<b>A V Rajwade:</b> The spectre of a currency war

Such a war would hurt global growth and that of India as well

Whatever the logic of Donald Trump’s criticism of other countries running trade surpluses with the US through currency manipulation, the possibility of his imposing import duties can hardly be ruled out. He has certainly highlighted trade imbalances as the major issue in the global economy. 

The possible currency/trade war is only one of several interesting parallels to the 1930s. Both the 1930s and the 2000s were preceded by major crises in asset markets. In 1929, it was the stock market crash, while 2008 witnessed a major global banking crisis following the collapse of the mortgage market in the US. Another parallel is that the 1930s witnessed the largest ever drop in global output, often referred to as the Great Depression — the second-largest drop in global output occurred after the 2008 crisis. The 1930s witnessed a currency war amongst the then major economies, particularly the US, Britain and France: Competitive devaluations (against gold — remember it was the era of the Gold Standard) and tariffs or import duties, were the weapons used. Trump is now threatening a trade war. 

In June 1933, representatives of 66 countries met in London at a World Economic Conference. While many heads of government attended it, the US official delegation had no major figure, indicating then president Franklin D Roosevelt’s lack of enthusiasm. Arguably, the Bretton Woods conference in 1944, which led to the formation of the International Monetary Fund (IMF) and the World Bank, was aimed at developing an orderly post-war global economic and trading system, learning from the lessons of the 1930s. Indeed, the fixed exchange rate system then brought into being worked well for about three decades, leading to a continued and rapid rise in global output. As most advanced industrial countries relaxed controls on capital movements, the fixed exchange rate system collapsed and the advanced countries are living in an era of floating, market-determined exchange rates, which have led not only to great volatility in exchange rates but also persistent global imbalances, which Trump correctly highlighted.

To come back to capital flows and exchange rates, Article VI of the IMF charter prohibited member countries from borrowing from the fund, “to meet a large or sustained outflow of capital”. Under it, the IMF could also “request a member to exercise (capital) controls to prevent such use”. The reality is that most of the crises, at least in the emerging markets, have been the result of capital outflows — and from Mexico in 1994 onwards, the IMF has always lent money to countries suffering capital outflows. Indeed, the IMF has never invoked the provisions of Article VI enabling it to encourage imposition of capital controls. Perhaps by the 1990s, the “Wall Street/Treasury Axis”, as Jagdish Bhagwati once described it, had become too powerful an influence on IMF policies. 

Chicago School theories of rational expectations, efficient markets etc sanctified the virtues of markets and the sins of government intervention. The banking system clearly has a strong vested interest in floating, indeed volatile, exchange rates as much of banks’ currency trading profit comes from volatility. The finance capital’s gains obviously come at the cost of the real economy. In today’s world, speculative and volatile capital flows have become the major determinants of exchange rates. (After reading a 2014 speech by the former governor of the New Zealand central bank on floating exchange rates, I have started wondering whether even central bankers understand the role of capital flows in the modern era!) The other side is that were exchange rates to be primarily determined by trade flows, they would be far more self-correcting. Deficits would lead to currency depreciation as the demand for foreign currencies by the domestic economy (to pay for imports) would exceed the supply through exports; the currency would depreciate; the deficit would be corrected. (Trade surpluses would lead to currency appreciation and help reduce surpluses.)

In the last article I had quoted the difference between “managed” and “manipulated exchange rates”. Manipulation occurs when intervention by the central bank in the market leads to a movement of the exchange rate away from what a balanced external account, on both flow (“current account”, net of secondary income) and stock (“international investment position”) accounts, requires. Management may also require controls on capital flows as Article VI of the IMF prescribes.

Does a trade/currency war between the US, Germany, China and Japan matter to us? In my view, yes; if global growth slows, it will affect every economy, sooner or later, some more, some less.

The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com