Despite the ongoing recession, the dollar has been by and large steady and strong. In the absence of any better investment avenues the appreciation is bound to continue.

Following the September 11 terrorist attacks, the US plunged into a state of gloom. Still, the US dollar has appreciated from Yen 119 to Yen 133 and from Euro 1.09 to Euro 1.14 (See graphs). It is well-known that the Japanese yen is overvalued against the dollar. A further appreciation of the dollar against the yen cannot be ruled out, especially in view of Japan's prolonged recession and a serious crisis in the country's financial system. But the appreciation against the euro has been surprising, when we keep in mind that macroeconomic parameters in the eurozone have generally looked better than in the US.

At the outset, we need to understand that the global forex market is highly speculative in nature. It is this speculation that generates liquidity and makes it an almost perfect market. And in any such market, what drives rates is expectations. Theories such as purchasing power parity and interest parity are too weak to explain exchange rate movements. If speculators expect a currency to move up, they will buy the currency and sell it later to book profits. Similarly, if speculators expect a currency to fall, they will start selling it and book profits by squaring up their original short position.

If the dollar is rising against the euro, it means that speculators are betting heavily on the US economy in relation to the eurozone. One reason could be that Europe's attempts to reform its economies are not fully convincing. The labor markets in the eurozone continue to be rigid unlike the hire-and-fire system in the US. Most large European companies have still not been able to brace themselves against major downsizing. Many of the eurozone countries, especially France, protect their domestic state-owned companies from direct competition. A good example is the French electricity company, Electricite de France, which is protected at home but is aggressively making acquisitions broad. In Germany, there are various restrictions on business operations. For example, retailers cannot open shops before prescribed opening hours. Capital markets in Europe are also less efficient. In particular, venture capital availability is a problem compared to the US. As a result, European companies, barring aside isolated examples like Nokia, have not been as innovative as their American counterparts. And innovation is the engine of long-term growth for all developed economies.

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