It was September 27, 2010, when the Brazilian finance minister stated that an “international currency war” has erupted. Three separate but related battles are going on – first, there is the old and serious problem of a more or less inflexible pegging of the Chinese Yuan to the US dollar contributing to the massive Chinese current account surpluses and huge international reserve holdings and correspondingly large and unsustainable deficits elsewhere.
Second is the exceptionally loose monetary policy being followed (after the 2008-09 global crisis) by major industrial countries, including the USA, the UK, Japan and, to some extent, the Euro zone. 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 an action normally tends to cheapen the currencies involved. 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.
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However, all the three battles have been around for well over a decade. But it is just that at the present juncture their concurrence and virulence are unduly strong and threaten international economic harmony.
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% of GDP, holds an unprecedented $2.6 trillion of reserves and has a currency variously estimated to be undervalued by 20 to 40 %.
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 and lower savings in surplus economies like China, Germany, Japan, and the oil exporters.
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Following the onset of the Great recession, nearly all significant economies have frequently deployed loose (expansionary) monetary policy to revive aggregate demand. They also resorted to massive fiscal stimuli. Since the global crisis over in EMEs like China and India, there has been an exit from exceptionally loose monetary and fiscal policies.
However, in most industrial countries, monetary policy has been 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 and sharp fiscal tightening provokes compensatory monetary loosening. The Euro zone might also loosen monetary policy as announced fiscal austerity bites.
Therefore, 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 counter measures: Brazil has doubled its tax (levied a few months ago) on debt inflows; Thailand has announced a new 15% with-holding 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 modest appreciation.
With regard to India, our authorities (government and the RBI) seem to have succumbed to watchful inaction. Since March 2009, the rupee has been allowed to rock up the sharpest appreciation (by a long margin) in real effective exchange rate (REER) terms in our recorded history: about 25% up till September 2010 according to six-currency index (major trading partners) and 15% 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% of GDP in the current year. Our exchange rate policies have resulted into significant job losses in labour- intensive sectors producing traded goods and services.
And the encouragement of external borrowings (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.
What to do then requires many measures – first, the RBI should actively intervene in the forex market to counter excess capital inflows and contain further real rupee appreciation. Consequences of forex purchases should be sterilised through the standard techniques deployed so effectively in 2004-07. Second, tools for containing surging flows be used for capital account management. Third, the government should seriously consider levying temporary taxes of the kind imposed by Brazil and Thailand.