Introduction

Definition

• Competitive devaluation– Condition in international affairs where countries

compete against each other to achieve a relatively low exchange rate for their home currency

• Help their domestic industry.

• Dollar Vs. BRIC• China, India and Russia, along with Iran and members

of the Shanghai Co-operation Organization took early steps to use their own currencies for trade, rather than the dollar.

More Political than Economic• A "currency war" is more of a political than an economic condition. • Governments frequently intervene in their currency markets. They

increase the money supply to stimulate trade and reduce unemployment; or they decrease the supply to combat inflation.

• When China keeps the YUAN artificially low versus the U.S. dollar, it keeps the cost of Chinese goods low in the United States, contributing to a Trade Imbalance.

• This provides a steep incentive for the United States to retaliate by lowering its currency as well. Of course, because two countries can only have one exchange rate, this race to the bottom isn't likely to benefit either party.

Chinese Reserves: A Snapshot

After Effects

• Unstable exchange rates can deter international investment, hence slowing the pace of global economic recovery.

• Currency wars can have secondary Political effects. When countries are fighting over currency, they're less likely to agree to bilateral trade. Additionally, currency pressures could make China less likely to go along with U.S. efforts to contain Iran or North Korea.

• Unlike real wars, currency wars don't have defined start dates, but they can be ended with something like peace treaties.

The Build Up

• Why Asia saves?– Major Wars after WWII were fought in Asia– Major famines have been faced by Asia

• Why the US does not?– No Wars since the 1940s– Major supplier of arms– Never seen famines

• Has been a donor to 3rd world countries during famines

• Asia Invested Its Surplus In Rainy-day funds– Abu Dhabi Investment Authority– Saudi Arabia Investment Authority– HK Monetary Authority

• Rainy-day Funds Invested In US Treasury Bonds in order to stay liquid

• Even Before The Debt Crisis Of 2008 , The Wealth Funds Of China And The Middle East Heavily Invested In The US Dollar And Treasury Bonds

• The US spends the intakes just as quickly• The spending as a percent of the GDP spiraled

• The Money Supply jumped from $ 4.5 Trillion in 2000 to over $ 8.5 Trillion in 2010

• Added spending did not create more jobs• Created volatility in oil prices• It drove up US housing prices and created a

huge market for sub-prime mortgages– Eventually collapsed and brought about a world

wide credit crisis• Also, it drove up food prices

– Commodity index sky-rocketed• $ 15 billion in 2003 $ 317 billion in 2008

• More money in speculative ventures– US banks stopped lending to SMEs

• Lending rates are low unlike emerging economies• Job market suffered & economic revival became difficult

• THEN, Western investors came to Asia– BRIC felt the first rush– South Korea, Taiwan also witnessed the same– Resulted in huge $$ cash flow into the country

• Resulted in huge domestic currency appreciation– Inflation resulted

» Increased interest rates to contain it» Resulted in more liquidity from US markets

• Brazil was one of the first few countries to slap a 2% Tax on Investment on Stocks and Bonds (Not on FDI)– Both stock markets and the Real nosedived for some time

• Though the US Economy was slow, the emerging economies kept buying US Treasury bonds and the Dollar to keep it strong– Prime reason

• Keep the $ strong & • the oil and commodity prices under control

– Ensured sustained exports to the US– Ensured lesser volatility in the currency markets

• The US budget deficit kept on increasing– Huge difference in exports & imports

Implication

IMPLICATION of CURRENCY WAR

CURRENT SCENARIOTRIGGER

“An international currency war has broken out.” -Brazil’s finance minister, Guido Mantega, on

September 27th, 2010

Advantages

Positive Implications of Currency Wars

1. Competitive Devaluation : When a country tries to devalue its currency to increase its international competitiveness.

2. Economic GrowthIf the dollar becomes weaker, exports become cheaper leading to an increase in demand for US exports. This can help to increase AD and improve the rate of economic growth. This may be important, because problems in the US housing market are threatening the rate of economic growth. Falling house prices are potentially reducing consumer spending, therefore, a rise in exports could help to boost economic growth and prevent any move towards a recession.

3. Balance of PaymentsThe US has a large current account deficit (7% of GDP) therefore a devaluation will help to improve and reduce the current account deficit. However, a devaluation alone is unlikely to solve the problem.

4. InflationA devaluation may lead to increased inflationary pressures for 3 reasons:

1) Increase in exports causes rising AD and therefore could lead to demand pull inflation.2) Imported goods will be more expensive. American consumers would definitely experience a rise in price for many imported manufactured goods and imports of raw materials could increase costs of business.3) It is argued a devaluation reduces the incentive, for manufacturers and exporters, to cut costs and become more efficient.

5. Countries need to do it to simply survive at the moment : The overwhelming fact of the global currency system is that America needs a much

weaker dollar to bring its economy back . Asian investment in plant has run ahead of Western ability to consume. The debt-

strapped households of Middle America, or Britain and Spain, can no longer drive their economy. They need the help of Asian nations to do so. Japan to avoid a deflationary crisis, China to hold together a political order that is more fragile than it looks.

6. Import and Export Imbalance A country with a higher valuated currency will get more imports while a country

with a low evaluated currency will export a lot. The devaluation of consumer market currencies will lead to producer countries

having to improve their domestic consumption and achieve a balance between export and import.

7. Political Compulsions: The American political powers cannot go on like this. In a country ravaged by recession and looking

at potential ruin in the face of an increasingly bleak employment situation, it needs to create jobs, even if it is not the most economically sound thing to do. No government will be able to survive without it. These new employment opportunities need to be created, if nothing, to pacify and improve the American populace’s situation.

Disadvantages

The other view………

Disadvantages Of Currency war•NOT AN IMMIDIATE SOLUTION (As most people tend to see it as) o A rapid revaluation will not have a large and immediate positive effect on the American economy oPositive effect will be offset, in part if not in whole, by the negative impact on the Chinese economy o Rebalancing should take pace gradually, through nominal exchange rate adjustments and complementary structural adjustments on both sides

•EMPLOYEMENT BUBBLE o US and the European major economies can sustain the devaluation and drive their own employment opportunities . oAs a short term option China will devalue its own Yuan (which would happen otherwise as well) and go back to the previous situation .oUS market will be flooded with very cheap Chinese products leading to another downturn in the economy and loss of all those newly created jobs.

• HARM TO BILATERAL TRADE o Solutions to their problems lie in working together and not in fighting guerilla wars o A negative impact on bilateral trade o Hamper the development and implementation of mutually beneficial economic and trade

policies

• POLITICAL RAMIFICATIONS o World cannot afford a conflict between major powers like US and China.

The Road Ahead

• Issues– Role of Exchange rates– Spillover from policy choices

• Within rich world• Between rich & poor world

– Emerging economies• Distinguish between permanent & temporary surge in

capital inflows

– In General• More harmony is required

• Issues (cont’d)– General consensus

• Global rebalancing– Systematic Analysis of exchange rate adjustments– Assessment of spillovers in policies– QE can work beyond exchange rate

• “Avoidance is Bliss”

• Major Solution– Financial Transaction Tax

• Keeps speculation under control• Curbs Short-time Investors

– Have to pay tax for every exchange

• Long-time investors– Will only be taxed once