C.R.L. Narasimhan

Averting currency crisis by consensus

NEW HIGH: An Australian 100 dollar note (centre) amidst a raft of foreign currencies. The Australian dollar hit a new record against the U.S. currency on October 7, smashing through its post-1983 float high on expectations of higher interest rates.  

The world's major economies, which had so heavily depended on mutual collaboration and co-operation during the crisis period, seem unable to stem a rash of competitive depreciations of individual currencies.

At the G-20 meetings and subsequent summits, the agenda and the declarations were built on the premise that the world's leading economies, which had come together to hammer out a co-ordinated strategy to tackle the crisis, would exhibit the same spirit of co-operation and nurture the nascent global recovery.

However, even as the focus of the discussions at the summits has been on building a consensus on such weighty matters as withdrawing from the stimulus packages and global financial sector regulatory rules, there has been a dangerous drift towards unilateralism in currency matters.

Given that there is a singular lack of co-operation even in trade matters — the Doha round has very little chance of reaching a culmination this year as agreed — the developments in the currency markets are particularly ominous.

Incidentally, currency management policies, even if they seem to be manipulative by other countries, are not proscribed by the WTO rules but such practices do undermine the spirit of multilateralism.

Beginning of a war?

Brazil's Finance Minister Guido Montego has described the general weakening of currencies as a manifestation of an international currency war.

The IMF chief has warned against the tendency of individual countries using their exchange rates to solve their domestic problems.

He was referring to the fact that a depreciation of a country's exchange rate enhances export competitiveness, at least over the short run.

If, however, every country were to weaken its currency in retaliation, there can only be one result: in the past policies such as ‘beggar thy neighbour' have had disastrous consequences for the global economy in the 1930s. At the present juncture, such policies can only be inimical to growth.

On the face of it, it looks as though there is a contest between two super powers, the U.S. and China, against a background of weak global demand, with other countries suffering damage.

Strong case

There is a strong case for the IMF, the World Bank and other multilateral institutions to try and persuade individual countries to agree to a degree of co-operation. For now, however, the ‘currency war' seems only to escalate.

The latest to join the game has been Japan, which recently announced an asset purchase scheme.

Large scale asset purchases by central banks appear to be the latest weapon of choice in advanced countries.

In the U.K. and the U.S. there has been a strident debate over the merits of quantitative easing, but their trading partners are convinced that they are engaging in competitive devaluation. While this boosts liquidity and may well become a potent weapon in the next round of currency war, what is more worrying is Japan's decision to intervene directly in currency markets after a gap of several years.

Japan, however, is in good company. Switzerland, South Korea and Taiwan have intervened recently to restrain their currencies from rising but so far with mixed results. Brazil has imposed a tax on capital inflows, a move that has been emulated by a few other important emerging economies.

What lies ahead?

Competitive currency devaluations are but a manifestation of the global imbalance. Unless a way is found to tackle the imbalance in an orderly manner, the world will see many more instances of currency and trade war.

Already in the developed countries protectionism is on the rise.

As in the 1930s, every country is looking to export its way out of trouble but by definition only a few can succeed.

In the run up to the November G-20 meeting in Seoul, there has been a renewed call for global cooperation to halt the trend towards unilateralism in trade and currency matters.

However, the necessary preconditions for a mutually beneficial agreement are not being met. There will have to be supportive shifts in underlying policies to rebalance the global economy.

Surplus countries like China, Japan and Germany would like to see fiscal consolidation by the U.S. to protect the value of their reserves now overwhelmingly in American government securities and paper.

The U.S. and other deficit countries would like china to revalue its currency at a faster pace along with supply side policies to rebalance economies towards consumption. Obviously plenty of sacrifices are required on both sides.

Another important pre-requisite is policy flexibility which for a variety of reasons is not in evidence in the U.S. and certain other big developed economies.

Rupee appreciation and RBI's stance

India has had a tradition of intervening in the foreign exchange markets to prevent a sharp rupee appreciation. However, at a time when the country is facing a flood of money from foreign institutional investors the central bank is keeping away from the markets. During this calendar year total FII flows have so far aggregated $19 billion.

The rupee has appreciated sharply. Some observers hold the view that the appreciation in real terms is not as significant when compared with the currencies of some of India's competitors. However, the rupee is rising at a time the trade and current account deficits have been widening. The Finance Minister has ruled out curbs on foreign inflows for now.

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