“University biologists working with infectious viruses have airtight facilities to ensure that the objects of their study do not escape from the laboratory and damage the population at large. Unfortunately, no such safeguards are imposed on economics departments.”
James Rickards, Currency Wars: The Making of the Next Gobal Crisis
Currency wars become a matter of concern in international economy with the recent decision taken by China to devalue its currency yuan by nearly 2% versus dollar, which is the biggest on day fall in two decades. Currency war refers to a situation where a number of nations seek to deliberately depreciate the value of their domestic currencies in order to stimulate their economies. Although currency depreciation or devaluation is a common occurrence in the foreign exchange market, the hallmark of a currency war is the significant number of nations simultaneously engaged in attempts to devalue their currency at the same time. Before understanding the dynamics of currency wars we have to understand the dynamics of exchange rate regimes and their chronological evaluation.
Historical outlook and rise of currency wars:
Brettonwood system of monetary management emerged in late 1950s out of the currency wars raised between the nations, aftermath of World War I. After World War I, Britain owed to the US substantial sums, which Britain could not repay because it had used the funds to support allies such as France during the War; the Allies could not pay back Britain, so Britain could not pay back the US. So Britain and France caught in debt overhang problems followed by stock market crash in US led to a breakdown of the international financial system and a worldwide economic depression. The so-called “beggar thy neighbor” policies that emerged as the crisis continued saw some trading nations using currency devaluations in an attempt to increase their competitiveness (i.e. raise exports and lower imports). In 1931, sterling was taken off the Gold Standard. It was devalued against gold and hence against the ‘gold bloc’ currencies (currencies that remained pegged to gold). Following the devaluation of sterling, Norway, Sweden and Denmark went off the Gold Standard. The US economy, like other countries of the gold bloc, lost competitiveness and exports turned down. Eventually, it forced devaluation of US dollar against gold. Like US economy, remaining gold bloc countries (France, Germany and some smaller economies) also suffered a loss of competitiveness, poor export and industrial production growth. By 1936, they gave up and abandoned the Gold Standard as well. The devaluations also led to some countries imposing tariffs on imports as means of protectionism. So in 1944 at BrettonWoods system of exchange was evolved, as a result of the collective conventional wisdom favoring a regulated system of fixed exchange rates, indirectly disciplined by a US dollar tied to gold.
But in late 1970’s, negative balance of payments, growing public debt incurred by the Vietnam War and Great Society programs, and monetary inflation by the Federal Reserve caused the dollar to become increasingly overvalued. The drain on US gold reserves culminated with more and more dollars were being printed in Washington, then being pumped overseas, to pay for government expenditure on the military and social programs. In the first six months of 1971, assets for $22 billion fled the U.S. In response, on 15 August 1971, Nixon suspended convertibility of dollar into gold. Unusually, this decision was made without consulting members of the international monetary system or even his own State Department, and was soon dubbed as Nixon Shock. Throughout the fall of 1971, a series of multilateral and bilateral negotiations between the Group of Ten countries took place, seeking to redesign the exchange rate regime. Meeting in December 1971 at the Smithsonian Institution in Washington D.C., the Group of Ten signed the Smithsonian Agreement.
Finally Smithsonian agreement also failed resulting to collapse of Brettonwood and left all the countries to manage their own currency regime either floating or fixed or managed floating with occasional intervention of central bank.
2008 great recession and new era of currency wars:
According to Guido Mantega, the Brazilian Minister for Finance, third global currency war broke out in 2010. This view was echoed by numerous other government officials and financial journalists from around the world. But the stage for financial war game was made more intense by the fact it took place amid the market panic in late 2008 and early ’09. States engaging in possible competitive devaluation since 2010 have used a mix of policy tools, including direct government intervention, the imposition of capital controls, and, indirectly, quantitative easing.
“Regulators and bankers were using the wrong tools and the wrong metrics. Unfortunately, they still are.”
China initially started currency manipulation in which they sell their own currencies in the foreign exchange markets, usually against dollars, to keep their exchange rates weak and the dollar strong. So thereby subsidize their exports and raise the price of their imports, sometimes by as much as 30-40%. They strengthen their international competitive positions, increase their trade surpluses and generate domestic production and employment at the expense of the United States and others. The U.S. trade deficit has been several hundred billion dollars a year higher and it resulted to loss of several million additional jobs during the Great Recession. Currency manipulation is, by far, the world’s most protectionist international economic policy in the 21st century, but the responsible international institutions, neither the International Monetary Fund nor the World Trade Organization, have mounted effective responses. There was no supranational authority to control the uneven devaluations or revaluations of currencies, so it was become easy for the nation states to indulge in currency wars.
After 2008 financial crisis in order to boost their economic growth, US debased currency through Quantative Easing (QE). By using quantitative easing to generate inflation abroad, the United States was increasing the cost structure of almost every major exporting nation and fast-growing emerging economy in the world all at once. That led to the US dollar depreciating vis-a-vis other currencies, including yuan. US once again attained the growth track with recent World Economic Outlook update, the International Monetary Fund projected that the US economy would grow by 3.1% in 2015 and 2016, the fastest growth rate of the G-7.
Japan’s Shinzo Abe devalued the yen to revive the economy, and so did European Central Bank’s Mario Dragh launched a fresh programme of quantitative easing in January 2015, to revive the Eurozone, flooding the market with liquidity. Once again race to the bottom started, with China devaluing the yuan to regain competitiveness and to eke out an economic advantage for its exports. It has set off other Asian countries such as Vietnam, Kazakhstan, Turkey and Malaysia to devalue their currencies.
Implications for India:
For India, the devaluation could mean “triple whammy” in the form of rise in rupee volatility, exporters facing more competition and China dumping more goods into India. India is already struggling on the domestic front with issues like infrastructure and stalling of key legislations. India and china compete with each other on several export items like textiles, gems and jewellery, a loss in currency competitiveness against the yuan will further hurt its ailing exports.
India’s major export items to China consist of primary commodities with cotton, copper and mineral fuels alone constituting more than 45 per cent of the total exports. Meanwhile, India’s major imports from China are electrical machinery and nuclear appliances (45 per cent of total imports).
Devaluation of yuan results to reduction in cost of Chinese goods and exacerbate the problem of dumping into India from China finally impacting the domestic manufacturers. Tyre makers, steel industry and organic chemicals, petrochemicals industry are already reeling under the increasing dumping cases from China as lower currency incentivizes the country’s exports. India has already huge trade deficit with china and it will further intensify with the situation impacting the current account deficit. Value of rupee will be effected stoking inflation and it will bad for the companies that have dollar denominated loans resulting to decrease foreign flows making stock market unattractive. India imports 80% of its crude oil requirements, and a weaker rupee would mean that our import bill would not fall as much as historically low global oil prices would warrant. This would prompt oil companies to hike petrol and diesel prices. Costlier transport fuel will knock up prices of most goods and stoke inflation.
Higher inflation would mean the central bank will not cut interest rates, ensuring that we have to pay large amounts every month to pay our housing loans. A weaker rupee implies us end up paying more to buy dollars for our foreign education. Likewise, if we were planning an overseas vacation, you had better set aside more money because air tickets, hotel tariffs, shopping and other costs will all go up.
If the yuan continues to lose value, then it might create pressure for the Reserve Bank of India governor to intervene to provide relief for the exporters and cut the key interest rate else the Indian goods would become less competitive.
Similar problems were faced India by during fed tapering following Quantative easing of US. To counter these problems Reserve bank of India has to sell dollars in the market to increase the rupee value at the cost of our foreign exchange reserves. So, developing countries like India, who are prone to hoarding reserves, must address the structural imbalances within their own economies. It will be much easier to do so before a crisis begins than when one begins, because financial markets are prone to “sudden stops”.