It is significant that the two most contentious issues in global economic policy today are linked to the politics of currencies—the future of the euro and the yuan.

The very basics of the deal between several European countries—22 at last count—to shift to a common currency are now in question. An area can have a common currency only if the underlying economies have similar profiles in terms of fiscal deficits, public debt, inflation and unemployment.

The European countries that signed up for the euro had agreed in 1997 to keep fiscal deficits at 3% or less of their respective gross domestic product (GDP) and public debt lower than 60% of GDP, through a Stability and Growth Pact. All the signatories to this pact have crossed these limits in their battle against recession, and some such as Greece and Portugal are in a deep fiscal hole. In fact, most European countries now have public debts that are bigger than the value of their annual output. All this has cast doubts on the ambitious attempt to manage European economies through a common currency and central bank.

India has no direct stake in the ongoing European drama. However, we have to keep a close eye on the intermittent war of words between the US and China over how the latter is managing its currency. China has followed the classic mercantilist policy of maintaining a cheap currency to promote exports—as part of a national plan to grow the tradables sector of its economy and create jobs that will avert the social chaos that the communists are deeply worried about.

There is little doubt that China needs to let its currency appreciate if the global economy has to be more balanced. Some economists such as Paul Krugman have been urging the Obama administration to get tough on China; there is even talk about imposing a special tax on Chinese imports into the US.

But the Chinese current account surplus is not a result of a cheap currency alone. A current account surplus is the end result of a country saving more than it is investing, and getting China to spend more will require far-reaching reforms in the domestic incentive structure. In fact, Shang-Jin Wei of Columbia University has even suggested that China’s one-child policy has led to a surplus of men and thus a very competitive marriage market that has driven up the savings rate in that country.

India need not take sides in this currency war, but we have a direct stake in it. Arvind Subramanian of the Peterson Institute quite rightly said in a recent essay that while Chinese exchange rate policy is usually brought up in the context of global imbalances, the direct costs are borne by other emerging economies such as India which compete with China in the global markets.

The frictions in the US, China and Europe are perhaps early indicators that exchange rates will be a key concern in the coming months, a fact that Indian policymakers will have to take on board as well.

There is still a lot of inconclusive debate about what caused the financial crisis from which the world economy is recovering. But there should be little doubt that the two most important underlying factors were global imbalances and a berserk Western financial system. The difficult question of how to rebalance the world economy is evident in the heat and dust generated in recent weeks about Chinese currency policy. The cost of saving the Western financial system and fighting the subsequent collapse in output and jobs has led to strains on the European single currency agreement.

The realignment of currencies is always a messy affair—and the world has seen several volatile episodes since the post-war system of fixed exchange rates unravelled in 1973. But we are currently seeing a strange situation when the three most widely used currencies in global trade and investment—the US dollar, the euro and the yen—represent economies with frightening levels of fiscal deficits and public debt. And there is no obvious replacement right now, not gold and definitely not either the Chinese yuan or the Indian rupee.

Global power shifts are usually followed by changes in the global reserve currency, though the latter can often happen with lags as large as two decades. Is the world moving into such a grey zone right now? The economies that dominated the world in the 20th century are losing ground to emerging giants from Asia, but their currencies will continue to be the preferred ones to conduct trade and investments across national borders.

Is the world economy moving into a twilight zone where it does not have a single, dominant currency that is issued by a country with strong economic fundamentals? And are we headed for a bout of currency volatility in the short term as government finances groan under the weight of growing deficits and public debt? These are worrisome possibilities.

Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at