Simply Put: Why a currency war is a worry

Headline : Simply Put: Why a currency war is a worry

Details :

Context

  • Recently, the RBI Governor warned that trade wars among various countries may lead to a currency war.

What is Currency War?

  • Currency war is a situation when economies, in order to maintain and preserve their export competitiveness, manage the exchange rates vis-à-vis hard currencies.
  • A hard currency is a monetary system that is widely accepted around the world as a form of payment for goods and services. It usually comes from a country that has a strong economic and political situation. The most common hard currencies include the US dollar (USD), UK pound sterling (GBP), the euro (EUR).
  • Generally, the economies are seen devaluing their currencies in order to preserve their export competitiveness.

Why do economies devalue their currencies?

Some Basics

  • If the demand for US dollar increases in India, we end up paying ‘more’ rupee to get the same amount of dollars. In such situations, the value of rupee is said have depreciated.
  • On the other hand, if ‘less’ rupee is offered to buy same amount of USD as a result of reduced demand for dollars, the value of rupee is said have appreciated.
  • If the rupee value is low, the exports from India become cheaper, thereby becoming competitive in the global market.
  • On the other hand, an appreciated rupee makes exports from India costlier.
  • Thus, some economies tend to manipulate their currencies by devaluing their currency in order to make exports from their economies cheaper.
  • This is done by buying out excess dollars in their economy in order create a slump in the supply of dollars thereby increasing the demand for dollars.
  • On the other hand, some economies having ‘pegged exchange rates’ – they directly peg a lower value to their currency vis-à-vis a hard currency.

What is the problem?

  • In a globalised world, free trade is promoted in order to maximize welfare for all.
  • However, as a result of managed exchange rates, some economies are able manipulate the global markets providing cheaper products thus stifling competition.
  • Further, cheaper products from other economies can arrest the growth in one’s own economy.
  • In such a situation, the negatively impacted economies sometimes adopt protectionist policies.
  • However, this leads to closing of economies which is against the principle of free trade in a globalised world.

Background

  • The 2008 global financial crisis led to sharp slide in growth curves of major economies of the world.
  • At the G20 Summit held in 2008, the countries decided to coordinate efforts for reviving of the global economy.
  • In order to revive growth, developed economies adopted expansionary fiscal and monetary policies.
  • Further, some countries also turned protectionist in order to revive growth in their own economies. They introduced non-tariff barriers, and also occasionally imposed higher duties on imports.
  • Thus, imports from some economies became expensive.
  • Many countries resorted to devaluing their currencies so that their exports remained cheaper and competitive in the world market.
  • China a major global exporter deliberately kept its currency value low.
  • Even Japan and South Korea stepped into the currency markets to keep their currencies low.
  • Such competitive lowering of currency values using monetary and exchange rate instruments was described as “international currency wars”.

Currency wars in play

  • The debates on protectionism have resurfaced.
  • In March 2018, the US President threatened to slap tariffs on Chinese goods.
  • Higher tariffs make Chinese products more expensive.
  • However, the Chinese yuan has depreciated almost 8% vis-à-vis the US dollar in the recent times, offsetting the impact.
  • Similarly, US imposed tariffs on European steel and aluminum in the beginning of June.
  • Higher customs duties on EU steel and aluminum make these expensive in the US.
  • This may entail the risk of countries using exchange rate and monetary policy instruments competitively to weaken or devalue their currencies.
  • Thus, trade skirmishes raise fears of a global currency war.

Impact on India

  • Indian economy is integrated with global markets.
  • Rising crude oil prices impacts major macro-economic indicators in India like fiscal deficit and current account deficit.
  • Further, if the macro-economic indicators worsen, it will adversely impact currency, inflation and interest rates.
  • This might lead to capital outflow from India.
  • This leads to increasing demand for USD thus depreciating the value of rupee.
  • In 2018, the Indian rupee has already depreciated or weakened 6.77% against the dollar.
  • This has the potential of creating a currency crisis or a free fall situation.
  • This might severely hurt India’s growth prospects too.
Section : Economics

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