Depreciation is a politically easy way out for industrialised nations

Dubai: One of the great puzzles of the past two years that defied expectations was the appreciation of currencies of the industrialised nations (hereafter, Majors) against the emerging markets (hereafter, Minors). Especially as the credit crises worsened in the Majors! But it was always not so.

At first the markets did behave as textbooks predicted. Against the US dollar, the Turkish lira went from a low of 1.4 (late April 2007) to a high of 1.14 (in August 2008) and declined back to 1.79 (February 2009). Similarly, the Indian rupee went from a low of 44 (March 2007) to a high of 40 (March 2008) and then declined to 51 (February 2009). This schizoid pattern - of appreciation followed by depreciation - was observed in the Korean won, Brazilian real and others. As this seesaw unfolded, uncertainty mired the markets.

In retrospect, following is clear. As the markets in the Majors declined - the dollar, euro and yen went into a relative free-fall. Weak economy leads to currency outflow. Furthermore, the Minors held stable. However, as the crises worsened and financial disasters mushroomed - risk aversion in investors skyrocketed. Global players (hedge funds, investment banks, pension and mutual funds, high net-worth individuals) came under increased pressures via redemption of funds, asset value declines, margin calls and panic ensued.

A natural response was a flight to safety. And safety was defined by two criterions: (a) a liquid investment market (b) well understood institutional mechanisms. And thus US Treasuries and other 'non-sexy' instruments - despite almost zero interest rates - became assets of choice.

The Majors appreciated. Till then, most asset managers paid lip service to institutional quality while they chased higher returns by taking on risk. Suddenly, institutions and market depths mattered! To echo Donald Rumsfeld, in times of crises, global capital ("the money that never sleeps") preferred the known unknown of a shaky US market rather than the unknown known of the stable emerging markets.

Today, as paranoia and fear recedes - normalcy and "greed" return. Two fundamental concerns drive exchange rates - one feeding the other.

A gradual anxiety has begun to emerge about the unprecedented quantitative easing that central banks of the Majors undertook. The second major concern is inflation driven by goods market through demand-supply shocks via commodities and agricultural products. And signs are writ large that both factors manifest in different ways.

The equity markets in the Minors are up by more than 55 per cent this year, and as Barclays reports, higher than 2005 levels. Growth has been robust alongside stable political economy cycles. In contrast, the Majors struggle to escape massive retrenchment of capital investments and decline in private assets. Resultantly, perceptions about inflation (real and monetary driven) are substantively different in the Majors and Minors.

Predictably, so will policy prescriptions and technocratic perceptions vary in markedly dichotomous fashion. For example, the Reserve Bank of India's inflation estimates continues to play catch-up with reality (see potato and sugar prices rising - up 28 per cent) induced by erratic monsoon and larger structural concerns in agriculture.

In contrast, the Majors, particularly the EU and US continue to tackle a troika of issues: negative to zero growth, mild to non-existent inflation and rising unemployment numbers.

So interest rate hikes in the Minors are inevitable by early to mid 2010 - as soon as their central banks are convinced that growth is stable.

The markets have begun pricing in the rise of the Minors. The one-year rupee par-swap rate has dramatically risen from 0.95 to 1.6 percentage. In case of the US, with a crumbling manufacturing sector, depreciation will indeed be a policy instrument of choice.

Since the Napoleonic Wars in the 1800s, when historic powers suffer from underutilisation of resources - depreciation is a politically easy way out.

America in 2009 is no different!

- The columnist works for a major European investment bank in New York City. Views expressed here are the author's own and do not necessarily reflect the views of his company or of Gulf News.