Economies where foreign reserves are very high, trade is in surplus and capital flows are positive, their currencies have a tendency to appreciate.
A country’s currency strength determines its competitiveness in global trade. This strength is determined by fiscal deficit, trade deficit, forex reserves and capital flows in an economy. Economies where foreign reserves are very high, trade is in surplus and capital flows are positive, their currencies have a tendency to appreciate. Countries, where there is high trade deficit, negative capital flows and negative current account, are likely to witness depreciation in currency. Depending on the situation, countries resort to manipulation of currency by either buying or selling dollars. Buying dollars leads to appreciation of currency and selling dollars leads to depreciation. The extent of buying and selling determines the level of appreciation or depreciation.
Weak currencies provide cost-competitive advantage to nations in gaining share in global trade. China gained advantage in global trade by keeping its currency weak for long, supported by artificial depression of cost of production in the country. This helped China become the leader in global manufacturing. After pressure from the US and others, China allowed appreciation of its currency.
The advent of the trade war is posing a major challenge to countries. It will lead to slow growth in global trade and many countries that mainly depend on trade will be affected in a big way. To counter the trade war, countries will adopt the strategy of weakening their currencies.
This year, China’s renminbi has already weakened. After a fall in 2016, the renminbi appreciated in the second half of 2017. It lost momentum in early 2018 due to slowing economic growth and the escalating trade dispute with the US. The renminbi depreciated by 3.2% against the dollar in June alone, its worst-ever monthly performance. This will lead to exchange-rate volatility. China will continue to allow the depreciation of its currency if trade wars continue.
A similar trend was witnessed by many emerging economies, whose currencies depreciated against the dollar. This depreciation leads to inflation since imported commodities cost more. If trade wars continue, even large exporting countries will start depreciating their currencies, leading to currency wars.
When countries want their currency to remain stable, they resort to buying dollars, which results in appreciation of currencies. This helps make the economy stable and helps importers. When countries want to increase competitiveness of products, central banks sell dollars in large quantities, which leads to depreciation of local currency. A commodity exporter, a manufactured product exporter or a service exporter benefits from this move, since their sales are in dollars or equivalent and the proceeds are realised in India.
Since April, the dollar has rallied and market expects Fed will accelerate the pace of monetary tightening and expects US interest rates to go up, which will make reverse flow of capital from emerging economies.
The rupee has also witnessed a fall, almost touching 70 to a dollar. Yet experts believe that the rupee will not depreciate beyond 70, since RBI intervenes at regular intervals to keep the rupee stable, to ensure the stability of the overall economy. Even so, there are predictions that the rupee could touch 72 if oil prices rise and our trade deficit continues to show a rising trend.
If trade wars continue, it will be a challenge for India to keep export competitiveness high. Allowing the rupee to depreciate will lead to inflation. In the last 3-4 years, inflation was contained. Now that we are in the election year, the currency has to be kept stable. Since the US is raising interest rates, withdrawal of capital from Indian markets by foreign investors will lead to weakening of our currency. It will be a challenge for policy-makers, and we have to be ready with solutions, so that inflation is contained, our economic stability is maintained and our exports are competitive.
Head, Corporate Performance Monitoring & Research, Hinduja Group