International Currency wars

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7 months ago

The Brazilian finance minister claimed that an "international currency war" had broken out on September 27, 2010. First, there is the long-standing and critical issue of the Chinese Yuan's more or less rigid peg to the US dollar, which contributes to China's gigantic current account surpluses, huge international reserve holdings, and proportionally large and unsustainable deficits elsewhere.

The second is the extraordinarily loose monetary policy that major industrial nations, such as the United States, the United Kingdom, Japan, and, to some extent, the Euro zone, are pursuing (following the global financial crisis of 2008–2009). In these countries, policy rates are at or almost at zero, and the money supply is increased by "quantitative easing" (QE), in which the central banks increase liquidity by buying securities such as government bonds and other assets.

This usually results in the currencies involved being less valuable. Third, many emerging economies (EMEs) are affected by the spillover effects of the worldwide money flood that is coming into their nations in quest of higher yields, which causes unintended currency appreciation and asset price inflation. But all three of these conflicts have existed for well over a decade. But at this particular time, their concurrence and virulence are excessively great and endanger the stability of the global economy.

China is hardly the only nation that has amassed sizable surpluses and reserves while maintaining a devalued currency. But in the modern world, there isn't any significant country that maintains current account surpluses between 8 and 10% of GDP, owns a record $2.6 trillion in reserves, and has a currency that is variably estimated to be between 20 and 40% undervalued.

Therefore, any effort to reduce global trading imbalances (and all the negative effects that go along with it) must place a significant emphasis on the appreciation of the Yuan. Naturally, it also calls for lower savings in surplus economies like China, Germany, and Japan, as well as more savings in deficit economies like those that export oil. Nearly all large economies have repeatedly used loose (expansionary) monetary policy to boost aggregate demand since the start of the Great Recession. They also used significant budgetary incentives. Since the global crisis has passed, EMEs like China and India have shifted away from excessively lax fiscal and monetary policy.

However, monetary policy has been extremely lax in the majority of industrialised nations. Additionally, it is likely to become looser in the US giant (as well as the UK) as the effects of the fiscal stimulus fade, the jobless rate remains high, and rapid fiscal tightening results in compensatory monetary loosening. The announced fiscal austerity measures may potentially cause the Euro zone to ease monetary policy.

Therefore, it is unlikely that the influx of foreign liquidity into EMEs would slow down any time soon. Some EMEs have taken countermeasures as their currencies have appreciated and their ability to compete globally has decreased. For example, Brazil recently doubled its tax on debt inflows; Thailand recently announced a new 15% withholding tax on foreign bond purchases; Taiwan has imposed restrictions on portfolio inflows; and several EMEs (as well as Japan) have intervened in currency markets to restrain their currency appreciation. For instance, China has permitted minor appreciation.

Our government and the RBI appear to have given in to watchful inaction in regards to India. Since March 2009, the rupee has been permitted to appreciate at its fastest rate (by a wide margin) in real effective exchange rate (REER) terms in our history. Up until September 2010, the six-currency index (major trading partners) pegged the rupee's appreciation at about 25%, and the 36-currency index pegged it at 15%. (includes significant competitor countries). Unsurprisingly, both the trade and current account deficits have grown significantly, with the latter likely reaching a record 4% of GDP in the current year. The share of merchandise exports in GDP has also stagnated, while the share of net invisible earnings has decreased. Significant employment losses have been caused by our exchange rate policies in labor-intensive industries that produce traded goods and services.

Additionally, the promotion of external borrowings (including the recently increased limits on FII investment in bonds) and soaring portfolio inflows have refuelled asset bubbles in equity and real estate, which, if they burst, could put stress on certain aspects of our financial system and resemble what occurred in 2008–2009. The medium-term viability of our balance of payments has, of course, been undermined by the dramatically rising rupee.

What to do next involves numerous actions. First, to combat excessive capital inflows and stop further real rupee appreciation, the RBI should actively engage in the FX market. Consequences of currency purchases should be eliminated using the tried-and-true methods that worked so well from 2004 to 2007. Second, capital account management should employ measures for controlling soaring flows. Third, the government ought to give serious thought to enacting temporary levies similar to what Brazil and Thailand do.


Lead image credited to pixabay. Thank you for your time.

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