sustained weakness in the dollar over the last 10 years led to question marks over the US dollar as a reserve currency. Markets were at one point of time building in scenarios of a collapse of the dollar, leading to hectic speculation on commodities and emerging asset classes.

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The markets will now have to build in a scenario of a strong dollar. Before going into the repercussions of a strong dollar on world economies and markets, a case for a strong dollar has to be made.

Why will the USD show sustained strength?

The US economy has exhibited more strength than expected over the last eight months. Unemployment levels are down to 8.3 percent from 9.5 percent while 1.2 million jobs have been added over the last six months. GDP growth for the fourth quarter of 2011 was up by 3 percent annualised, higher than estimates of 2.8 percent.

Retail sales were up by 1.1 percent in February, the fastest growth over the last five months. Existing home sales held at a two-year high in February 2012 as lower prices and improving job prospects led to a healthier housing market.

The US Federal Reserve’s (Fed) inflation barometer, at 1.2 percent annualised in February 2012, is lower than its target rate of 2 percent. US consumer price inflation, at 2.9 percent in February, was at a 10-month high led by high fuel prices. Oil prices have gone up by over 15 percent in the calendar year to date, leading to a rise in fuel costs in the US. However, the high fuel costs are seen as manageable and more transitory in nature and does not have policies makers in the US worried.

The US is also seeing an energy revolution with better technology being used to tap its vast shale gas reserves. The shale gas supply has dropped natural gas prices to decade lows while coal prices have dropped to two-year lows as power producers shifted from coal to gas to fuel power plants. US being an energy-dependent country will benefit from the falling prices of natural gas and coal as power costs turn cheaper.

Monetary policy in the US is accommodative with the Fed pledging to keep policy rates at all-time lows well into 2014. The Fed need not resort to a third round of quantitative easing as the economy is showing signs of improving while other central banks - the European Central Bank (ECB), Bank of England and Bank of Japan - are resorting to buying of government bonds or lending to banks (as in the case of ECB) to shore up their respective economies. The dollar will benefit from other central banks printing money.

Emerging economies, including India and China, are facing problems of growing below trend levels due to issues of inflation, property bubbles and weak fiscal position. India and China are coming out of an inflation threat that took inflation levels well beyond comfort zones. India’s inflation was consistently above 9 percent for 2011 while China’s inflation touched peaks of 6.5 percent in 2011.

China has also seen a property bubble that is looking to burst and the government is intent on preventing more such bubbles. Hence monetary policies in India and China have been restrictive, leading to growth forecasts for 2012 for both countries around 7.5 percent, well below levels seen in most part of 2000’s decade. India is facing a weak fiscal position with fiscal deficit overshooting targets by 1.3 percent in 2011-12. India is looking to bring its fiscal position back to more comfortable levels, leading to growth taking a back seat. The dollar will benefit from below trend growths in Indian and China.

What are the repercussions of a strong USD?

A strong dollar is positive for US equities as more money goes into US assets from across the world. A strengthening US economy will also improve economic prospects across the globe, thereby improving sentiments in equity markets globally. Commodity prices will stay down on a firm USD, as commodities are priced in USD and will become cheaper as the USD strengthens. Commodity prices will also lose out on their weak USD hedge status as the dollar will no longer be seen as a weak currency.

Commodity prices will also feel the effect of below trend growth in India and China and the weak growth forecast in the eurozone due to sovereign debt issues. Stable to lower commodity prices will keep down inflation across the globe prompting central banks to ease off on policy. Bond yields in emerging markets will benefit from lower inflation and monetary easing.

India will benefit from a strong USD as software exports pick up on more outsourcing from a strengthening economy and commodity prices are kept down, leading to easing monetary policy. Indian equities will benefit as economic prospects improve for the largest economy in the world. The Indian rupee will see its range move up from levels of Rs 44-48 seen in 2011 to Rs 48-52 to the USD. Indian bonds will see yields trend down as inflation stays down and monetary policy is eased.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.