Currency Wars

In recent times, a major war is going on among countries – with most of us oblivious of it going on. It has been widely written about and discussed by market makers, regulatory bodies and economists. This is the “currency war” about which newspapers are carrying articles everyday now.

Let’s see why this is happening and how it can impact our lives.

What is happening?

I remember reading today - “There are two kinds of growth in the world – the speed at which the developing countries are growing and the speed at which the developed countries are going”. It is essential that we understand this before going to currency wars.

For the past few years, developing nations have been growing at a much faster pace. India for example, continued GDP growth of 6.5% even in the peak of recession in 2008. Impressive - when the GDP of the U.S was a meager 0.3% at that time. (The GDP of developed and developing countries cannot be compared directly – the growing ones have more avenues to expand than the saturated markets. Even by these standards, India, China, Brazil and Russia showed palpably higher growth than their developed counterparts). In an attempt to propel the sagging growth rates, the U.S, Japan and other Euro Zone countries are keeping interest rates almost close to zero. India is one of the very few countries where interest rates are going up. In short, these developed countries are not seeing demand growth. The six biggest high income economies – the US, Japan, Germany, France, the UK and Italy all have GDP less than levels in the first quarter of 2008. For the year 2011, the International Monetary Fund projects that the emerging economies will grow 6.4%, while the advanced economies will hobble along at 2.2%

Now, these developed nations of the world, including Japan, Brazil, Peru, are mulling heavily to devalue their currency. The dollar is weakening on lack of trust in the U.S – the world’s largest economy. This causes their currency to appreciate vis-à-vis the dollar. The major currencies in which Central banks of the world keep their reserves are the GBP, Yen, Euro and the highest chunk constitutes the dollar. Why?? The dollar still remains the reserve currency of the world because commodities like crude oil, copper and others are dollar denominated. Also, trade world over majorly happens with the dollar as an exchange standard, which requires countries to hold dollars as reserve. It still remains a fact that the Indian Gross Domestic Product in real terms is nowhere near that of the U.S even though we fare much better year on year GDP growth figures. ($1.235 trillion is India’s GDP in 2009 compared to U.S’ $14.256 trillion; GDP growth in the last quarter for Indian and the U.S were 8.8% and 1.7% respectively).

The U.S Federal Reserve is pumping in money (also fancifully called quantitative easing or printing notes) into the system and continues to keep interest rates at near zero levels. It prints notes and uses the extra cash to buy its own government bonds. What does this mean? Countries will not find an incentive to keep investing in U.S treasury securities, considered historically one of the safest assets to invest in the world. As a consequence now, the trade that investors are doing is simple – sell the U.S dollar, buy gold and equity in emerging markets. China – the biggest holder of U.S treasury bonds has bought Spanish and Greek bonds, re-iterating its commitment to hold on to Euro reserves.

The Central banks of Canada, New Zealand and Australia are withholding further interest rate hikes. If interest rates go up, money invested in the nations own currency goes up, increasing its value against the dollar.

The Bank of England is also looking at further quantitative easing. U.K is keeping its rates unchanged at 1.5% and the central banks of Australian and Indonesia have also decided to keep rates constant and 4.5% and 6.5% respectively. The RBI on the other hand, continues to tighten its monetary policy – hiking up interest rates to suck out the extra money from the system and control persisting inflation.

The Indian rupee has gone up in value from ` 47/dollar to about Rs.45/dollar in a month. Most of us must have heard that the Indian stock markets are on a roll now – the Indian bulls are stomping their way to all time highs. In the last two months alone, foreign institutional investors have brought in $10 billion to the Indian markets. In the last two years, the RBI has not done anything to control the rupee – the rupee rises and falls as per the demand for the currency. Now as a lot of foreign money is coming into India, in other words, foreign investors are converting their currency into rupees for investing in India. The result is that the demand for the rupee rises and hence, the value of rupee appreciates with the demand.

Japan is intervening in the forex markets to keep up the value of the Yen vis-à-vis the dollar. India is the only major economy raising its interest rates whereas all other major economies including China are maintaining low interest rates.

On Sep 16 this year, Japan, the world’s third largest economy decided it has had enough of the Yen reaching 15 year highs. It sold about 2-trillion yen to stop its appreciation. The move drew flak from the U.S Federal Reserve and the IMF that this will not be a sustainable strategy. However, this set an example for other countries like Brazil to follow suit. The lack of faith in Japanese equity markets pushed money towards buying government securities, jacking up the yen to record highs against an already weakening dollar. Japan is majorly keeping tab of its forex rate -it feels the strength of the yen is hitting exports. Bank of Japan recently announced that it would maintain zero percent interest rates till it sees some level of internal demand for goods. It will keep pumping in money to banks which will in turn lend to people at rock bottom rates in an attempt to infuse demand in the slowing economy. Which means one can borrow money for no interest in Japan and U.S and invest it in countries like India (read more on “carry trade” for this).

Money is flowing in like crazy into developing economies – including India, Brazil and China. So much that Brazil and South Korea are finding ways to curb inflow of money. Why? They are scared that the intense demand for their currency will cause currency appreciation and hurt exports. “We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness”, said the Brazilian finance minister. Brazil is buying the dollar aggressively in a bid to keep its currency down.

Why are countries doing this?

Money is flowing into countries that give a higher interest rate for investments rather than to the U.S where investments would hardly give returns at a close-to- zero rates. One reason why countries are looking at devaluing their currency is to improve exports. Developed countries are looking at developing countries as markets for their products and services – tides certainly have changed in favour of developing nations like the BRIC group. So they do not want a higher currency as it would dampen margins for exporters.

Euro Zone worries and talks of another recession (infamously, the double dip recession) there have been put to a temporary rest as the major hit countries in the zone like Greece and Spain have implemented “austerity measures”.

(Wiki explains austerity measures: “Austerity policies are often used by governments to reduce their deficit spending. This might be coupled with increases in taxes to pay back creditors to reduce debt”. )

Most major Asian economies like China and Japan are export oriented (India is an exception – our growth relies more on internal demand). If their exchange rate (read “value of the currency”) shoots up, then it is going to hurt the margins for exporters.

Essentially, countries are following the “beg- thy- neighbor” policy for propping up their economy. This is the policy that is said to have caused the Great Depression in the 1930s. Elaborating on “beg-thy-neighbor”, this is policy where one country tries to solve domestic problems at the expense of another. The best definition of the term comes from www.businessdictionary.com –

“That attempts to cure a country's balance of trade, inflation, and unemployment problems by practices that harm the economic interests of its trading partners.

It usually takes the form of (1) restricting imports by quotas or by raising tariffs,

(2) currency devaluation that makes imports more expensive and exports cheaper, or

(3) currency appreciation that reduces domestic inflation but makes its product more expensive in the importing countries.”
Point Number 2 is what countries are doing right now. Countries like Brazil and South Korea are trying to clamp down on the inflow of money into their countries.

Classic case of this is China – China has deliberately kept the value of its currency low to forge ahead in exports. U.S and Europe and crying hoarse that China keeping the Renminbi artificially low is costing their economies dearly. To quote from the Wall Street Journal, “The higher the Chinese currency, the costlier and thus less attractive are Chinese exports to Americans and others, and the more attractive are imports to Chinese business and consumers.” How much of this claim is true is debatable. There are views that the U.S would do better to boost consumption and productivity at home rather than point fingers at China. China has let the yuan appreciate 20% from 2005-2008 when it again pegged the yuan to the dollar. In June this year, it let the currency float again after international pressure and it is now 3% up against the dollar. China says it wants to reduce dependency on exports and let internal demand grow.

Implications:

The main sections of Indian society that get hit by a rising rupee are exporters –who are majorly small and medium industries like the garment exporters. But the value of the rupee is not the sole determinant for exports. Even though the rupee has appreciated 9% since May this year, exports grew at a health rate. But if countries everywhere continue to devalue their currency, global trade will be heavily affected and the situation could change drastically. The ramifications of continued currency devaluation can be hugely detrimental – lowering currency value makes imports costlier, prevents free trade and artificially keeps demand for the currency low – which can threaten long term growth. Lower growth world over would mean lesser demand for the goods and services we deliver as a country, eventually affecting our daily mundane work, family incomes and budgets. It is interesting to watch how macro economic factors trickle down and translate into effects in the layman’s livelihood.

The meeting of monetary rule makers of the G7 and the IMF are meeting in Washington starting Oct 7 to discuss this. The U.S is expected to call for change of policy in countries with a trade surplus like China and Japan – it wants them to focus on creating more local demand. It will be interesting to watch what pans out in these meetings and which direction the war will take in the months to come. I shall keep updating major developments.........