Policing Currencies

Have you noticed that in any organisation - whether it's your family or your workplace - when times are good, the environment is harmonious and cooperative. But when difficult times arrive stresses and fractures appear. Something similar is happening to the global economy today. Amidst the prolonged and difficult recovery following the crisis of 2008, the world has turned into an acrimonious place. Currency manipulation, so much in the news these days, is one manifestation of the current difficulties. It is also an issue for which the rules by which players conduct themselves need to be set in the near future.

Over the years the world economy has developed extreme imbalances in the domain of external trade. Some nations - China, Germany, Japan and many East Asian nations - have followed an export-centric growth strategy to grow rapidly out of the ranks of poor nations. This was a good strategy for the early adherents, such as Japan and Germany, who followed it after their economies were devastated by World War II. But now with so many nations climbing on to the export bandwagon, it has led to problems.

For quite some time now you have had a situation where there has been a glut of exports searching for markets that will absorb them. In recent years, the US economy with its rich and consumption-centric populace has served as the major consumer of these exports. But now with the US in the midst of a slowdown and its consumers mired in debt, the export-oriented model of growth is in trouble.

A fundamental rebalancing of the global economy is now called for. The export-centric nations need to follow policies that will encourage domestic consumption so that their dependence on exports declines. And the US will have to rein in consumption and export more. But such rebalancing doesn't happen overnight and could perhaps take decades. Meanwhile, nations continue to follow the same old mantra: export your way out of trouble. And to gain that marginal bit of advantage in the export markets they manipulate the currency.

How is this done? Broadly speaking, when a country's exports (and remittances from abroad) exceed its imports, it runs up what is known as a current account surplus. Normally when a nation earns more foreign currency, its businessmen convert their foreign-exchange earnings into the local currency. As demand for the local currency increases, it appreciates. But allowing the local currency to appreciate lowers export competitiveness. So central banks of export-surplus nations intervene in the currency markets and buy up the incoming dollars. This allows their foreign exchange reserves to appreciate (this hoard also serves as an insurance against the rainy day when capital inflows into your country might reverse and cause macro-economic disruptions; this is a lesson that East Asian economies imbibed the hard way after the crisis of the late nineties). Such intervention also prevents the local currency from appreciating.

This operation is not entirely cost-free. The central bank's purchases let loose a flood of the local currency into the economy, which could fuel inflation if production fails to keep pace with money supply. The central bank then sterilises these flows, i.e., it issues bonds in order to soak up the excess liquidity. There is an interest cost to be paid on these bonds, which is in line with the interest rates prevailing in the local economy. Meanwhile, there is not much that a central bank can do with the foreign currency reserve (you can't take too much market risk with these reserves) that it has accumulated except to invest it in safe-haven instruments such as US treasury bonds. The differential between the two (interest paid on its own bonds versus interest earned on US treasury bonds) is the cost that nations pay for not allowing their currency to appreciate. But since this manipulation results in large gains in the export market, many nations are willing to play the game.

The Indian central bank too intervenes in the foreign exchange market. But there is a difference between a nation with a current account deficit (such as India) sterilising capital inflows to prevent excess inflation or a sudden and disruptive appreciation of the exchange rate vis-à-vis a nation with a current account surplus doing so. The former doesn't contribute to global trade imbalances; the latter does. The worst offender in the matter of currency manipulation, as you would be aware, is China. According to a February 2010 paper by Morris Goldstein, a Senior Fellow at the Peterson Institute for International Economics, between 2003 and 2007 China's current-account surplus rose from around 3 per cent to around 11 per cent of GDP. Throughout this period it engaged in extensive interventions in the foreign currency market so that between February 2002 and the end of 2007 the cumulative real effective appreciation of the renminbi was zero. Estimates of the extent of the renminbi's undervaluation vis-à-vis the dollar range from 15-30 per cent.

Thus currency manipulation is an old game. The world chose to countenance it when the global economy was in a sweet spot. But in the current environment, nations, especially the US with its nearly 10 per cent unemployment level, have become less tolerant towards it, so much that it has come to be regarded as yet another form of unfair trade practices.

Who will bell the cat?
Global trade is regulated by the World Trade Organisation (WTO). Over the years it has developed a set of norms identifying what constitutes fair trade practices and tries to ensure that member nations abide by them. Now a similar body is required for overseeing the international monetary system. The organisation most qualified to undertake this task is the International Monetary Fund (IMF), but alas, in its present form it is too effete. It may have been able to impose conditionalities on East Asian nations during the Asian crisis, but it lacks the clout to get China to fall in line.

But as the saying goes: “Never waste a crisis.” With memories of the devastation wrought by the crisis still fresh in their minds, member nations of the IMF may be more willing today to give it the mandate to conduct surveillance of currency manipulation more robustly; name-and-shame offenders; impose penalties on habitual ones, culminating in termination of membership under extreme circumstances. All this is still in the realm of academic discussions today and will not happen overnight. But if over the next five years global policing of exchange-rate practices becomes a reality, some good would have emerged out of the recent crisis.

You may argue, and legitimately so, that with the US letting loose so much liquidity, what is an emerging market to do but intervene in the currency markets? That too is another aspect of the problem. Let us discuss that next month. By then the US's QE2 (second round of quantitative easing) programme will have been announced and capital inflows will be even more of a problem for emerging nations than they are today.