Home / Opinion / A sharper instrument for exchange rate stabilization

The US has agreed to put $150 billion tariffs on Chinese goods on hold though China has restricted itself only to making vague commitments. This suggests that Donald Trump’s gambit to reduce the US-China trade deficit by $200 billion is far from achieving its aim.

The trade deficit is, we believe, a symptom of a deeper malaise in the US. A large number of jobs have been outsourced to other countries, thereby creating a labour force that is sharply divided between those serving in the high-value services and high-technology sectors and others who are stuck in a stagnant spiral of low income and growth prospects.

This structural problem can not be solved by a tariff rate policy. Trump’s strategy on tariffs would have engendered a “tariff dilemma" game where countries can either raise or lower tariffs. They end up raising tariffs—this being the dominant strategy, even though all countries would be better off with low tariffs.

The US economy’s imbalance needs a long-term focus on a portfolio of activities, including reviving US manufacturing competitiveness. We restrict ourselves to the question of whether the exchange rate policy has any role to play in the US revival, given Trump’s election rhetoric on China being a currency manipulator.

Note that, unlike in the case of tariffs where all countries can raise tariffs simultaneously, all countries cannot simultaneously devalue their currencies against each other. Hence, the process of competitive devaluation is one marked by rapid volatility of exchange rates as countries sequentially depreciate their currencies. The resulting uncertainty is harmful to all. Yet again, the pursuit of self-interest appears to end up in deleterious outcomes a la the prisoners’ dilemma.

Even if there is some benefit from depreciating the US dollar, how it is to be done is not clear. Low interest rates may trigger a migration of dollars in search of yield, resulting in a weak dollar. On the other hand, if the low rates represent depressed expectations about global economic conditions, they may result in a “flight to safety" into the US, thus strengthening the dollar.

Nevertheless, there remains an important asymmetry in the management of exchange rates between advanced and emerging economies. In emerging economies, central banks often intervene in foreign exchange markets. For instance, when there is an excess inflow of portfolio investment (let us assume the inflow is in dollars), central banks buy dollars to keep the value of their currency at a low level. This is justified on the basis of the many crises occasioned by the volatility of portfolio flows into these economies. Advanced economies like the US are not subject to such volatility.

While emerging economies do need a tool to stabilize capital flows, intervention by central banks in foreign exchange markets is a blunt instrument with many uncontrolled spillover effects. Simultaneously, it leaves room for central banks to intervene in the foreign exchange market despite having stable inflows with a large component of foreign direct investment (FDI), only to make exports and domestic assets more competitive. China has been accused of precisely such a transgression.

The result of possible manipulation of exchange rates is two-fold. First, US exports become expensive and imports from emerging economies cheap. Second, the desire of US companies to move to emerging economies, taking advantage of cheap factor inputs and favourable business conditions, gets strengthened given the devalued exchange rate. These firms export products all over the world from their foreign bases. Thus, jobs are shipped outside the US, hurting the US worker, while the business elite earn huge returns, increasing inequality.

Hence, the US must use its political capital to move to a different paradigm of managing exchange rates, both in emerging and advanced economies. Central bank intervention in foreign exchange markets should be avoided. Instead, in line with suggestions made by Olivier Jeanne and Anton Korinek, a tax-subsidy policy for regulating unstable capital flows should be adopted. A tax is imposed in case of a sudden spike in capital inflows, and a subsidy is given if inflows unexpectedly slow down. This policy does not have spillover effects and results in an inter-temporal balance in the government’s budget.

The recommendation of a tax subsidy scheme is in line with an old tradition in economics, associated with the British economist Arthur C. Pigou, in the treatment of externalities. Externalities are uncompensated costs imposed on others. Volatile capital flows cause externalities in emerging economies, as these can lead to an appreciation of the domestic currency, thus adversely affecting exports and employment. In this context, a tax on sudden and large capital inflows imposes a cost on the market participants and results in improved pace of capital flows.

Positioning the proposed policy within the Union ministry of finance could make it susceptible to political pressures. Hence, it’s advisable to create an independent body for such a purpose. This institutional structure would be similar to a Public Debt Office in countries like the UK as an autonomous government agency.

With exchange rate management occupying a space separate from both the monetary functions of the central bank and the usual fiscal role of the ministry of finance, we can look forward to greater stability in foreign exchange markets.

Rohit Prasad and Gurbachan Singh are, respectively, professor at MDI Gurgaon and visiting faculty at the Indian Statistical Institute (Delhi Centre).

Comments are welcome at views@livemint.com.

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