The Currency Wars

“Problems are like babies the more you nurse them the bigger they grow”.

By

Prof Anil Menon

“Our currency your problem“is the new war cry. On Sept 27, 2010 the Brazilian finance
minister stated the obvious speaking of “an international currency war”. This fear of
currency wars, which ironically is a race to making ones currency weaker, has
increasingly gripped the financial markets and global leaders. This has been the topic of
discussion at IMF, World Bank, G7, G20 meet etc. The present article examines
logically its causes and consequences.

Q1) What is a currency war?

Ans. This refers to the manipulation by countries of their respective currencies. Countries
are now actively seeking to influence the value of its currency. This intervention is at
different levels. Some are seeking to prevent a rapid appreciation of their currency by
levying taxes on foreign exchange inflows and outflows. Many are seeking to undervalue
their currency as it would help them boost their exports and compete better in global
trade.

Q2) How will an undervalued currency boost exports?

Ans. An undervalued currency or depreciation in the local currency will always help
exporters fetch more for the same FX value of exports. For e.g. Indian exporters would
be happy when the rupee is at Rs. 50 to a dollar, as they would earn Rs. 50000 for every
1000 $ worth of exports. However in case the rupee appreciates to Rs. 40 to a dollar, then
they would earn only Rs. 40000/- (20% lower) than earlier. Thus Indian exporters will
always prefer the rupee (India’s local currency) to depreciate or be undervalued. This
principle applies for exporters all around the world.

Q3) What is the origin of the current crisis?

Ans. The origin can be attributed to the Chinese policy of fixed peg i.e. holding the value
of its local currency Yuan fixed against the US dollar. The fixed peg policy has helped
China boost their exports and become the No 2 economy of the world. They have
maintained a peg of 6.83 Yuan per dollar from July 2008 to June 2010. In June 2010,
China promised to let the Yuan respond more freely to market forces. However it is
worth noting that its value has risen only 2% against the US dollar. Thus the fixed peg
has in fact been China’s stated policy and has been practiced by it for a long time. It is
only now that many countries have been voicing their disapproval of the same.

Q4) What is the reason for the increasing vocal disapproval of the Chinese policy?
Ans. The global economy is very weak and is still reeling from the after effects of the
global meltdown. Countries are fighting for a share of a shrunk market and lower demand
from developed economies. Many countries especially export oriented countries like
Germany; Japan etc are finding it difficult to compete with cheaper Chinese goods. This
unfair advantage enjoyed by China is highlighted by the fact that their foreign exchange
reserves rose by a high $194 billion in 3rd quarter of 2010 primarily due to their exports.

China in its defense says that that it has always followed the fixed peg policy and that it is
actually the US dollar which has fallen on value. It blames the easy monetary policy
adopted by US and other developed countries US for the current global problems.

Q5) What is the easy monetary policy adopted by many developed countries?
Ans. Developed countries including US, UK and rest of Europe are currently faced with
lower economic growth and anemic demand. In order to spur economic growth they are
maintaining a low interest rate regime. In fact US have cut interest rates to historic lows
to and is pumping money into the system in order to kick start growth. However this has
led to the problem of carry trade.

Q6) What is carry trade?

Ans. As explained above many developed economies including US have kept their
interest rates at historic lows. This has encouraged many institutional investors (FIIs etc)
to borrow from these economies and invest in developing economies like BRIC (Brazil,
Russia, India, China). The carry trade was a normal phenomenon when investors used to
borrow in Japan and invest elsewhere. However the financial markets are witnessing the
mother of all carry trades where many FIIs are borrowing in the US markets and
investing in emerging economies. This has led to appreciation of the currencies of many
countries making their exports non competitive.

Q7) Why are investors investing in BRIC economies?

Ans. The investors are encouraged to invest in BRIC as they are comparatively less
affected by the global meltdown. Also a substantial part of future global growth (about
60% of the total global growth) is expected from these economies. Investors are hoping
to make a good return on their investments in these economies. This coupled with the low
interest costs has encouraged a lot of foreign exchange flows into various economies.

Q8) How have currencies of major economies been affected and what has been the
response of the affected countries?

Ans. The Japanese Yen has risen to a 15 year high of 82.87 yen against the US dollar in
mid Sept and has hovered around that rate since. The Euro too has touched an eight
month high. Brazil’s currency has risen more than 30% against the dollar since last year.
Many countries have seen an appreciation in their currencies prompting them to respond.

Japan sold the yen for the first time in six years. The effort was to primarily weaken the
yen so as to boost their exports. Switzerland has been intervening to prevent the
appreciation of the Swiss franc for close to 6 months now. Brazil has doubled taxes on
foreign inflows and South Korea has also indicated curbs on currency trades. Asian
economies like Singapore, Malaysia, Taiwan, and Thailand and Latin American countries
like Columbia & Peru have intervened to tap down their currencies. In case of India too,
RBI has also finally intervened due to the strengthening of the Indian rupee to 44 levels.

Q10) What is the solution to this problem?

Ans. The rule to be remembered in these times of weak global recovery is that “When
you are in a hole stop digging.” Therefore countries should give up their beggar thy
neighbor strategies of competitive devaluation. This strategy would be of nobody’s gain
and the world trade would be a loser at large. They should instead adopt a coordinated
action to put the global economy on track. The real structural cause is that there are some
countries like China, Germany, and Japan etc which have based their growth on exports.
These economies should slowly reorient and try to increase domestic consumption.
Countries like US which have been a net consumer should also reorient towards lower
consumption, more savings and exports. This alone in the long run can set right the
global imbalances. However this is easier said than done as good economics need not
necessarily be good politics and vice versa.

Points To Ponder
a) Many countries are seeking to lower the value of their respective currencies
(currency devaluation).
b) This is being done to boost exports and the growth of their economy.
c) Many analysts believe that the Chinese currency Yuan is grossly undervalued.
This gives China an unfair advantage in world trade.
d) China on the other hand says that the lower interest rates set by the developed
economies especially US is fuelling capital flows into other economies.
e) This has led to a war between many countries of devaluing their currency.
f) If not controlled, this may lead to an all out trade protectionism. IMF, G 20 etc
should act to prevent an all out currency war.