Currency wars and what can be done

On September 27, Brazil's finance minister stated that an "international currency war" has erupted. In its October 16 issue, The Economist put "Currency wars" on its cover, with evocative imagery of an aerial dogfight between paper planes of currency notes from different countries.

As that issue pointed out, there are really three separate but related battles going on. First, there is the old and serious problem of a more or less inflexible pegging of the Chinese yuan (aka renminbi) to the US dollar, contributing to the massive Chinese current account surpluses and huge international reserve holdings and correspondingly large and unsustainable deficits elsewhere.

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Second is the exceptionally loose monetary policy being followed (after the 2008-09 global crisis) by major industrial countries, including the US, the UK, Japan and, to a somewhat lesser extent, the eurozone.

Policy rates in these jurisdictions are at or close to zero and money supply is being boosted through "quantitative easing" (QE), whereby the central banks pump up liquidity by purchasing government bonds and other assets. Such action normally tends to cheapen the currencies involved.

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Third is the spillover impact on (and response of) many emerging economies (EMEs) as they are confronted with the flood of international liquidity flowing into their countries in search of higher returns, leading to unwanted currency appreciation and asset price inflation.

Actually, all three of these phenomena or "battles" have been around for well over a decade. It's just that at the present juncture their concurrence and virulence are unduly strong and threaten international economic harmony, to put it mildly. A few words on each of these.

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China is not the only country to have operated an undervalued exchange rate and built large surpluses and reserves. But in today's world, there is no other major economy which runs current account surpluses of 8-10 per cent of GDP, holds an unprecedented $2.6 trillion of reserves and has a currency variously estimated to be undervalued by 20 to 40 per cent.

So, any effort at moderating global trading imbalances (and all the ills that go with them) must involve a central role for the yuan's appreciation. Of course, it also requires higher savings in deficit countries (such as the US and the UK) and lower savings in surplus economies (such as China, Germany, Japan and the oil exporters).

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Countries have frequently deployed loose (expansionary) monetary policy to revive aggregate demand. Following the onset of the Great Recession, nearly all significant economies did so.

They also resorted to massive fiscal stimuli. As the world began to climb out of recession (growth recession in some major EMEs, such as China and India) in late 2009, a number of countries began the process of "exit" from exceptionally loose monetary and fiscal policies.

India began in early 2010, China very recently and many fiscally stressed European nations began fiscal consolidation this summer, especially after the Greek fiscal crisis.

However, in most industrial countries, monetary policy has remained very loose. And in the US behemoth (and also the UK), it is likely to get looser as fiscal stimulus peters out and unemployment stays high (in the US), and sharp fiscal tightening (in the UK) provokes compensatory monetary loosening. The eurozone might also loosen monetary policy as announced fiscal austerity bites.

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So, the flood of international liquidity surging into EMEs is not likely to abate soon.

As EME currencies have appreciated and their international competitiveness has weakened, some have resorted to countermeasures: Brazil has doubled its tax (levied a few months ago) on debt inflows; Thailand has announced a new 15 per cent withholding tax on bond purchases by foreigners; Taiwan has placed restrictions on portfolio inflows; and several EMEs (and Japan) have intervened in currency markets to moderate their currency appreciations. China, for example, has allowed very modest appreciation.

What about India? What have we done? Our authorities (government and RBI) seem to have succumbed to watchful inaction. Since March 2009 the rupee has been allowed to rack up the sharpest appreciation (by a long margin) in real effective exchange rate (REER) terms in our recorded history: about 25 per cent up till September 2010 according to the six-currency index (major trading partners) and 15 per cent according to the 36-currency index (includes significant competitor countries).

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Unsurprisingly, the share of merchandise exports in GDP has stagnated, the share of net invisible earnings has dropped and both trade and current account deficits have widened significantly, with the latter likely to attain a record 4 per cent of GDP in the current year.

Despite all the noble official pronouncements favouring "inclusive growth" and "financial inclusion", our exchange rate policies have contributed to significant job losses in labour-intensive sectors producing traded goods and services.

And the encouragement of external borrowing (including the recently raised caps on FII investment in bonds) and surging portfolio inflows have refuelled asset bubbles in equities and real estate, which, if they reverse, could stress parts of our financial system in a replay of what happened in 2008-09.

The sharply appreciating rupee has, of course, weakened the medium-term viability of our balance of payments. Basically, we have failed to reduce significantly the collateral damage from the ongoing international currency/monetary wars.

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What should be done? Some of the damage is irreparable. But looking ahead, RBI should actively intervene in the forex market to counter excess capital inflows and contain further real rupee appreciation (preferably roll back some of the huge increase that has already occurred).

Of course, the liquidity consequences of the forex purchases should be sterilised through the standard techniques deployed so effectively in 2004-07. Second, we should deploy whatever tools for capital account management that are at hand to contain surging flows.

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Third, the government should seriously consider levying temporary taxes of the kind imposed by Brazil and Thailand.

If our G20 peers suggest that such actions are inconsistent with the spirit of the recent G20 finance ministers' communique, we should simply point out that: a) we are running a large and rising current account deficit and thus contributing to resolving the global imbalances problem; b) we are only moderating the free play of market forces in forex markets; and c) we would not have to undertake such actions if the big players adopted truly market-determined exchange rates (China) and exited from exceptionally loose monetary policies (the US and others).

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As Stanley Fischer is reported to have pointed out (The Economist, October 16, 2010, p.71): why should emerging countries that didn't have financial crises accept currency appreciation forced on them by strong capital inflows as the rich world cleaned up its mess?

In the G20 context, we should have little difficulty in supporting the recent US proposal for numerical caps of around 4 per cent of GDP for current account surpluses and deficits. The proposal is obviously aimed at the major surplus countries. The problem is the absence of any realistic enforcement mechanism even if such caps could be agreed.

The author is honorary professor at ICRIER and former chief economic adviser to the Government of India. The views expressed are personal.

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