Currency Wars

Currency wars – Will spoil the Party

A country’s Currency strength determines its competitiveness in the global trade. Strength of a currency in determined by Fiscal deficit, Trade deficit, Forex reserves and capital flows in an economy.

The economies where the foreign reserves are very high,  trade surplus is there and positive  capital inflows in the economy, currencies have a tendency to appreciate. The countries where there is high trade deficit, negative capital flows, negative current account are likely to witness depreciation in currency. Depending on the situation, countries resort to manipulation of currency by either buying or selling dollars. Buying dollars lead to appreciation of currency and selling dollars lead to depreciation of currency. Extent of buying , Selling determines the level of appreciation / depreciation.

Currencies which are weak, provides the cost competitive advantage to nations in gaining share in global trade. China gained lot of advantage in the global trade by keeping its currency weak for long, supported by artificial depression of Cost of production in the country. This helped China to become the leader in manufacturing in the world. After the pressures from US and others, China allowed the appreciation of currency .

The advent of Trade war now is posing a big challenge to nations across the world. Trade war will lead to slow growth in global trade and many of the nations which mainly depend on trade will be affected in a big way. To counter the trade war, Countries will adopt  the strategy of weakening their  currency.

This year, China’s remnibi already weakened. After a fall in 2016,  renminbi witnessed appreciation  in the second half of 2017. It lost momentum in early 2018 due to slowing economic growth and the escalating trade dispute with the US. The renminbi depreciated by 3.2% against the US currency in June alone, its worst-ever monthly performance. This will lead to exchange-rate volatility . China will continue to allow the depreciation of its currency if the trade wars continue.

A similar trend was witnessed by many of the emerging economies where they saw their currency depreciating against the dollar. Currency depreciation leads to inflation since the imported commodities cost more. If trade wars continue, even, other large exporting countries will start depreciating their currency. This will lead to currency wars.

When the countries want their currency to remain stable to ensure a stable economy, they resort to  buying dollars, which results in appreciation of currencies. This will help in making the 

economy stable and helps importers .

When countries want to increase the competitiveness of products, central banks sell dollars in large quantities, which leads to depreciation of the local currency. When a commodity exporter, a manufactured product exporter or a service exporter , benefit from this move, Since their sales is dollars or equivalent and when the proceeds are realised in India, they will be able to make good profit. 

Since April the US dollar has rallied and market expects Fed will accelerate the pace of monetary tightening and expects US interest rates to go up ,which will make reverse flow of capital from the Emerging economies.

In line with the emerging trends, Indian currency also witnessed a fall . Rupee depreciated by 7%  from Rs 64.50 to a dollar on June 23 to Rs 69.05 on 24 July, a very sharp depreciation. India has a huge current account deficit and fiscal deficit. Indian Economic growth was supported by capital inflows in the last few years , when the interest rates in global markets and US were very low. Now that US has started increasing the interest rates, some of the capital which flowed to Indian Economy will go back. This will put a pressure on rupee.

 Many experts believe that Indian Rupee will not depreciate beyond Rs.70, since RBI intervenes at regular intervals to keep the rupee stable, which will ensure the stability of the overall economy. There are predictions that it could touch Rs.72 also if oil prices rise further and our trade deficit continues to  show a rising trend.

If the trade wars continue, it will be a challenge for India to keep the export competitiveness high . Allowing rupee to depreciate , will lead to inflation. In the last three , four years, inflation was contained. Now that we are in the election year, the currency has to be kept stable. It will be a challenge for Policy makers in the area of currency management and Trade management. We have to be ready with solutions for each possible scenario , so that inflation is contained, our economic stability is maintained, our exports are competitive.