Currency Wars – Will it save the world?

We have seen the central banks, the world over pursuing policies to keep their respective currencies weak in order to stimulate growth by making exports competitive. Central banks have resorted to verbal as well as monetary intervention to prevent their respective currencies from appreciating on a relative basis. This competitive non-appreciation was termed “Currency War” by the Brazilian Finance Minister Guido Mantega in 2010. Going back in time, to the 20th century, there have been numerous instances of devaluation.

History of Devaluation in 20th century

1)   During the Gold standard era, post the great depression of 1929; in order to deal with deflation, the US Congress passed the Gold Reserve Act in 1934 that required all Federal Reserve banks of the US to surrender their gold to the US treasury. At the same time the US Dollar was revalued to USD 35 per troy ounce of gold from USD 20.67 i.e. a devaluation of 40%!!! Increase in gold reserves due to confiscation and revaluation increased the money supply and brought interest rates down which in turn provided a fillip to investment.

2)   Second major instance was during the later part of the Bretton Woods era. US Dollar had become overvalued (relative to peg of USD 35 per troy ounce of gold) due to several reasons. In order to combat the problem of falling gold reserves, high inflation and unemployment, then US President Richard Nixon decided to abandon the convertibility of US Dollars to gold (Nixon shock). This resulted in appreciation of all major currencies relative to the US Dollar; In the Smithsonian agreement (1971) that followed thereafter, the US Dollar was devalued to USD 38 and in 1973 to USD 42.22 per troy ounce of gold. From then on, the US Dollar became a freely floating currency.

3)   The third instance was the historic Plaza Accord (1985). It was unique in its own way as it was an agreement between West Germany, Japan, France, the UK and the USA (G-5) to devalue the US Dollar in a concerted manner to revive global growth. To combat the stagflation of 1970s, then US Federal Reserve Governor, Paul Volcker had raised interest rates that in turn had caused the US Dollar to strengthen by over 50% between 1980 and 1985 against the major currencies. As the US was then the engine for global growth, the other countries agreed to let the US Dollar depreciate to revive the US export sector. The US Dollar as a result depreciated by around 50% against the other four major currencies but failed to export in the Japanese markets due to Japan’s structural restrictions on imports.

4)   The Indian Rupee has also been devalued twice. Once in 1966 by around 36% and then in 1991 by around 19%. Prior to 1966 the Indian Rupee was pegged to the US Dollar at 4.76. High domestic inflation coupled with war against Pakistan necessitated devaluation to 7.5/USD to obtain foreign aid. Prior to 1991 Indian Rupee was pegged against a basket of currencies of trading partners. Faced with government default and balance of payment crisis, a decision was taken to devalue the Rupee.

Major Central Banks currently intending to keep their currency weak

Most of the major central banks are currently running ultra loose monetary policies intended at stimulating consumption, investment and generating employment.This has resulted in record low interest rates, multi year lows on several currencies, huge increase in money supply and record balance sheet sizes of central banks. Low interest rates and weak currencies naturally go hand in hand. Former RBI governor Dr. Raghuram Rajan has referred to this as the central banks being caught up in a classical prisoner’s dilemma (as in whether to opt not too follow an ultra loose monetary policy and risk conceding the advantage to competing economies).

The People’s Bank of China for quite some time now has been known to have kept the Yuan artificially devalued to support its economy heavily reliant on exports. It is currently grappling with a huge real estate bubble, overcapacity and capital outflows.It has been accused of dumping goods and exporting deflation around the globe. Free movement of capital, an independent monetary policy and a fixed exchange rate constitute an impossible trinity. If a country were to have an independent monetary policy and were to allow free movement of capital, it cannot have a managed exchange rate.

The European Central Bank (through TLTRO), Swiss National Bank, Bank of Japan (through QQE), Reserve Bank of Australia are also currently pursuing expansionary monetary polices intended to keep their currencies weak. The SNB is known to have intervened from time to time to keep the Swiss Franc weaker than the Euro. The officials from other central banks have often reiterated on numerous occasions that a strong domestic currency is not good for the economy. The Federal Reserve officials and the MPC members of BoE (prior to Brexit vote) have also engaged in verbal intervention to prevent the US Dollar and Sterling respectively from appreciating.

At a time when all the major central banks are engaged in policies to weaken their respective currencies it is quite obvious for one to question the rationale of central bankers. Such policies may in fact do more harm than good as they create financial disturbances, trade imbalances and political turmoil. It is no longer absolute but relative (prisoner’s dilemma).

Evidence of Financial Disturbances

The commitment of central banks such as ECB and BoJ to keep respective currencies weak encourages speculators to take nakedone-sided bets, resulting in asset bubbles like the one that is possibly building up in US equities right now. Several US stocks to me are currently trading at prices much higher than their valuations merit.

For a long time the Swiss National Bank (SNB) was committed to protecting a floor of 1.20 against the Euro. On January 15th, 2015, the SNB removed the floor price for EUR/CHF. This led to a crash in the Swiss stock market and resulted in huge losses for several hedge funds which had taken on bets assuming that the SNB would continue to defend the floor.

The US Federal Reserve had held the US interest rates down and kept the currency weak for a long time after the dot com bubble bust. A prolonged period of low interest rates and a delay in hiking them is thought to have planted the seeds of the sub prime mortgage crisis. 

Former RBI governor Dr. Raghuram Rajan has been vocal about central banks of developed economies considering the fallout of their policies on emerging market economies like India. Ultra loose monetary policies of developed economy central banks floods the emerging economy capital markets creating asset bubbles (distorting valuations) and undesirable currency volatility. When the developed economy central banks start normalizing their policies, the unwind that happens in emerging economy capital markets is equally severe.To put things into perspective, the FPIs had net bought USD 8 Bn worth of Indian stocks and bonds up to September this calendar year. In October, November, December alone on fears of faster pace of US rate hikes, the FPIs have dumped USD 9 Bn worth of Indian stocks and bonds! We saw much wilder moves in USD Debt of governments and corporations in the Mexican and the East Asian economies.

In an attempt to generate goods inflation by stimulating demand and getting the engines of growth running, asset price inflation is often ignored which often plants seeds for the next recession.

Evidence of Trade disruptions

US president elect, Donald Trump has been vocal about imposing trade restrictions on Chinese goods to bring back manufacturing jobs to the US. Several other countries in the past have imposed tariffs, anti dumping duty or ban on certain Chinese goods to safeguard the interests of domestic producers. Extreme currency manipulation is therefore not in the interest of global free trade.

Social & Political Implications

There is growing resentment among voters of developed economies against the “beggar thy neighbor” polices of some of the developing economies that result in offshoring of jobs.This resentment explains the unexpected electoral outcomes favoring right wing candidates/parties who campaigned for protectionism and promised enhancing job opportunities on shore. Outcomes of the Brexit referendum, US presidential elections and Italian referendum bear testimony to the tide of nationalism that has swept across developed economies.

Should Emerging Economies Like India Join the Bandwagon?

Most of the economies striving to keep their currencies weak discussed above are trade surplus economies (with the exception of the US and UK; Germany the major economy in Eurozone is a trade surplus economy) or developed economies with low inflation which can to some extent afford to have weaker currencies. This brings us to the question; whether central banks of emerging market economies that run a trade deficit should also strive to keep their currencies weak. There are a host of factors that emerging economy policy makers should consider before they decide to do so.

1)   What percentage of GDP is accounted for by exports? i.e. How significant the contribution of the export sector to growth and employment generation is?

2)   How they can improve productivity to make exports more competitive? Currency is only one of the factors affecting export competitiveness. Incentives to exporters that facilitate productivity enhancement and ease of doing business initiatives such as simplified trade finance documentation etc can also increase export competitiveness.

3)   How would currency depreciation impact the fiscal deficit and inflation? Considering current international crude prices, and current demand of crude oil, every 2.2% depreciation of the Indian Rupee increases the fiscal deficit by 0.1%

4)   What message would currency depreciation convey to international investors? How would it affect capital flows? A stable currency fosters confidence for durable FPI inflows into capital markets. A persistently weakening currency reduces the return on investments in Dollar terms

5)   To what extent are the country’s exports unique? In other words what is the elasticity of demand in global markets?

6)   What is the global demand outlook? In a period of global demand slump, weakening the currency is unlikely to boost exports.

Empirical evidence shows that in case of India, depreciation of the rupee in REER terms has not contributed significantly to increase in exports. Indian Rupee has been appreciating on REER (real effective exchange rate) basis that can be explained by the Balassa Samuelson effect, which suggests that for an economy experiencing an increase in productivity (GDP per capita), real exchange rate appreciation is likely.

The correlation between the REER and Services exports is 0.25. Thus there is no evidence that the currency overvaluation impacted exports in a significant way. Services exports have been considered, as it is a better indicator for this comparison. A Major share of goods exports comprises of petrochemicals, price of which is closely linked to crude prices. Therefore the USD value of goods exports is very sensitive to crude prices.

In summary, at a time when global demand is faltering, an export focused growth strategy may not prove to be as effective as it was earlier. Countries like Japanese are still paying the brunt and Chinese have started following suit. Emerging markets should therefore look to tap the immense potential of domestic demand to boost growth. They should strive to differentiate their export basket from those of competing economies. These exports would be relatively less sensitive to variation in valuation of domestic currency. Enhancing productivity through technological innovation can possibly be the future going forward.