The currency war’s likely to wage on

Japan recently indicated that it may intervene in the forex market, given the sharp strengthening of its yen. Just this display of intent helped them to momentarily contain the yen’s appreciation.

Ironically, sometime back, Prime Minister Shinzo Abe had said that countries should avoid competitive devaluation, as the yen was hitting a high against the US dollar. The yen has strengthened by 13 per cent since the beginning of the year, with negative implications for the Japan’s exports and growth.

As global growth remains weak, countries are indulging in competitive devaluation. This means countries are trying to gain export competitiveness by causing their exchange rates to weaken. However, this may or may not be justified by the country’s economic fundamentals. Brazil’s finance minister termed this phenomenon the “currency war” in 2010. Competitive devaluation may not necessarily be done through intervention in the forex market. It can also be done by cutting policy interest rates, or quantitative easing. Or even talking down a currency by signalling preference or intent.

From mid 2014 to end 2015, the US dollar strengthened by about 15 per cent on Fed rate hike expectations, andweakened most emerging market currencies. Worried, China devalued the yuan in August 2015 and January 2016 by almost 5 per cent. The devaluation further weakened other emerging market currencies. This was a classic case of currency war on display.

Competitive devaluation in itself may appear to be a zero sum game for the global economy, with some countries gaining at the expense of others. But in reality, a long-drawn currency war can have severe repercussions on the growth and stability of countries, which in turn can jeopardise global growth. Currency war can cause extreme volatility in financial markets. For instance, the yuan devaluation propelled outflows of around $670 billion from China in 2015, which caused jitters in other markets. Taking cognisance of the consequences, global leaders decided at the G20 meeting in Shanghai in February 2016 to refrain from currency war.

The war has continued in the last couple of months, even as the players have changed sides. The sharp strengthening of dollar in 2015 was pinching the US economy through a contraction in exports. The Fed signalled the postponement of the policy rate hike which halted the dollar rally in 2016. While this provided a reprieve to the US economy, it came at the expense of the EU and Japan. Both, the euro and the yen have strengthened strongly in 2016. This, in spite of poor growth recorded by both the economies and negative policy interest rates being followed by their central banks. Strengthening the yen and the euro is hitting the respective countries not only by hampering exports but making matters worse in the fight against deflation. A stronger currency implies cheaper imports, and imported deflation.

The rupee is very much a part of the global currency play and its movement is being influenced more and more by external factors such as US dollar movement, the Fed’s stance and the course taken by the yuan. As far as competitive devaluation is concerned, there will not be much benefit for the Indian economy if the Reserve Bank of India tries to weaken the currency. Studies have shown that Indian exports are less price-elastic and more income-elastic. This implies that exports gain less from price fall through depreciation of the rupee, but more from increase in global income. The RBI has always maintained that its intervention in the forex market is not to achieve a specific level for the rupee but to avoid extreme volatility in the market.

Can we, then, see some peace in the ongoing war? There is a lot of uncertainty on the timing of the US Fed rate hike. However, having learnt its lesson, the Fed would ensure that the interest rate hike is gradual and the global markets are well prepared. This should result in the dollar appreciation being muted this year. This should lead to muted weakening of emerging market currencies which, in turn, implies less pressure on the People’s Bank of China (PBoC) to resort to sharp devaluation of the yuan.

In fact, of late, PBoC has been very gradually weakening the yuan to avoid sharp devaluation. This may also help the euro region and Japan, where growth is languishing, to give up on some their currency gains. Hence, we may see time off from the currency war. However, we must not forget that as long as global growth is languishing, there will always be temptations to indulge in currency manipulation.

The writer is a corporate economist based in Mumbai

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