By Akshay Kumar
RBI last month stepped in to save the plummeting rupee through various currency purchases and prohibiting proprietary trading in forex market by banks to curb undue speculation in rupee which was resulting in the volatility of the exchange rate. Japan, on the other hand, has been consistently pushing measures to devalue its currency since the beginning of this year, the policy also famously or infamously known as Abenomics. This sparks one critical question Why do specific countries devalue their currency while others intervene when their respective currencies are devalued? The answer lies in understanding the basics. Lets discuss with the few specific cases.
Inflation-deflation hysteria
Japan has been in pertinent economic mire since the 1990s housing crisis. Its inflation has been consistently below the critically accepted 2% or 4% level. In fact, the last two decades have been characterised by pertinent low-level deflation, averaged 0.3% since 2000; deflation is detrimental due to various demand and supply side reasons and hence minimal inflation is necessary. With the advent of PM Shinzo Abe, Japan has adopted aggressive Keynesian remedies with a target to push inflation to 2%. With this in sight, Bank of Japan (BoJ) plans to expand its monetary base to 270 trillion yen by 2014, meaning that each month BoJ will have to buy $ 76 bilion through various options to induce heavy quantitative easing.
When people speculate falling prices i.e. deflation, they become more conservative in spending because sitting on money yields more positive benefits than spending it. Loans are suppressed and even zero interest rates are unable to push money in the economy. Hence, economy may stay depressed this way, a phenomenon also referred to as deflationary trap. A second effect is the worsening position of debtors unmatched by the corresponding gains for creditors, further resulting in a depressing effect on spending and further encouraging deflation. Last but not least, the fact that in a deflationary economy, wages and prices fall which results in more unemployment as cutting wages in not a normal practice. It is primarily in this perspective that stable inflation level of close to 4% is preferred rather than no inflation or deflation. Hence, in this background it perfectly makes sense for Japan to adhere to quantitative easing- the practice in which a central bank tries to mitigate a potential or actual recession by increasing the money supply for its domestic economy- or selling its own currency via buying other currencies.
The devaluation of Yen also makes sense for Japanese economy as it is heavily dependent on exports, unlike Indian economy, implying that decline in value of yen relative to a foreign currency yields cheaper export goods to foreigners. For instance, a weaker yen drives the price lower for a Nissan car, thus making it more attractive than a GM car to Americans. This will lead to more Nissan cars being produced and less GM cars being produced. Therefore, this has the effect of boosting auto employment in Japan, but lowering auto employment in the U.S. The importing country, therefore, has two options- either reduce reliance on exports and bolster domestic production and consumption, a measure that is long term, or engage in currency devaluation which results in inflation, a measure that is short term. This, sometimes, has resulted in currency wars between economies, for instance, between China and US between 2010 and 2011.
The case for current account deficit and inflation
Indias imports are far higher than its exports. Hence, the plummeting fall of rupee is driving up negative import prices and lowering export prices, as discussed above, thereby, resulting in widening current account deficit. The CAD, which widened to an all-time high of 4.8 per cent of GDP in FY13, in turn, has brought the external payments situation under increased stress, reflecting rising external indebtedness and the burden of increased interest rates with feared debt trap. The fall in rupee has also resulted in imported inflation, imported for the very nature that the inflation was not self-induced as in the case of Japan. In June 2013, the inflation for food items hovered in double digits with Wholesale Price Index at 4.86%. For a growing economy like India, low minimal inflation of close to 4% is necessary; since, one, minimal inflation will keep interest rates positive, thereby, resulting in higher investment projects such as infrastructural in a developing country; two, minimal inflation helps in sustaining nominal wages; three, minimal inflation in not detrimental to unemployment as both are negatively correlated. With higher inflation, these relationships break down resulting in a perplexed macroeconomic scenario for an Indian consumer. In this background, one can comprehend the RBI measures last month to arrest the fall of rupee, further, demanding limiting the CAD in order to be effective.
Either case reveals that currency devaluation is not just a simple economic tool but a much complex one, involving various quantitative and qualitative considerations. An economy can neither holistically refrain from nor adhere to practicing such a tool in the present global economic outlook.
Akshay Kumar: He is an undergraduate in Civil Engineering from IIT Delhi and, currently, working at Ernst & Young in strategy consulting. He has been engaged in debating for the past 11 years at various levels. Since past 4 years, he has primarily focused on policy and economics debates and research papers and has been engaged at premier global debating platforms such as G8-G20 Group, Harvard debates, EUDC. Recently, he has developed debating models and tested them at national debating conferences
-akshaykumar.iitd@gmail.com