China had long been a conscientious objector in the global currency wars as the combination of unprecedented money printing or 'quantitative easing' programmes by the European Central Bank (ECB) and the Bank of Japan (BoJ) and the US' increasingly propitious macro-economic prospects have produced a near unprecedented divergence in their prospective paths for monetary policy. The result was to push the US dollar sharply between last July and March before the rally petered out in the spring as renewed uncertainty over US economic prospects once again intensified as what appear to have been largely temporary factors held back the economy in the first quarter.
But, with evidence stacking up that momentum has once again returned to the US economy with GDP growth posting an solid 3.4 per cent annualised gain in the second quarter and seemingly set fair to expand at a similar clip in the third quarter, the clock appeared to be ticking down to 'lift off' by the US Federal Reserve. In turn, another leg of US dollar strength was widely anticipated with concerns that the key EUR/USD could fall to close parity as the US Federal Reserve delivers a slow, but nonetheless steady, stream of rate increases and the ECB continuing quantitative easing deep into 2016.
China had passively accommodated the first bout of US dollar strength, keeping its currency relatively steady against the greenback and so enduring hefty appreciations against both the Euro and Yen. All told, China's trade-weighted exchange rate appreciated by more than 15 per cent between July last year and this march; a painful loss of competitiveness that has worked as a further brake on China's already slowing economy.
China's passive approach to the first round of USD strength was in part a function of the huge speculative stock market bubble, that cheered on by the authorities, saw the Shanghai Composite rise around 150% between last July and this June. With equities soaring, the authorities were hopeful that the worst of the competitiveness shock could be shrugged as the economy rebalanced towards increased service-sector activity.
But the equity market bubble burst violently over the summer with mainland stocks falling by almost 50 per cent since June. Combined with increasingly hard evidence that China still huge manufacturing base is continuing to slide, the tipping point for China's currency regime was apparently reached last month.
China's initial devaluation against the US dollar has been relatively nugatory; only around 3-4 per cent. Financial market volatility has spiked however, ironically calling into question the timing of the very rate increases by the US Federal Reserve that the move was partially designed to pre-emptively insure against. The impact on financial markets has been significant as it has inevitably raised the spectre of a much larger moves in the future and also because of China's importance for global commodity demand. A weaker Chinese currency increases the dollar cost of commodity imports into China and so is seen as demand destructive. China's mini-devaluation, with the threat of more to come, has therefore intensified downward pressure on global commodity prices already laboring under the twin headwinds of excess supply in many markets and the slowing Chinese economy.
India too has so far essentially been a conscientious objector in the global currency wars partly helped by the fact that the Rupee depreciated heavily in the second half of 2013, providing the economy with a significant fillip to competitiveness that is yet to be fully eroded. Recent developments have led to a renewed chorus of siren voices arguing that India must now somehow 'fight back'.
But there are a number of compelling arguments why Indian policy makers should discountenance a more bellicose approach. First, to the extent that China's devaluation was spurred by its rapidly slowing economy, India is relatively unaffected. India exports relatively little but imports a lot from the Middle Kingdom. A cheaper Chinese currency therefore lowers India's import bill and, with competition in third markets relatively limited due to different export mixes, Indian exporters will also be relatively unaffected by the cheaper Yuan. Second, India is obviously a substantial net commodity importer, particularly of oil. To the extent that Chinese devaluation pushes down global commodity prices, India is a net beneficiary.
And if further Chinese devaluation continues to roil global financial markets, the Rupee should at least partially self-equilibrate. The 'risk off' tone to global markets that Chinese developments have ironically seen the Rupee fall more against the US dollar over the last month than the Chinese Yuan!
Last, and by no means least, India has relatively limited tools to fight back. Currency wars are of course a monetary phenomenon so retaliation is largely a matter for the Reserve Bank of India (RBI). In theory, RBI has basically two options: sell foreign exchange reserves to deliberately drive down the value of Rupee, or cut interest rates. The former in particular would be reckless. India's foreign exchange reserves were worryingly low only a few years ago, contributing to the Rupee's aforementioned weakness in 2013. While reserves have subsequently been rebuilt to more healthy levels, any intervention aimed at explicitly weakening the Rupee could quickly trigger accelerating capital flight.
Indeed, China's experience over the last month offers a salutary lesson. One reason is that the Yuan's devaluation has so far remained strictly limited is that depreciation expectations appear to have turned extrapolative, forcing the authorities to start intervening heavily to prevent a disorderly plunge in the currency. China's mini-devaluation has, so far at least, come at a high, and still, rising cost.
Direct intervention to lower the Rupee would therefore almost certainly quickly become counterproductive. A premature cut in interest rates that indirectly seeks to weaken the currency may also backfire. As RBI Governor Raghuram Rajan has repeatedly stressed, India's key macro-economic challenge is the restoration of inflation control. While inflation has shown a welcome pull-back over the last year, but the improvement is far from entrenched.
Worryingly, household inflation expectations remain high and inconsistent with RBI's medium-term inflation objectives. Any loosening of monetary policy explicitly aimed at weakening the Rupee risks entrenching too high inflation expectations, making RBI's job in ensconcing low inflation harder, not easier. If RBI does decide to further trim policy rates in the next few months, perhaps if global commodity prices continue to swoon, it is critical that both any such decision is made solely with reference to India's inflation prospects and that it is clearly communicated as such.
With money printing by the ECB and the BoJ unlikely to end any time soon and China's recent policy shift opening a Pandora's Box of further depreciation expectations, the global currency wars look here to stay for the foreseeable future. India's best strategy should be to continue to observe strict neutrality with RBI staying focused on a different war: the war against domestic inflation.
(The author is chief economist for Asia at BNP Paribas.)
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