Fallout of global currency wars on India

India too has been experiencing a surge in financial inflows but, unlike most other emerging economies, has been loathe to resort to capital controls as it has been relying on such short-term capital inflows to fund its current account deficit.

CRL Narasimhan

THOSE who have hoped for at least a temporary truce if not a more permanent pause in the ongoing currency wars in the New Year are apt to be disappointed. Brazil, which has been in the vanguard of the moves to check the pernicious influence of unbridled short-term capital flows, has announced some more measures in this direction. More surprising has been the decision of Chile to clamp down on inflows. Chile had continued with free market practices even when faced with surging capital inflows from abroad. For investors as well as importers and exporters there is a lot of uncertainty that has arisen as a result of the currency wars.

Seemingly irrational factors drive the currency movements and these are naturally very difficult to anticipate. In an overall sense, currency wars inflict heavy costs on international trade and appear to be the most visible manifestation of the lack of cooperation among major economic powers. Brazil's Finance Minister was the first to use the term 'currency wars' last year. He was referring to the phenomenon of countries entering into competitive depreciation of their currencies to retain their hold in export markets. For each country, the goal has been to prevent its currency from being the only one to rise. The policies are injurious to all countries but once begun it seems almost impossible to control. In this connection, the highly publicised dispute between the US and China over the external value of the yuan may be the most visible but is hardly the only one. The US along with other countries has accused China of keeping the value of its domestic currency at artificially low levels to sustain its booming export-led growth.

The reasons why the currency wars will continue are fairly obvious. The principal motivation - to check the destabilising capital inflows - remains. Inflows are, in fact, expected to increase. The emerging economies are in the forefront of the global recovery. So funds from the more slowly growing advanced economies seek greener pastures in the emerging markets. Also, global recovery has reduced risk aversion. Global fund managers see value as well as safety in, say, Indian or Brazilian equities. A third factor is the decision of the US and other advanced economies to persist with their extremely loose monetary policies. In the US case, there has been a quantitative easing and a buy-back of long-dated bonds. This unconventional move is expected to lower long-term interest rates which had remained sticky even when the near-term rates have hovered around zero. But for India and other emerging economies, however, that has meant even larger flows.

For developing countries, managing the capital inflows remains a daunting task. The International Monetary Fund in a recent study rates it as one of the two key challenges for this year, the other one being the task of managing the quantum and timing the exit from stimulus policies of the recession period.

Global monitoring?

As more and more countries seek ways to check the capital inflows and global financial institutions such as the World Bank and the IMF realise that they are unavoidable, there is a school of thought that some ground rules for monitoring the actions of the government are needed. A study undertaken by the IMF at the beginning of the year suggested such a course. The idea seems to be to constrain actions of governments in imposing control over capital flows. But the suggestion has been brushed aside as being too complex and in the present climate of global disharmony highly impractical as well.

The government action to stem capital flows need not always take the form of or be confined to currency rate manipulation. Other measures include inflows control, raising reserve requirements selectively for foreign inflows and emergency measures banning flight of currency outside during a crisis. Chile once had a system which required foreign investors to deposit a portion of their investment in interest-free deposits with its central bank. The objective is to discourage short-term flows and, where it is not possible, to increase its tenure from short-term to a longer period. It would be impossible to have global ground rules to monitor all these.

But the very idea of having a global forum and rules to oversee capital flows shows how far mainline economic opinion has traversed since the 1990s. At that time enthusiasm for free markets led the US and the IMF to try to amend the Fund's mandate to promote capital account convertibility. Such efforts floundered amid stiff opposition from the emerging markets and the Asian currency crisis which convinced policymakers of the dangers of relying too much on short-term flows. Many Asian countries saw their currencies collapse as global short-term funds reversed themselves. It was at that time the then Malaysian Prime Minister Mahathir Mohamad defied what was then considered to be orthodoxy and imposed capital controls as part of a programme to defend a fixed exchange rate for the ringgit.

India has proceeded cautiously with capital account convertibility. Its currency management, a managed float for the rupee, has paid off and been emulated by many countries. However, there are some major policy issues to be settled on the surging portfolio capital flows which have buoyed and depressed the share markets. There has been a clamour for imposing some kind of controls on such flows but the rationale for persisting with the status quo seems to lie in the crucial dependence the country's balance of payments has on capital flows from abroad. The argument becomes particularly relevant at a time the current account deficit is widening. However, there are obviously great risks in an ever-widening deficit and, equally importantly, in relying on short-term flows to fund the deficits.

CRL Narasimhan is Associate Editor of the Indian daily The Hindu. This article first appeared in The Hindu (7 February 2011) and is reprinted with permission.

*Third World Resurgence No. 245/246, January/February 2011, pp 22-23