Sunday, November 14, 2010

Currency War -An Insight

The term ‘currency war’ was used in recent times by Brazil’s finance minister Guido Mantega in the first week of October, 2010 reacting to China’s attempt to protect the Yuan from rising too quickly against the dollar.

Apart from interest rates, inflation and long term trends in economy, Supply & demand is the major factor in determining the currency exchange rate. Trade balance is the difference between the amount of imports and the amount of exports between two countries. For example if exports from India to US is more than the imports from US into India means India is in surplus in trade with US where US is in trade deficit with India. In this situation the supply of dollars in India will be more than actual demand. As India accumulates surplus dollars, USD becomes cheaper and USD.INR starts climbing.

The world is divided into two parts, the surplus countries, most Asian countries like China, Korea and Japan with manufacture based economies and deficit countries like USA and UK. Deficit countries used to borrow money from rest of the world so that they can import goods more than they export. After recent economic crisis and global recession the deficit countries wanted to export more to create more manufacture based jobs in their home land. But the export countries are not ready to lose their economic advantage of having cheap currency. They are showing Japan’s case as an example and avoiding re-value their currency. In mid 90s Japan had surplus economy and allowed to raise the value of Yen after pressure from all over the world, resulting in loosing competitive advantage and entered into log term deflation.
Most of the export countries pegged their currencies with USD. They started buying dollars through their central banks to keep the exchange rate of the local currency at lower levels. This has triggered the currency war. Though the strategy of buying foreign currency through central banks is not recent development, most of sovereign governments started feeling this as a problem for their economies to recover.
The solution for the deficit countries is to apply beggar thy neighbor policy. Either they have to impose tariffs or quota on the imports (heading towards protectionism) or competitive devaluation. The first option becomes obsolete after globalization and they are left with pumping more paper currency into economy as part of quantitative easing (QE). This would increase the supply of their currency and gives competitive advantage in exporting more goods. In the month of November 2010 US Fed announced $600 billion pumping into its economy to boost the exports.

Asian countries expressed concerns over quantitative easing as this could result in another asset bubble in Asia similar to 1997 Asian crisis. Reserve Bank of India (RBI) already started taking measures to avoid such asset bubble by imposing cap on real estate loans. The amount of loan issued on a home should not exceed 80% of the value of the property. This will keep only genuine buyers in the market and avoids most of the speculators.

China started hedging strategy against the currency war by imposing quota on rare earth metals. China has the monopoly in exporting rare earths with a holding 97% of the world’s reserve. These materials are used in making hybrid batteries, computer chips, iPods, and even by US military for building radars. China is trying to climb the value chain by producing the end products than exporting rare material.