On August 11, People’s Bank of China (PBoC) announced a near 2% devaluation in Renminbi. By August 13, the Chinese currency had fallen by more than 3%. This was the biggest single-day devaluation in Renminbi in two decades, setting off speculation that China was resorting to competitive devaluation, a euphemism for what’s more fascinatingly called ‘currency war’.
In response, PBoC has stressed that the move is entirely market-based, arguing that Renminbi was overvalued substantially. A market-based currency is in line with the China’s dream of including Renminbi in IMF’s Special Drawing Rights (SDR), which would go a long way in making Renminbi a global reserve currency. Already, China has taken a massive step in this direction by loosening capital controls1 and letting volatile foreign capital flow into the country. IMF has bought this explanation, but not all countries seem to agree. US, Japan, India and South Korea have expressed grave concern about China’s initiating a fresh round of currency war.
The concern is not without precedent. Currency wars have been colourfully described as “race to the bottom”2, “beggar-thy-neighbor” and “mutually assisted suicide amongst countries”. The first major incidence of widespread currency war was during the Great Depression of 1930s. Another bout was witnessed amongst Asian economies during the Asian crisis of 1997. Both these incidences of currency wars inflicted severe damage on global trade and economic growth, the reasons for which have been discussed later.
Competitive currency devaluation is essentially a mechanism to boost exports, and has been one of the foundational pillars of the export-led model of growth, championed by Japan and West Germany post-WWII, then imitated by the Asian Tigers (Hong Kong, Singapore, Taiwan and South Korea), and finally by China. Devaluation makes foreign debt payment more difficult, but the pros are supposed to outweigh the cons. By intervening in forex markets, these countries kept their respective currency artificially weak during different eras. Japan still actively practices this. China moved to a market-based mechanism in 2005, and after a brief return to devaluation post the financial crisis, has largely gone back to a market-based currency.
During times of robust global growth, currency devaluations are largely neglected. That’s because cheaper imports are welcomed by foreign (usually developed) countries. However, during times of global stagnation, such as this, devaluation amounts to war, triggered by several countries – developed and developing - devaluing their currencies simultaneously. The developed countries devalue largely because, by encouraging export-based production in the domestic country, competitive devaluation pushes unemployment abroad. Besides unemployment, a weaker currency also encourages inflation in the domestic economy, thereby pushing deflation abroad. Both of these – unemployment and deflation – are grave concerns now, especially in the developed world. The developing countries devalue mainly to keep their exports competitive.
Already, US Fed is considering a longer postponement of a hike in rates. Vietnam has allowed Dong to weaken3. Indian Rupee has sunk to a 2-year low4. Other Asian currencies are also showing increasing downward volatility. It will almost certainly prompt BoE, ECB and BoJ to continue with QE, which also helps devaluation, thus fuelling asset bubbles of the kind that wrecked global economy in 2008.
Currency devaluation is not the only protectionist measure used by countries. Higher import tariffs, anti-dumping duties etc., levied in response, have been observed commonly. Thus, in times of weak global growth, competitive devaluation destroys the very entity – global trade - it is meant to strengthen. This was one of the factors that led to the ruin of global and Asian economy during 1930s and 1990s.
Before countries engage in mindless devaluation, they need to ask themselves two critical questions:
1. If currency devaluation is supposed to boost exports, is it fulfilling its objective?
2. Taking a step back, if the export-led model is supposed to boost economic growth, is it fulfilling its objective?
Each of these is discussed under separate headings below.
Relationship between currency devaluation and exports
Data for July shows that exports for India and China have fallen YoY by 10.3% and 8% respectively. In the same period, Rupee has weakened by 7% while Yuan has remained constant. India’s exports have been falling for the last 8 months. For China, this is the biggest dip in 4 months. Most other big exporters have either shown contraction or tepid expansion. Japan has shown a 7.6% increase YoY, but its exports have fallen 4.4% compared to last quarter. The situation is especially worrying for Japan, whose exports haven’t shown strength despite its currency Yen having depreciated by nearly 35% over the past 3 years. Such data is a slap in the face for the firmest pillar of Abenomics- currency devaluation to increase exports. The situation is no better for Australia, whose 10% devaluation of currency this year has not helped exports.
But, despite overall weakening of currencies, why haven’t exports picked up? Of course, the sluggish global demand has kept exports under check. But besides that, academic literature has some interesting answers.
A recent paper5 published by World Bank concludes that “the elasticity of manufacturing export volumes to the real effective exchange rate has decreased over time”, which is a jargon-laced way of saying that devaluing currencies doesn’t provide the same fillip to exports anymore. The paper cites Japan as symbolic of countries that have, in the aftermath of the 2008 financial crisis, unsuccessfully and repeatedly used devaluation to boost exports.
The paper lists two primary reasons behind the considerable decrease in sensitivity exports show to currency devaluation: participation in Global Value Chain (GVC), and protectionist measures by countries in response to currency devaluation.
Regarding participation in GVC, the paper argues that different components of exported materials (goods and services) no longer come from the same country. For example, an iPhone might be finally exported from China, but will have its different components manufactured in Taiwan, Singapore, South Korea, Japan etc., which will then all be exported to China, where they’re finally assembled and exported as a finished product. This implies that the ‘import intensity of export’ – share of imported components in exports – has gone up substantially. A devalued currency mitigates boost in exports by making the imported components cheaper. The paper says that this factor on average explains 40% of the fall in sensitivity of exports, and 50% for countries whose import intensity of export is high.
Regarding the second reason, Bown and Crowley (2012) find evidence that temporary trade barriers such as antidumping and countervailing duties are set in response to currency movements by trading partners, which hampers exports. As discussed earlier, this move inflicts severe damage on global trade overall.
Efficacy of export-led model of growth
Reasons for weak export growth are not too far to seek. Commodity prices have collapsed and global demand is sluggish, especially in the developed markets. But, instead of turning to other models of growth, most countries continue to crowd out the already cramped space for exports by devaluing their currency.
In the lead up to the 2008 crisis, global export growth had far outpaced global GDP growth. Globalisation was the order of the day and export-based model seemed the way to go for many countries, especially the developing ones. Almost overnight, the 2008 crisis brought down the global export-to-GDP ratio by 4 percentage points. Exports have recovered since then, but continue to be sluggish. The share has remained constant at a tad under 30% between 2011 and 2013. The chart below encapsulates the numbers.
Palley (2011)6 says that the export-led model “is exhausted owing to changed conditions in emerging market (EM) and developed economies.” It cites several long-term, structural impediments which have brought this model to grief. First, and perhaps the most critical, is the debt saturation of western, especially US, consumers. This saturation has crushed western demand, on which the export-led model free-rode for decades. Second, the EM economies are now much bigger than their pigmy selves when they started out with this model. They have become such a large share of the global economy – share of EMs in global GDP has increased by 15 percentage points in the past two decades - that their exports are now sabotaging the recovery of those economies.
The paper, not the only one which does so, strongly recommends forsaking overreliance on exports, and instead moving to a domestic demand-led growth model. In this regard, China has done well to trigger a structural shift in its economy. As shown by the chart below, the ratio of China’s exports in GDP has fallen from 35% in 2006 to 22% in 2014. This has been enabled by moving to a market-based currency, structural reforms to allow easier domestic business, and letting wages rise so that domestic demand picks up. On the other hand, Japan’s numbers show that it is still addicted to the same model. The growth rates for the two countries tell a story: Japan is cheered for non-negative growth; China is jeered for ‘just’ 7% growth. In that, China holds lessons for Japan.
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