Last week, Reserve Bank of India Governor Urjit Patel warned that trade wars among various countries may lead to a currency war. What does this expression mean, what leads to a currency war, and what are its implications on economies around the world, including India’s?
When did the world first hear of a currency war?
In the immediate aftermath of the financial crisis that started with the collapse of Lehman Brothers in the US in September 2008, fears of a global contagion followed. The biggest concern of countries then was to avert a sharp slide in their respective economic growth curves; decelerating growth means job losses, and slow growth means no new jobs. In view of the enormity of the situation, then US President George W Bush announced the G20 (Group of 20) Summit, the first to be held, in Washington DC in November 2008. India, the 13th largest economy then, was a member of the G20, a grouping that represented almost four-fifths of the world economy. The single most important decision by the summit leaders in DC was to coordinate efforts and strive for a broad revival of the global economy. Developed countries — the US and members of the European Union — embarked on expansionary fiscal and monetary policies (spending more and keeping interest rates low). Worried about their individual growth prospects, some countries turned protectionist in due course by introducing non-tariff barriers, and also occasionally imposing higher duties on imports.
A potent weapon wielded by many countries was to either devalue their currencies, or deliberately keep the value suppressed so that their exports remained cheaper and competitive in the world market. The US and key European countries adopted several measures to keep interest rates low and stoke demand. China, the fourth largest economy and a major global exporter even in 2008, deliberately kept the renminbi value low, and Japanese and South Korean central bankers stepped into the currency markets to keep their currencies low too. Then finance minister of Brazil (also a G20 member) Guido Mantega described such competitive lowering of currency values using monetary and exchange rate instruments as “international currency wars”.
Why talk about a currency war now?
Global trade skirmishes have intensified since March this year, when US President Donald Trump threatened to slap tariffs on Chinese goods. China refused to blink, and the war has only intensified in the past few months. The US tariffs on Chinese imports that are actually in effect are less than 10% of total $506 billion US imports of Chinese products. But the war may escalate given the shrill voices of the currently dominant power, the US, and the rising power, China. Higher tariffs make Chinese products more expensive, but a weakening of the yuan partly offsets the impact. In the last three months, the yuan has depreciated almost 8% vis-à-vis the US dollar. While this may be due to fundamental changes in the Chinese economy (slower growth), it has left Trump frustrated, leading him him to announce more measures.
Similarly, a war between the US and Europe too has escalated after Trump imposed tariffs on European steel and aluminum in the beginning of June, and the EU retaliated three weeks later. Such protectionist measures (higher customs duties on EU steel and aluminum make these expensive in the US and protect domestic US producers) entail the risk of countries using various exchange rate and monetary policy instruments competitively to weaken or devalue their currencies. This is what RBI Governor Patel meant on August 1 when, after a meeting of the monetary policy committee, he said: “We are possibly at the beginning of a currency war.”
Does India need to worry about this currency war?
In the last 10 years, the Indian economy has grown rapidly, from being the 13th largest in 2008 to the sixth largest in 2018. It has integrated more and more with global markets. When world trade is robust and the global economy is on an upswing, India’s growth rate gets a booster. This happened during 2003-08 when the Indian economy grew almost in double digits. Rising crude oil prices (around $68-70 a barrel now), however, do not bode well for India. The country is a net importer of energy and higher prices will put pressure on key macro-economic variables such as fiscal deficit and current account deficit. There is also this fear of capital flight if the macroeconomic situation worsens. Flight of capital may not be restricted to institutions pulling out money from the markets. Indians have been remitting more and more money abroad over the last few years. In 2017-18, these outward remittances totalled $11.33 billion. Just a decade ago, it was just $1.58 billion. This will adversely impact currency, inflation and interest rates. In the calendar year 2018, the Indian rupee has already depreciated or weakened 6.77% against the dollar.
Patel’s warning on increasing external risks and a currency war should be seen in the context of the global trade skirmishes that have intensified since March when Trump first threatened tariffs on Chinese goods. China has refused to blink and so has the European Union.
Countries are looking inward, and have become more protectionist in trade. The US, and India as well, may be growing at a faster clip now. But fears of a global trade war loom large unless countries retreat from their current positions of remarkable brinkmanship. The current 25-basis-points increase in policy rate, that came quickly on the back of a similar hike in June, in part, addresses the problem of currency too. Higher interest rates and stable inflation make a country more attractive for foreign investment. This helps the rupee strengthen. An international currency war due to heightened tariff tensions can hurt the global economy, and in the process hurt India’s growth prospects too. This is worrisome for India, because it would curtail the central bank’s flexibility in use of instruments to address problems of high inflation, slowing growth and weakening rupee.