#366days366posts – Day 10 – Some lessons on currency devaluation

“Above all, we need to avoid beggar-thy-neighbor policies, such as unconventional monetary policy or sustained exchange-rate intervention, that primarily induce capital outflows and competitive currency devaluations.”

– Raghuram Rajan, Governor – Reserve Bank of India

Beggar-thy-neighbor? What the heck? That was my first reaction when I came across this section in Raghuram Rajan’s article in Project Syndicate (http://www.project-syndicate.org/commentary/unconventional-monetary-policy-weak-growth-by-raghuram-rajan-2016-01). So I decided to do some research.

Wikipedia (https://en.wikipedia.org/wiki/Beggar_thy_neighbour) says

a beggar-thy-neighbour policy is an economic policy through which one country attempts to remedy its economic problems by means that tend to worsen the economic problems of other countries.

Okay, this got me somewhere. The RBI governor was suggesting that competitive currency devaluation is a poor measure to achieve growth, as it affects other countries as well. Well, if you understand the basics of currency devaluation, you would concur with him.

Currency devaluation happens when one country devalues its currency relative to the currency of other countries or a basket of currencies. For example, imagine that 1 INR = USD 65 and the Indian Government suddenly decides to intervene in the currency market and revise its exchange rate to 1 INR = USD 70 or ~ -8%. This is a case of currency devaluation. This is quite different from currency depreciation where the market forces of demand and supply determine that the exchange rate should be revised downwards. Ideally, currencies should not be manipulated. Then why do countries like China resort to currency devaluation?

The thing with China is that we cannot take anything to be true – they have immersed themselves in a quagmire of secrecy that what comes out must be thoroughly delved into to fathom if there is an iota of truth in it. China is apparently going through its worst economic crisis. To boost its exports and revive a flagging economy, China decided to devalue its currency – the Yuan, by 0.5% last Thursday – the latest in a series of devaluations since 2011. Obviously, such measures coming from China is alarming because either they are deliberately manipulating their economic system and projecting false numbers to the outside world or they are really in serious trouble. Let us for once believe that the latter is true. That brings us to the next question – How does devaluation boost exports?

In the example we considered above, let us imagine that India’s exports to the US is $100,000 when the exchange rate is INR 65. When the currency is devalued to INR 70, the exports suddenly become competitive. That is because the US would only need to spend $0.014 on an INR ($1 = INR 70; 1 INR = $0.014) vs. $0.015 that it would have coughed up if the exchange rate was INR 65 ($1 = INR 65; 1 INR = $0.015).

India’s exports are boosted because more countries would buy from us owing to the exchange rate differential. Therefore, when exports turn competitive, imports become very expensive. We would refrain from buying things from outside but would rather look inside our country for materials and stuff that are necessary to get production running. Eventually, as Exports less Imports turns positive, it results in an improved balance of payments (essentially the excess of exports over imports) situation. Also, demand back home increases and the economy is revived.

Simple enough, but that again brings us back to ‘beggar-thy-neighbor’. Devaluation is a very powerful sword. A country can resort to successive devaluations just like that as China has been doing. The other countries will think , “Oh, this is good. Why don’t we do it as well?”. The result will be an all-out currency war, which could be catastrophic. The policy virtually makes other countries poorer while at the same time making itself rich. This not only goes against the economic balance of the countries but is also against the 1976 revision in the International Monetary Fund (IMF) charter that exhorts countries from manipulating their exchange rates to gain an unfair advantage over others.

So, is China beggaring its neighbors by resorting to a devaluation of the Yuan? One could say to a certain extent that it is as rumors have it they are inclined to have a go at it again. The other nations have been patient so far but that is soon going to run out. With provocation reaching levels never seen before, the last thing we want is a currency war.

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Author:

I'm an avid reader and writer. Reading gets me a feeling of understanding the world through different perspectives and writing helps me outline my thoughts from the cobwebs that the mind has trapped it in!

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