Echoes of 1930s in trade-cum-currency war
The ride ahead won’t be easy for emerging markets such as India if the trade war morphs into a currency war
Even as some Indian investors cheer the rollback of contentious budget proposals by the finance ministry, an escalation of the US-China conflict seems to have spooked markets worldwide. The latest trigger appears to be the new set of tariffs on American products imposed by China, and the statements of the US President, Donald Trump, who has said he would retaliate and might consider asking US firms to exit China under a ‘national emergency’.
The escalating conflict between the two global economic giants seem to have taken a toll on investor sentiments, and intensified fears of a global recession. Bond markets in advanced economies have been signalling rising stress for some time, and the latest sabre-rattling will only add to the bond market jitters.
The yield curves, or at least a part of the yield curves, have inverted in many of the advanced economies, including the USA, UK, and Japan. Under normal circumstances, yield curves tend to be upward sloping --- indicating that lenders need to be paid more (higher yields) for longer term bonds compared to bonds with shorter maturity. But when uncertainty about the future or fears of recession grip the markets, this relationship between term (time until maturity) of bonds (or borrowing) can crumble, as has happened over the past month.
As the monetary stimulus provided by central banks of advanced economies have run their course without lifting the real economy significantly, and the two major global powers have continued to escalate their trade-cum-currency war, we are back in the zone of ‘unusual uncertainty’, a phrase used often by central bankers in the wake of the global financial crash of 2008.
Both the US and China seem to be adopting similar tools of monetary easing to edge out the other in this high-stakes drama. The US President Trump has often chided the Fed for not lowering interest rates enough, in the face of cuts by other countries, and it is possible that he might get his way. Meanwhile, China too cut one of its managed interest rates recently and indicated that it could do more to stimulate the economy.
Thus these two economies are embracing looser monetary policy at home to stimulate the economy even as they continue to engage in a tariff war. While US threatens to impose more tariffs, China could not only impose further retaliatory tariffs but could also offset the effects of American tariffs somewhat by devaluing its currency. Lowering of interest rates at home also often acts as a tool to weaken one’s own currency, and thus forms a part of the arsenal in the on-going trade war.
As in the 1930s, when another crash led to a tariff war, followed by a currency war which played out even as advanced economies were reeling under the effects of the Great Depression, a similar set of circumstances, though less severe than that era, have come together to ignite recessionary fears.
During the trade-cum-currency warfare of the 1930s, those countries which aggressively loosened their monetary policy fared relatively better, according to the American macro-economist Barry Eichengreen.
While “the own-country impact of unconventional monetary policies in the 1930s was unambiguously positive”, such policies also often had negative spillovers for other countries, he wrote.
Had all countries eased monetary policies and depreciated their currencies to the same extent, it was possible for the world to be reflated quickly, Eichengreen contended. But the then prevailing policy of trade restrictions and capital controls delayed a global recovery.
Given apparent lack of coordination between the two biggest economies today, a repeat of 1930s cannot be ruled out.
The situation now is not entirely the same though, with risks of capital flight from emerging economies complicating the situation. While China recently did devalue its yuan, it is not clear if it is a sustainable path. The last time China had sharply devalued its yuan in 2015, it suffered capital flight and stock market losses. Also, devaluing its own currency will undermine years of China’s efforts to internationalize its currency.
Similarly, a weak currency in India triggers many concerns, ranging from capital flight to inflation to corporates’ external commercial borrowing exposures. Indian stock markets have in the past reacted strongly and negatively to rupee depreciation.
The ride won’t be easy for emerging markets if the global trade war morphs into a currency war. According to estimates of real effective exchange rates (REER), the US, UK and Eurozone have already succeeded in weakening their currencies in 2019, i.e. rendering their currencies more competitive even as most emerging market currencies, including that of India, have become overvalued compared to the previous year.
Even if an all-out currency war is averted, volatility in currency markets will add another layer of uncertainty to emerging market investments, making it more difficult for countries such as India to attract foreign funds.
More worryingly, a renewed round of global monetary easing could risk inflating asset bubbles, sowing the seeds of the next crisis. The Stanford University economist John Taylor famously argued that the 2008 recession in the US could partly be attributed to the excessively low interest rates in the 2003-2005 period which encouraged risky lending and excessive borrowing.
Economists at the Bank for International Settlements (BIS) have often warned against creating credit bubbles, arguing that they often result in money flowing to the least productive sectors such as real estate, sowing the seeds of economic crises. Credit-to-GDP in 11 advanced economies accounting for 55% of global GDP remains at a bloated level of 270% (December 2018), up from 240% on the eve of the 2008 crisis. Further credit expansion will only take them to uncharted territory and may quicken the eventual bust.
Even if there is no sudden crash as bond markets are fearing, and there is a slower but equally painful deleveraging, the spillover effects will be felt across the globe.
We should be prepared for the storm.
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First Published:26 Aug 2019, 12:19 PM IST
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