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The rupee and the clash of currencies

At the recent meeting of G-20 finance ministers at Gyeongju in South Korea, member countries voiced their consensus against competitive devaluation. The forthcoming G-20 summit in Seoul will indicate whether they mean it. As of now, currency wars or clash of currencies is the buzz word in international financial world. Central banks in India, Japan, South Korea and Taiwan have intervened in the currency markets in an effort to make their currencies cheaper.

Brazil recently doubled a tax on foreign purchases of its domestic debt. Thailand has announced a new 15 per cent withholding tax for foreign investors in its bonds.

There are three distinct though interlinked areas of the clash of currencies. First, there is the old and serious problem of an effective pegging of the Chinese yuan to the US dollar. This makes the Chinese currency chronically undervalued and assures China of a persistent large trade surplus with correspondingly large and unsustainable deficits elsewhere.

Second is the exceptionally loose monetary policy being followed by major industrial countries, including the US, the UK, Japan and, to a somewhat lesser extent, the eurozone. Policy rates in these jurisdictions are at or close to zero and money supply is being boosted through printing of currencies (quantitative easing).

Such action normally tends to cheapen the currencies involved. However, the cheap dollars created by Federal Reserve (instead of stimulating production, jobs and incomes at home) find their way into emerging markets like China and India whose asset markets offer better returns.

Third is the impact on and response of several emerging economies to the massive inflows of foreign capital, leading to unwanted currency appreciation and asset price inflation.

India’s response to this emerging scenario has been watchful inaction. It has allowed the rupee to appreciate sharply, ruled out any curbs on inflows of foreign capital and, inexplicably, encouraged external borrowing by recently raising caps on FII investment in bonds. As a result, the share of merchandise exports in GDP has stagnated and the share of net invisible earnings has dropped. India’s trade and current account deficits have widened significantly, with the latter may be a record 4 per cent of GDP in the current year.

Jobs are being destroyed in labour-intensive sectors producing goods and services for exports. The surging portfolio inflows have fuelled asset bubbles in equities and real estate, which, if they reverse, could put a severe strain on parts of the financial system. Basically, India has failed to reduce significantly the collateral damage from the ongoing international currency/monetary wars.

What should be done has long been obvious. First, the RBI should actively intervene in the forex market to counter excess capital inflows and contain further appreciation of the rupee both in the nominal and real terms. Preferably, it should roll back some of the huge increase in the real effective exchange rate that has already occurred. Of course, the additional liquidity pumped into the system by buying dollars should be sterilised through the standard techniques. Second, India should use whatever tools are currently available to contain surging flows. Third, the government should seriously consider levying temporary taxes of the kind imposed by Brazil and Thailand.

At the G-20 summit, India could support the recent US proposal for numerical caps of around four per cent of GDP for current account surpluses and deficits. The proposal is obviously aimed at the major surplus countries. Even if such caps could be agreed upon, the problem of its realistic enforcement would remain. But that is not India’s worry.

Views expressed by the author are his own and do not reflect the newspaper’s policy.