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Another global breakdown

Another global breakdown

All wars inflict collateral damage, so there is good reason for the rest of the world to watch the currency war between the US and China with trepidation.The two countries are gunning for each other because an earlier economic arrangement between them shows signs of crumbling. The deal that was in place till the financial crisis began was a neat one. China sold cheap goods to US consumers. The dollars the Chinese earned through exports were recycled back into the US financial system. This money was eventually lent to indebted US consumers.

The arrangement was convenient for politicians from both sides of the Pacific Ocean. China could keep growing its economy despite weak domestic demand. The US could provide its citizens with the illusion of prosperity despite stagnant median incomes—a merry consumption binge fuelled by cheap credit and overpriced housing assets.

Central to this arrangement was currency policy: a strong dollar and a weak renminbi. The interests of the US and China are no longer well aligned as far as currency policy goes. Both countries now want a weak currency. China wants to keep its export engine purring while the US has now developed a renewed interest in exports to drive growth, as households cut spending to repair balance sheets and companies remain wary of investing in new capacities despite huge cash reserves.

Enter the currency war, with both the US and China trying to keep their respective currencies down. China continues to intervene in the foreign exchange market, buying dollars to prevent dollar decline. The US seems ready to print more money to debase its currency: a larger supply of anything usually reduces its price.

The numbers are mind-boggling. The US Federal Reserve is expected to decide in November for a second round of quantitative easing of at least $600 billion. China has increased its foreign exchange reserves by a record $195 billion in the third quarter. A research firm, Capital Economics, estimates that $108 billion of these additions came from outright foreign exchange purchases with the rest being accounted for by interest earned on existing holdings and foreign exchange fluctuations.

The money deluge has rushed into commodities and emerging markets. Currencies of economies as diverse as Japan and India have soared. Many central banks have started intervening in the foreign exchange market to keep their currencies down; a few such as Brazil and Thailand have partially closed the floodgates with mild capital controls.

The Reserve Bank of India has allowed the rupee to appreciate, but began intervening in the forex market last week. It may have to take tougher steps, but these should preferably be through sterilized intervention rather than capital controls.

Is there a new global currency agreement in sight? Tell us at views@livemint.com

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