Wars of the currency kind

Context

Recently, RBI Governor Urjit Patel warned that the global trade war could escalate into a currency war.

Trade Wars: A Background

A trade war is when countries try to attack each other’s trade with taxes and quotas.
Trade wars erupt when countries impose tit-for-tat tariffs on imported goods under the garb of protectionism to protect domestic manufacturers.

Trade war in recent times

Recently, USA has been slapping steep tariffs on goods from the EU, Canada, Mexico and China.
In turn, these countries have also retaliated with levies on thousands of US products.
US-China trade war
US announced imposition of 25 percent duties on Chinese products in aerospace, information and communication technology and machinery.
Further, the US has imposed new investment restrictions on Chinese companies in USA.
In turn, China retaliated by imposing reciprocal tariffs on U.S. imports, including pork, wine, fruit and steel.

Impact

One of the major impacts is that the imports from these economies become expensive.
This affects the export competitiveness of goods and services (which use imported products) produced in such economies.
This triggers currency wars.

Trade wars trigger Currency wars

Many countries resorted to devaluing their currencies so that their exports remained cheaper and competitive in the world market.
Example:
China, a major global exporter, deliberately kept the renminbi value low.
Even Japan and South Korea stepped into the currency markets to keep their currencies low.

What is a currency war?

Currency wars are triggered when nations either allow their currencies to weaken appreciably or devalue them to gain a competitive advantage over trade rivals.
Such competitive lowering of currency values using monetary and exchange rate instruments was described as “international currency wars”.
This could lead to instability in markets.

What is devaluation?

Devaluation is a monetary policy tool to reduce the value of a currency, relative to other currencies, in a fixed exchange rate or ‘pegged currencies’.
On the other hand, a currency is said to have depreciated if the market forces reduces the value of a currency.
For instance, if 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.

Why do economies devalue their currencies?

If the currency value is low, the exports from that country become cheaper thereby becoming competitive in the global market.
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’ directly peg a lower value to their currency vis-à-vis a hard currency.

Devaluation while making exports more competitive also makes imports more expensive.
Thus the non-essential imports reduce narrowing the trade gap.

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.

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