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PROJECT 2010-2012



Smruti Gupta – 86
Sonam Daryanani –87
Sonam Gosalia 88
Soumitra Raut -89
Sowmya Charita 90
Introduction 3-7
• Definition of Currency War 3
• Reasons for Currency War 3
1. • Why do Countries Want a Weaker Currency? 4
• How Does An Economy Weaken Its Currency? 4
• Benefits of Devaluation 5
• Seoul Summit 6
Foreign Exchange Rate 8-13
• Meaning and Types 8
• Fluctuations in Exchange Rates 9
• Factors that Influence Exchange Rates 11
Competitive Devaluation: A Threat to Global Economy 14-24
(Major Countries) 15
• China
3. • US
• USA-China Economic Relations
• Japan
• European Union 24
Currency Wars and the Emerging Economies 25-29
• Impact on Emerging Economies 25
• QE and the trilemma for emerging economies 25
• National Policy Developments in some Countries 28
Impact on India 30-32
5. • What should be done 31
• India’s Take On Currency War 31
6. Conclusion 33
7. Bibliography 34

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Currency war, also known as competitive devaluation
devaluation, is a
condition in international affairs where countries compete
against each other to achieve a relatively low exchange rate for
their home currency, so as to help their domestic industry.
Traditionally, a currency war refers to the situation where one nation, relying on its strong economic
power, buffets its competitors and seizes other nations' wealth through monetary and foreign exchange
It is a form
m of economic warfare with cold premeditation, specific purpose and considerable destructive
power. However, there is no obvious evidence that many countries are conducting a "currency war" in
this sense.
ome nations, which are facing internal economic di
Some difficulties,
fficulties, devalue their currency to simulate exports
and create more jobs. If more and more nations adopt this kind of foreign exchange policy, the interest
conflicts between them will get worse, damaging the recovery of the global economy.
The term 'currency
rency war' was used in recent times by Brazil's finance minister Guido Mantega as a reaction
to China's attempt to protect the Yuan from rising too quickly against the dollar. It comprises competitive
measures by governments to improve their trade by maneu
vering exchange rates. A cheap currency, vis-à-
vis the dollar, adds to the competitive advantage to the exporter.


Firstly, there is the old and serious problem of a more or less inflexible pegging of the Chinese Yuan to
the US dollar, contributing to the massive Chinese current account surpluses and huge international
reserve holdings and correspondingly large and unsustainable defici
deficits elsewhere.
Secondly, is the exceptionally loose monetary policy being followed (after the 2008
2009 global crisis)
by leading industrial countries, including the US, UK, Japan and, to a somewhat lesser extent, the euro
zone. Policy rates in these jurisdictions
ictions are at or close to zero and money supply is being boosted through
“quantitative easing”,, whereby the central banks pump up liquidity by purchasing government bonds
and other assets. Such action normally tends to cheapen the currencies involved.
Lastly, is the spillover impact on many emerging economies as they are confronted with the flood of
international liquidity flowing into their countries in search of higher returns, leading to unwanted
currency appreciation and asset price inflation.

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The current situation is far from a war, although there is more conflict between nations' monetary
policies. The Western media's hyping of a "currency war" has exaggerated divisions on currency policies
and brought more tension to the international community.


A reason for preferring devaluation among emerging economies is that maintaining a relatively low
exchange rate helps them build up their foreign exchange reserves, which can protect them against future
financial crises. A lower value for the home currency will raise the price for imports while reducing the
price for exports.
Deficit countries want to export more to help their economy recover but the surplus countries do not want
their exporters to lose their competitive advantage. Devaluation can be especially attractive as a solution
to unemployment when other options like increased public spending are ruled out due to high public debt
and also when a country has a balance of payments imbalance which devaluation would help correct.
Often countries want to maintain a strong currency. A strong currency increases living standards and
enables cheaper imports. Also devaluation may cause inflation because imports are more expensive and
aggregate demand rises. However, in a recession and liquidity trap, inflation is not seen as a problem and
therefore, countries seek to boost demand by exchange rate.
Countries such as China, Brazil, South Korea and Japan have taken measures to devaluate their currencies
which would help them boost exports and create jobs. An attempt by the government to prevent its
currency from appreciating too steeply and too fast against competing nation is what is seen as currency
war between different countries. The history of currency wars dates back to the Great Depression era
when major economies devalued their currencies as a part of a measure to give preference to local goods
over imported ones.

Over the past decade, the world has been divided into "deficit" countries and "surplus" countries. Deficit
countries - US, UK, Greece & Spain
Surplus countries - China, Japan & Germany


• Cut interest rates -
Lower interest rates make it less attractive to save in an economy and less hot money flow

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• Print money / Quantitative Easing -
Increasing the supply of money, increases the supply of dollars (or Pounds). This leads to a fall in
the value of the dollar (Pound)

• Intervention Buying -
By purchasing the assets of other countries, you increase the value of their currency. For example, if
China uses its foreign currency to buy US Treasuries. It increases demand for the dollar and
therefore the dollar becomes weaker compared to the Yuan.

For example, the US Federal Reserve is pursuing quantitative easing. Japan has been recently been
selling Yen and buying US assets. China has long been accused of currency manipulation

• Economic Growth -
If the dollar becomes weaker, exports become cheaper leading to an increase in demand for US
exports. This can help to increase AD and improve the rate of economic growth. This may be
important, because problems in the US housing market are threatening the rate of economic growth.
Falling house prices are potentially reducing consumer spending, therefore, a rise in exports could
help to boost economic growth and prevent any move towards a recession.

• Balance of Payments -
The US has a large current account deficit (7% of GDP) therefore a devaluation will help to improve
and reduce the current account deficit. However, a devaluation alone is unlikely to solve the
problem. Also, there is evidence that demand for exports and imports is relatively inelastic;
therefore, any devaluation will have a small impact on the value of exports and imports. It is argued
that the fundamental reason for a deficit is the low levels of domestic savings and consequently high
levels of consumer spending.

• Inflation -
A devaluation may lead to increased inflationary pressures for 3 reasons:

§ Increase in exports causes rising AD and therefore could lead to demand pull inflation

§ Imported goods will be more expensive. American consumers would definitely experience a
rise in price for many imported manufactured goods and imports of raw materials could
increase costs of business

§ It is argued a devaluation reduces the incentive, for manufacturers and exporters, to cut costs
and become more efficient

However, the impact of devaluation depends on the state of the economy. As previously mentioned, the
US economy is slowing down; therefore inflationary pressures are subdued and therefore inflation is
unlikely to occur.

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USA: The Perceived Culprit of Currency War

The United States is facing a sluggish economic recovery and high
unemployment, and the country facing recession is a major issue.
Many US politicians have the impulse to use the Yuan exchange
rate issue as a scapegoat for the weakness of US economy. They
highlighted the question of the Yuan's exchange rate and
intensified the dispute, making the Yuan seem the eye of the
storm. The root cause is the Federal Reserve's massive printing of money in response to the financial
crisis. It has adopted expansionary fiscal and monetary policies and infused massive liquidity into the
market, which caused depreciation of its currency.

G20 Summit: Seoul Grounds for Currency Wars and Global Growth Pledges
The G20 summit was termed as a G2 summit by Prime Minister of United Kingdom, because it mainly
emphasized on the currency war between China and USA.
Leaders had gathered in Seoul for the fifth G20 summit where the market was to assess the comments and
the communiqué with crucial scrutiny amid the cold currency war.
The negotiators were taking crucial steps regarding financial safety and development issues; they did not
succeed in reaching an agreement over narrowing exchange rate differences or setting a benchmark as a
percentage of GDP for current account surpluses or deficits. (The 4% of GDP suggested last month by
Timothy Geithner that was rejected by Germany and China)
World Bank President Robert Zoellick said “Gold has become a reference point because holders of
money see weak or uncertain growth prospects in all currencies other than the Yuan, and the Yuan is not
free for exchange.
The US is the biggest lobbyist for the cause and pressures China to speed its currency revaluation as the
Yuan provide a very competitive advantage on export basis and surely it being the nation with the biggest
dollar reserve.
The US has been calling on China for years now and continues to fight as China takes little action and
now confronted with new pressures of HOT DOLLARS! The Feds are pumping extra cash into the
market with the newly introduced $600 billion asset purchase fund and the money is surely pouring into
China which continues to fear raging inflation and asset bubble formations.
The US wants more action from China and the Chinese are against any “shock therapy” to revaluate their

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G20 Leaders Agreement on Currency Deal in Seoul
Representatives from the 20 developed and emerging countries in Seoul agreed on "indicative guidelines"
to prevent tensions escalating into currency wars and the need to avoid protectionism.
At the end of the summit, the world's top industrialised nations said they would stop devaluing their
currencies to gain a competitive advantage over rival economies.
The US and Britain have accused China of keeping the value of its Yuan currency artificially low to make
its exports cheap, fuelling the massive trade imbalances which played a part in the global economic crisis
of 2008.The final communiqué also agreed to a move towards a more open system of international
exchange rates.

President Obama on Seoul agreement

US President Barack Obama said: "Exchange rates must reflect economic realities... Emerging economies
need to allow for currencies that are market-driven."This is something that I raised with President Hu
(Jintao) of China and we will closely watch the appreciation of China's currency."

Prime Minister, Manmohan Singh

The Prime Minister has called for three important things to be done—

• To avoid all competitive valuations in currency and resist protectionism.

• Advanced deficit countries to follow policies of fiscal consolidation consistent with their
individual circumstances, also stating that fiscal correction need not be frontloaded everywhere.

• Structural reforms which are necessary should be done in a manner to expand the internal demand
in surplus countries. "While structural reforms are necessary everywhere, these should increase
efficiency and competitiveness in deficit countries, while expanding internal demand in surplus
countries. This re-balancing will take time, but it must begin," Singh said.

Although India advocated the case for exchange rate flexibility, it did not support the US line of putting a
cap on current account balance, proposed at four per cent of the Gross Domestic Product (GDP).
India's argument has been that it may not be easy to reach agreement on sustainable current account
balances for individual countries given the structural differences of economies.

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In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between
two currencies specify how much one currency is worth in
terms of the other. It is the value of a foreign nation’s
currency in terms of the home nation’s currency.
For example an exchange rate of 91 Japanese yen (JPY, ¥)
to the United States dollar (USD, $) means that JPY 91 is
worth the same as USD 1.
The foreign exchange market is one of the largest markets
in the world. By some estimates, about 3.2 trillion USD
worth of currency changes hands every day.
The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an
exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

An exchange system quotation is given by stating the number of units of "quote currency" (payment
currency) that can be exchanged for one unit of "base currency" (transaction currency). For example, in a
quotation that says the EUR/USD exchange rate is 1.2290 the quote currency is USD and the base
currency is EUR
There are two types of Quotations -

• Direct quotation: 1 foreign currency unit = x home currency units

• Indirect quotation: 1 home currency unit = x foreign currency units

In direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable)
then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the
exchange rate number increases and the home currency is depreciating.

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Different Countries Follow Different Exchange Rate Systems:

China United States of America India
Egypt U.K Malaysia
Euro Zone
Pakistan Brazil Sri Lanka
(Euro countries)
Nepal Japan
Iraq South Africa

Free or Pegged:
If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is
determined by the market forces of supply and demand. Exchange rates for such currencies are likely to
change almost constantly as quoted on financial markets, mainly by banks, around the world. A movable
or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a
currency. For example, between 1994 and 2005, the Chinese Yuan (RMB) was pegged to the United
States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War
II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based
on the Bretton Woods system.

Real Exchange Rate:

The "real exchange rate" (RER) is the purchasing power of two currencies relative to one another. It is
based on the GDP deflator measurement of the price level in the domestic and foreign countries, which is
arbitrarily set equal to 1 in a given base year. Therefore, the level of the RER is arbitrarily set, depending
on which year is chosen as the base year for the GDP deflator of two countries. The changes of the RER
are instead informative on the evolution over time of the relative price of a unit of GDP in the foreign
country in terms of GDP units of the domestic country. If all goods were freely tradable, and foreign and
domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for
the GDP deflators of the two countries, and the RER would be constant and equal to one.

Bilateral VS Effective Exchange Rate:

Bilateral exchange rate involves a currency pair, while effective exchange rate is weighted average of a
basket of foreign currencies, and it can be viewed as an overall measure of the country's external

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Uncovered Interest Rate Parity:
Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against
another currency might be neutralized by a change in the interest rate differential. If US interest rates
increase while Japanese interest rates remain unchanged then the US dollar should depreciate against the
Japanese yen by an amount that prevents arbitrage (in reality the opposite (appreciation) quite frequently
happens, as explained below). The future exchange rate is reflected into the forward exchange rate stated
today. In our example, the forward exchange rate of the dollar is said to be at a discount because it buys
fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium.

Balance Of Payments Model:

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a
stable current account balance. A nation with a trade deficit will experience reduction in its foreign
exchange reserves which ultimately lowers (depreciates) the value of its currency. The cheaper currency
renders the nation's goods (exports) more affordable in the global market place while making imports
more expensive.

Asset Market Model:

The asset market approach views currencies as asset prices traded in an efficient financial market.
Consequently, currencies are increasingly demonstrating a strong correlation with other markets,
particularly equities. Like the stock exchange, money can be made or lost on the foreign exchange market
by investors and speculators buying and selling at the right times. Currencies can be traded at spot and
foreign exchange options markets. The spot market represents current exchange rates, whereas options are
derivatives of exchange rates

Exchange Rates (as on 10th December, 2010)*

Currency Rate (expressed as 1 USD)

US Dollar (USD) 1.00
Japanese Yen 83.72
UK Pound Sterling 1.58
Chinese Yuan 6.66
Indian Rupee 45.22
Euro 1.32
Brazilian Real 1.70

*Source: International Monetary Fund (

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A market based exchange rate will change whenever the values of either of the two component currencies
change. A currency will tend to become more valuable whenever demand for it is greater than the
available supply. It will become less valuable whenever demand is less than available supply (this does
not mean people no longer want money, it just means they prefer holding their wealth in some other form,
possibly another currency).
Increased demand for a currency is due to either an increased transaction demand for money, or an
increased speculative demand for money. The transaction demand for money is highly correlated to the
country's level of business activity, gross domestic product (GDP), and employment levels. The more
people there are unemployed, the less the public as a whole will spend on goods and services. Central
banks typically have little difficulty adjusting the available money supply to accommodate changes in the
demand for money due to business transactions.

Manipulation Of Exchange Rates:

Countries may gain an advantage in international trade if they manipulate the value of their currency by
artificially keeping its value low. This is what has been argued that China, Japan and even Brazil are
doing. A low exchange rate lowers the price of a country's goods for consumers in other countries but
raises the price of goods, especially imported goods, for consumers in the manipulating country.


Aside from factors such as interest rates and inflation, the exchange rate is one of the most important
determinants of a country's relative level of economic health. Exchange rates play a vital role in a
country's level of trade, which is critical to most every free market economy in the world. For this reason,
exchange rates are among the most watched, analyzed and governmentally manipulated economic
measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's
portfolio. Here we look at some of the major forces behind exchange rate movements.
Numerous factors determine exchange rates, and all are related to the trading relationship between two
countries. It is to be kept in mind that exchange rates are relative, and are expressed as a comparison of
the currencies of two countries. The following are some of the principal determinants of the exchange rate
between two countries. (These factors are in no particular order).

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1. Differentials in Inflation -
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its
purchasing power increases relative to other currencies. During the last half of the twentieth century, the
countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada
achieved low inflation only later. Those countries with higher inflation typically see depreciation in their
currency in relation to the currencies of their trading partners. This is also usually accompanied by higher
interest rates.

2. Differentials in Interest Rates -

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central
banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation
and currency values. Higher interest rates offer lenders in an economy a higher return relative to other
countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The
impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in
others, or if additional factors serve to drive the currency down. The opposite relationship exists for
decreasing interest rates - that is, lower interest rates tend to decrease exchange rates.

3. Current-Account Deficits -
The current account is the balance of trade between a country and its trading partners, reflecting all
payments between countries for goods, services, interest and dividends. A deficit in the current account
shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital
from foreign sources to make up the deficit. In other words, the country requires more foreign currency
than it receives through sales of exports, and it supplies more of its own currency than foreigners demand
for its products. The excess demand for foreign currency lowers the country's exchange rate until
domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to
generate sales for domestic interests.

4. Public Debt -
Countries will engage in large-scale deficit financing to pay for public sector projects and governmental
funding. While such activity stimulates the domestic economy, nations with large public deficits and
debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if
inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but increasing the
money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit
through domestic means (selling domestic bonds, increasing the money supply), then it must increase the

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supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove
worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be
less willing to own securities denominated in that currency if the risk of default is great.

5. Terms of Trade -
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the
balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its
terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's
exports. This, in turn, results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate
than that of its imports, the currency's value will decrease in relation to its trading partners.

6. Political Stability and Economic Performance -

Foreign investors inevitably seek out stable countries with strong economic performance in which to
invest their capital. A country with such positive attributes will draw investment funds away from other
countries perceived to have more political and economic risk. Political turmoil, for example, can cause a
loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that
portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and
capital gains derived from any returns. Moreover, the exchange rate influences other income factors such
as interest rates, inflation and even capital gains from domestic securities. While exchange rates are
determined by numerous complex factors that often leave even the most experienced economists puzzled,
investors should still have some understanding of how currency values and exchange rates play an
important role in the rate of return on their investments.

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There is an ongoing currency war among economies, especially the

United States (US) and China. Emerging markets have been caught
in the middle of a dispute over exchange rates and capital flows
between the United States and China.
With some economies still reeling from the global financial crisis,
countries have sought to weaken their currencies to boost exports
and improve trade balances.
Countries blame one another for distorting global demand, with
weapons that range from quantitative easing (printing money to buying bonds) to currency intervention
and capital controls. There are also trade restrictions that threaten the world economy through weakening
of currencies to boost exports instead of allowing markets set foreign exchange values. Thus, nations
from the United States to China are relying on cheap currencies to spur growth.
The movements in the currency markets and their effects on different economies are complicated. The US
Federal Reserve and central banks of other developed economies have lowered interest rates in their fight
to save their economies, leading to distortion in the world’s currency markets. The result is a many-sided
battle of the emerging economies against the United States, one that without some sort of cooperation will
end up with almost everyone losing in terms of slow global economy. And the winner, so far, is
undoubtedly, China.
Countries from Brazil to South Korea and Thailand have sold their currencies in recent weeks to curb
gains that threaten to impede export growth and slow their economies. South Korea, Taiwan, Brazil,
Colombia and Russia are tightening rules on capital flows to limit swings in their currencies.
The Japanese government has limited the Yuan’s advance to less than 3% since abandoning a two-year
peg against the dollar (in June). By comparison, Thailand’s baht has climbed 15% in the past two years,
Malaysia’s ringgit is up 13%, Brazil’s real has surged 28% and South Africa’s rand has appreciated 34%
versus the dollar.

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The Chinese
ese government is being criticised for the ‘manipulation’ of their currency. They have been
keeping the Chinese currency undervalued to promote growth and exports. At the
moment China only pegs its currency against the dollar and not a wider basket of

China’s Exchange Rate

An undervalued currency suggests that the Government is keeping the currency below
its ‘fair’ market equilibrium price by currency controls and intervention buying.
The Chinese currency, the Remenbi
Remenbi,, is in a managed floating exchange rate system. The government
manages its value primarily against the US dollar. According reports it is said that the Yuan is
undervalued by approximately 30% against other currencies. This currency value is maintained by
imposing foreign exchange controls.
For example, there is a limit to how much foreign currency Chinese residents can buy. Also, China uses
its foreign exchange reserves to buy US dollar assets. This reduces value of Chinese currency and
increases value of dollar.

Should The Chinese Revalue Their Currency ((Yuan)?

If the value of the Chinese currency increases, it will mean it is cheaper for Chinese consumers to import
from abroad. It will make Chinese exports relatively more expensive. The US currency will be weaker
and therefore it will be more expensive for American consumers to buy imports from China.
Therefore this may lead to a reduction in the Chinese current account surplus and a reduction in the US
current account deficit. This is because Chinese exp
orts become less competitive and so will import less
from China.
However, it depends upon the elasticity of demand for imports and exports. F
or example, if US demand
for Chinese exports is inelastic, then an increased price of exports will not reduce their value.

The Chinese government wish to keep the currency undervalued because:

• A weaker exchange rate makes exports more competitive and increases demand for Chinese

• Chinese economic growth is dependent on exports, so the value of the currency pla
plays a key role
in boosting growth

• China needs high growth. China’s economic growth is remarkable high by global standards. But,
because of the switch from a state controlled industry to free market economy, there is still a

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problem of unemployment. Growth in exporting manufacturing industries plays a key role in
creating jobs that are being lost in agriculture and other privatised state owned industries. With
little welfare support for the unemployed, the Chinese government are concerned about social
unrest should unemployment rise in the overcrowded cities.

Factors which Make the Weak Chinese Currency Unattractive:

• A weak currency creates inflationary pressure which means commodity prices are more
expensive. Since China is a big importer of commodities, a weaker exchange rate increases the
cost of living and the cost of raw materials. The Government has allowed an appreciation in the
exchange rate to help mitigate inflationary pressure.

• China is seeking to diversify away from dollar assets. To maintain a weak exchange rate, the
Chinese need to keep buying dollar assets. However, many are worried about holding so much
dollar assets given weakness of US economy. Therefore, China is seeking to diversify away from
US dollar, but, by doing this the exchange rate will appreciate.

Benefits of an Appreciation in the Chinese Currency:

• Improvement in current account deficit

China's trade surplus with America was $233 billion in 2006, this is almost 30% of America's
total deficit. However, the improvement in the deficit may be much smaller than anticipated. A
revaluation will not tackle underlying problems of low US savings and changing comparative

• Help Reduce Chinese Inflation

Higher exchange rate will help reduce inflationary pressures in China for 2 reasons;

§ Price of Imported goods is cheaper.

§ Chinese exporters have greater incentive to cut costs and increase efficiency. This can benefit
the economy in the long run

This is important, because the Chinese economy is growing above 10% per annum. This could lead to
inflationary pressures. An appreciation will help to moderate growth; in particular reduce the investment
and borrowing boom, which results from low interest rates.

• Help economic growth and reduce unemployment in US

If the Chinese Yuan was revalued, it would allow an increase in demand for US goods. This
could important with American growth slowing. However, American politicians exaggerate the
impact of a low Chinese currency on the US economy. Firstly, US unemployment is quite low at

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4.5% and the US trade deficit is merely a reflection of the low US savings ratio (and high
consumer spending) if the deficit wasn't with China it would be with somebody else.


The United States of America claims that the currency war is the
outcome of the policies of newly emerging economies —
particularly China and some other Asian countries, including
India. They say that the imbalances in the global economy arise
from the US’s massive current account deficit, coupled with
current account surpluses of China and other emerging
economies. This results in flight of capital away from crisis-hit
deficit economies.
The genesis of the current managed exchange rates started with the US abandoning the dollar’s link to
gold. This made the dollar the most preferred currency of exchange. This advantage allowed successive
US administrations to build deficits that have now reached unsustainable limits. The consumption of
cheap imports and the housing bubble also contributed to the present predicament of the US economy.
The cost of the first was loss of manufacturing jobs.
The US central bank is pursuing a deliberate policy of devaluing the dollar in order to cheapen the price
of US exports and make foreign imports more expensive. Under conditions of stagnant markets and
negligible economic growth in the US, Europe and Japan, such a policy inevitably fuels countermeasures
by America's competitors. They seek to defend their export industries by intervening to halt the rise in
their exchange rates and contain waves of speculative investments pushing up their currencies and
overheating their economies.

Reasons For Competitive Devaluation By USA

• To boost Economic Growth

If the dollar becomes weaker, exports become cheaper leading to an increase in demand for US
exports. This can help to increase AD and improve the rate of economic growth. This may be
important, because problems in the US housing market are threatening the rate of economic
growth. Falling house prices are potentially reducing consumer spending, therefore, a rise in
exports could help to boost economic growth and prevent any move towards a recession.

• Balance of Payments
The US has a large current account deficit (7% of GDP) therefore devaluation will help to

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improve and reduce the current account deficit. However, devaluation alone is unlikely to solve
the problem. Also, there is evidence that demand for exports and imports is relatively inelastic;
therefore, any devaluation will have a small impact on the value of exports and imports. It is
argued that the fundamental reason for a deficit is the low levels of domestic savings and
consequently high levels of consumer spending.

• Inflation
Devaluation may lead to increased inflationary pressures for 3 reasons

o Increase in exports causes rising AD and therefore could lead to demand pull inflation.

o Imported goods will be more expensive. American consumers would definitely

experience a rise in price for many imported manufactured goods and imports of raw
materials could increase costs of business.

o It is argued devaluation reduces the incentive, for manufacturers and exporters, to cut
costs and become more efficient.

However, the impact of devaluation depends on the state of the economy. As the US economy is slowing
down; therefore inflationary pressures are subdued and therefore inflation is unlikely to occur.

Mechanism Undertaken By USA to Competitively Devalue Their Currency:

Quantitative easing (QE) is the practice when a central bank tries to mitigate a potential or actual
recession by increasing the money supply for their home economy. This can be done by creating money
and injecting it into the domestic economy with open market operations.
Quantitative easing was widely used as a response to the financial crises that began in 2007, especially by
the US and the UK and to a lesser extent the Euro zone.
QE2 is a second iteration of the current financial war being waged by the USA against the rest of the
world. On 3 November 2010 there was a further devaluation of the US dollar by the Federal Reserve
which is the central bank of the US. This devaluation by which the US printed US$600 billion of its
currency is another manifestation of the present currency war.
The term, ‘currency war’ is another way of referring to the competitive devaluation of the top capitalist
currencies. The reason for the devaluation is to make a country’s exports cheaper in order to rebuild the
economy. The U.S. is allowing its currency, the dollar, to devalue by expansionary fiscal and monetary
policy. It's doing this through increasing spending, thereby increasing the debt, and by keeping the Fed
funds rate at virtually zero, increasing credit and the money supply.

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The relationship between China and the USA is an intriguing example of how economic ties can bind in a
way that political ideology never could.

Statistics of USA - China Economic Relations:

• The USA has a large trade deficit with China. In 2008, it

stood at $268 billion. (USA trade deficit statistics)

• For every $1 China spends on USA goods, USA citizens

spend $4.46 in China.

• Exports to the United States account for 6 percent of

China’s entire economic output.

• USA exports to China account for 0.5 percent of USA GDP. In a trade war, there would be one
clear loser.

• Because of this large trade surplus China has substantial foreign currency reserves. With these
foreign currency reserves, China has accumulated $2 trillion in foreign reserves, mostly in
Treasury bonds (government debt) and other dollar-denominated assets

China buys US assets for two reasons -

1. Buying USA bonds keeps the Chinese currency, the Yuan, undervalued. This makes Chinese
exports more competitive and helps boost Chinese growth.

2. The Chinese have so many USA assets they don't want to see them devalued. In a perverse way,
the Chinese have a vested interest in the value of the dollar. Also they need a strong USA
economy so USA consumers will keep buying its goods.

USA versus China

Although it’s not just the yen but the Yuan as the depreciation of the Yuan compared to the Dollar has
caused a growing tension between The U.S and China in recent weeks. The U.S is blaming the cheap
Yuan for its economic issues and even financial sanctions against China have been on the cards. If these
two giant economies are starting to threaten each other, the impact on the ever-slowing recovery could be

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USA Trade Deficit With China
USA’s trade deficit with China was $268 billion in 2008, an all-time high for a trade deficit with any
country. Explain some possible causes of a balance of trade deficit and consider if USA should be
concerned over its trade deficit with China.

Reasons for Balance of Trade Deficit Between US and China

1. Undervalued Yuan –
According to the Big Mac index compiled by the Economist, the Chinese Yuan is 49%
undervalued against the Dollar. This is partly because the Chinese Government seek to keep the
Yuan undervalued by restriction currency flows. The undervalued Yuan gives a competitive
advantage to Chinese exporters relative to US exporters.

2. Higher Savings Ratio in China -

The past decade has seen a very low level of savings in the US, but much higher in China. Low

Saving ratios mean that levels of consumption are higher in US. China’s high saving ratios mean

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that consumer spending on imports is relatively lower. Instead China use their savings to invest
and purchase capital flows from abroad. (It is these capital flows which help to finance current
account deficit.)

3. Changing Comparative Advantage –

China is becoming more competitive because it has:

• Low labour costs, elastic supply of labour

• Growing skills base

• In manufactured goods, China has a clear comparative advantage; it’s greater competitiveness
has contributed to US deficit

Why China needs the USA

China needs the USA to keep buying its goods. Without demand from USA, Chinese exports would fall
and the economy would suffer. With unemployment high and social instability increasing, this is
something the Chinese government don't want.

Why USA needs China

The USA need China, for cheap goods, cheap components and perhaps more importantly for their
holdings of US Treasury debt. With the US national debt edging towards 80% of GDP, China remains an
important player in buying US debt and keeping USA solvent.

Why is US Unhappy with the Situation?

By keeping dollar strong, US exports become less competitive. This makes the Chinese imports relatively
more attractive, increasing foreign demand at expense of domestic producers. The US argues this loss of
demand and jobs is something it can’t afford at its particular stage in the economic cycle.
While the US accuses China of undervaluing the Yuan, China blames loose US monetary policy for
driving money into emerging markets that threatens to destabilise their economies.
But to focus on America and China is to misunderstand the nature of the problem. The currency wars are
about more than one villain and one victim. Rather, redouble multilateral efforts behind the scenes,
especially by bringing in the emerging countries hurt by China’s policy. It should be noted that capital
controls have been recently endorsed by the International Monetary Fund (IMF) as a legitimate short term
weapon for reducing the impact of volatile capital flows.
The U.S. is allowing its currency, the dollar, to devalue by expansionary fiscal and monetary policy. It's

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doing this through increasing spending, thereby increasing the debt, and by keeping the Fed funds rate at
virtually zero, increasing credit and the money supply.
China is keeping its currency low by pegging it to the dollar, along with a basket of other currencies. It
keeps the peg by buying U.S. Treasuries, which limits the supply of dollars, thereby strengthening it. This
keeps the Yuan low by comparison.
Brazil and other emerging market countries are concerned because the currency wars are driving their
currencies higher, by comparison. This raises the prices of commodities, such as oil, copper and iron,
which are their primary exports. This ma
kes emerging market countries less competitive, and slows their
economic growth.
In case of India currently we have a managed float. The central bank hardly intervenes in the currency
market and refuses to take a clear view on the currency levels. With the growth we are seeing in the
domestic market, a lot of hot money in the form of FII inflows is entering the country.

The yen lost most of its value during and after World War II. After a period of instability, in 1949, the
value of the yen was fixed at ¥360 per US$1 through a
United States plan, which was part of the BRETTON
Woods System, to stabilize prices in the Japanese
economy. That exchange rate was maintained until
1971, when the United States abandoned the gold
standard, which had been a key element of the
BRETTON Woods System, and imposed a 10 percent
surcharge on imports, setting in motion changes that eventually led to floating exchange rates in 1973.
By 1971 the yen had become undervalued. Japanese exports were costing too little in iinternational
markets, and imports from abroad were costing the Japanese too much. This undervaluation was reflected
in the current account balance, which had risen from the deficits of the early 1960s to a then
then-large surplus
of U.S. $5.8 billion in 1971. The
he belief that the yen, and several other major currencies, were undervalued
motivated the United States' actions in 1971.
Japanese Yen has been touching new historical highs in the year 2010 with Yen breaching 15
15-year high
record in September. This is likely
ely to impact the Japanese exporters which form a significant part of
Japanese economy. Recently, Bank of Japan (BOJ) intervened twice in the currency market which by
many analysts has been seen as signs of open currency war in the coming years. The atmosp
atmosphere has

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become quiet tense in past few months and volatility is expected to be high in the currency market, which
is seen by many as a sign of dramatic change in the dominance of Greenback (US Dollar).

Reasons For Japan Adopting Competitive Devaluation

Japan is facing the danger of economy collapse as its economy relies on export and any appreciation of
Yen against USD will doubly hurt Japan. Japan wants to bring its economy back to life and protect its
export industries from and international currency war. There is ample evidence the yen's strength is
hindering economic growth.

• Industrial production unexpectedly declined for a third month and gains in retail sales were
smaller than economists' forecast, government figures released last week showed. The overall
economy grew just 1.7% in the April- June period, compared to a 5% expansion in the first three
months of the year.

• Japan's economy will probably contract in the fourth quarter because the government's incentives
to subsidize energy efficient cars expired in September, and increased consumer spending due to
an unusually hot summer will wane.

Japan has a number of challenges that limit its ability to allow ongoing currency appreciation, including
an aging population, high public debt (though not net debt as it has high private savings) and vulnerability
to deflation. The September devaluation did not draw widespread international condemnation. Within a
couple of weeks upwards pressure on the Yen from the markets had almost entirely undone the effect of
the intervention.
By artificially devaluing the yen, Japan joins a chorus of countries entering what is now being called an
"international currency war."

Mechanism Undertaken By Japan To Competitively Devalue Their Currency

Bank of Japan unilaterally intervenes in the international finance market (Forex) firstly by selling Yen
and buying USD to keep it export competitive in the international market followed by decreasing interest
rate to 0%. Yen broke record of all time high 82 USD/JPY in last 15 years and the Japanese currency is
appreciating further.

Japan also has a large current account surplus, and in 2009 and 2010 the country allowed the Yen to
appreciate. However, in September 2010 Japan twice intervened to effect devaluation

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The euro zone officially the euro area is an economic and
monetary union (EMU) of 16 European Union (EU)
member states which have adopted the euro currency as
their sole legal tender. It currently consists of Austria,
Belgium, Cyprus, Finland, France, Germany, Greece,
Ireland, Italy, Luxembourg, Malta, the Netherlands,
Portugal, Slovakia, Slovenia and Spain not including
Sweden, which has a de facto opt out) other states are
obliged to join the zone once they fulfil the strict entry

Competitive Devaluation By Eurozone

The “currency war” is raging with countries intervening in the FOREX markets, devaluing their
currencies and pausing on necessary rate hikes. Europe seems unable to deal with China and the rest of
the world. The Euro is on the rise and this will eventually hurt the European economies.
The Euro zone is a special case where some members, principally Germany, enjoy a large current account
surplus and so could accept or even benefit from a currency appreciation.
Other countries though such as Greece, Spain, Portugal and Ireland have twin deficits and so to a large
extent would benefit from depreciation.
The most important thing that Europe can do is to solve its own debt crisis. Europe is facing many
problems except the global currency tensions. Europe’s structure is rigid and it faces a full-fledged
sovereign debt crisis in the side-line. Right now, Portugal, Ireland, and Greece are in the eye of the storm,
but the storm could get even worse and engulf bigger European economies.
Vulnerable European states need help in terms of big reforms, austerity measures, and structural changes
that make the labour market more competitive and flexible. To support this, Germany and a few other
Western European countries need to adopt more expansionary fiscal and wage policies, but Germany is
very reluctant to do this.
While weaker European countries are now undertaking the necessary austerity measures because they
have no choice, they will need to be supported by looser fiscal policy in Germany and other countries at
the European core, as well as the continuation of highly expansionary monetary policy. The problem is
that this goes completely against the political view of German leaders.

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The US believes China engages in “currency manipulation”,

and “competitive non-appreciation”. China accuses the US of
excessively loose monetary policy, flooding the world with
liquidity. There is some truth in both charges, but some
As countries compete to devalue their currencies to save the
interest of their exporters, it collectively reduces demand for
foreign goods, something that world economies cannot afford
at a time when the process of global recovery from the after affects of the crisis of 2008-09 is still
underway. Also, competitive currency devaluation is happening at a time, when some of the developed
economies have a soft money situation, wherein monetary regulators are on a quantitative easing spree,
lowering their interest rates, which is making emerging economies trying to regulate their inflation an
arduous task, as direction of the capital flows has turned towards them.

QE And The Trilemma For Emerging Economies

In this context, we now explore the implications of QE, first in a small open economy, then for a big
country, then for a set of big countries. We assume the interest rate is constrained at the zero lower bound,
there is a “liquidity trap”, economic activity is weak, and there is some threat of deflation.
In a small open economy, when the central bank brings the interest rate to the zero bound, the exchange
rate depreciates. The monetary authorities can threaten to intervene or actually do so to keep the exchange
rate down. In this case, the weak currency is not “competitive devaluation” – it is just a normal part of an
easy monetary policy. In any case, there is little effect on the rest of the world.
In single large open economy like Japan, where it is proposed a foolproof way of avoiding deflation and
restoring growth in the country. The authorities need to create inflationary expectations, and they must
accept a short-run inflation rate above their long-run target. So they should go to a price-level target with
a jump: bring down the exchange rate, if necessary with (unsterilised) intervention. This also expands the
monetary base and their holdings of (typically) short-term foreign government securities (e.g. the UK and
Germany). If the exchange rate does not depreciate, then the markets do not expect inflation – the policy
has failed, or the extent of intervention has been inadequate and should go up. It is very important to note
that this is not QE, as the authorities are not purchasing domestic long-term assets. There are spillovers, of
course, and they are beneficial. Escaping the liquidity trap at home does not hinder other nations from

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achieving their monetary policy objectives, unless they too are in a liquidity trap (of which more below).
And if they are, then expansion in the home country (escape from the liquidity trap) raises the world
natural rate of interest and hence alleviates the others’ liquidity traps.
Now move to a world of big countries, all at the zero bound. Ideally, all should inflate in a coordinated
fashion, so that exchange rates are not affected. Uncoordinated policies could bring currency volatility.
This destabilises markets, creates a highly uncertain environment for business, and raises pressures for
trade policy interventions. With simultaneous QE, there might not be first-order effects on the exchange
rates between the big countries. And simultaneous QE could achieve simultaneous expansion, which
would have first-order effects on the natural rate of interest, helping to restore more normal monetary
Although simultaneous QE in all big economies might wash out in exchange rates, there are also many
small economies – including the emerging market countries. What happens in such a world? Some of the
additional liquidity in the economies at pursuing QE at the zero lower bound flows to countries with
higher interest rates. Their currencies appreciate, and expected appreciation attracts more capital flows.
(Yes, the carry trade is indeed profitable; uncovered interest parity is violated.) Global liquidity goes up,
foreign-exchange reserves rise in those smaller countries that intervene to try to resist appreciation. The
big economies are exporting bubbles. But global rebalancing should be achieved by raising consumption
in the rest of the world, rather than investment in financial assets and real estate.
Meanwhile, if one large economy does not participate (e.g., the Eurozone), then its currency will also
appreciate, with accompanying political and trade tensions. And volatility between exchange rates of
large countries is more harmful than if it is confined to small countries.
Here, it is vital to see that simultaneous QE is not the same as simultaneous exchange-rate intervention. In
the latter case, central banks will typically hold reserve increments in foreign short-run debt (as noted
above). If all do this, the net effect is that of domestic open-market operations in short-dated government
securities. At zero interest rates, these securities are perfectly substitutable for money. There is a liquidity
trap, so exchange-rate intervention at the zero lower bound achieves nothing – whereas QE does seem to
have an impact on both interest rates and exchange rates.

If the large developed market countries do more QE, however, then the flow of liquidity to the emerging
markets may force the latter to respond. They may try to resist exchange-rate appreciation by intervening
in the foreign exchange markets. Here we do have competitive devaluation i.e. the “currency wars”. And
if the emerging market countries do not sterilise the intervention, or if sterilisation is at least partly
ineffective, then they experience inflationary pressures. So capital inflow controls look tempting – but

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experience suggests they may not be very effective, unless there is much broader financial repression
(e.g., China).
This is why we see statements like “The US will win this war: it will either inflate the rest of the world or
force their exchange rates up against the dollar”. But there is a potential downside for the US. Substantial
dollar depreciation will weaken the global position of the dollar, as it did in the late 1970s.
If fiscal consolidation does not raise confidence in the home economy, then other nations take a double hit
- a fall in activity in their home economies and exchange-rate appreciation against them so Exchange-rate
intervention – another question in the currency wars!
If US monetary policy eases further, it will get the exchange rate depreciation that it wants. It will indeed
win the currency wars. Conventional wisdom is wrong: The US can, after all, devalue the dollar. But
there are costs:

• A wave of trade protectionism is not excluded, although its probability is low;

• More likely are capital account protectionism, in the form of emerging market capital controls;

• Damaging exchange-rate volatility, including among the large countries, if QE is not coordinated

Moreover, in the longer run, this could substantially weaken the hegemony of the dollar in the
international financial system. There is also the fear of a bubble, which will burst once developed
economies are back on track and the flow of capital shrinks. This shrinking is expected to be first
reflected in the currency markets.
Exchange-rate pressures, global imbalances and rebalancing, spillovers and the desirability of policy
coordination – these are at the centre of the economic interdependence between the developed and
emerging market countries. All this is in the context of weak US and European recoveries from the Great
Recession, the risk of deflation, and the likelihood of more quantitative easing (QE) by major central
banks. Domestic issues and inability to get direct action on exchange rates has led the US to propose
internationally agreed targets for current-account imbalances.
Policies such as these cannot be properly assessed without an analytic framework. In the current
discussion, the furthest this has gone is evocation of the “trilemma”: the impossibility of simultaneously
maintaining open capital markets, nominal exchange-rate stability, and monetary policy autonomy.
(“Inconsistent quartet”, which adds trade openness to these three – but protectionism, is indeed a potential
weapon in the currency wars, and we must not disregard that threat.)
While policymakers in both developed economies and emerging markets are aware of this trilemma, they
are not fully conscious of the international repercussions of QE by the largest economies when they are at

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the zero lower bound for interest rates, while policymakers appear to grasp some of the issues, they
underestimate the impact of quantitative easing by large economies on exchange rates worldwide.

National Policy Developments In Some Countries

The Bank of Japan has intervened to limit appreciation of the yen and may do further QE.
The Bank off England is actively considering additional QE beyond the £200 billion in asset purchases it
has already made.
The European Central Bank (ECB) is reluctant to expand its balance sheet further, but it may be forced to
buy more Greek, Portuguese, Irish, and Spanish bonds if the markets turn against any or all of these
sovereign debtors. And if the euro were to appreciate substantially against the dollar, threatening the weak
European recovery, the political pressure on the ECB for some form of intervention w
ould be hard to
China, for its part, continues to resist both political and market pressures for more rapid nominal
appreciation of the Yuan.. The East Asian countries that have effectively pegged to their currency to the
US dollar stand firm. Others
rs have experienced substantial appreciation (Indonesia, Malaysia, Thailand,
and Korea).

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Brazil had a massive appreciation in 2009 and imposed a transactions tax on capital inflows, which has
just been raised, since the inflows have continued, intervention has accumulated large reserves, monetary
aggregates are rising rapidly, while inflationary pressures have led to interest rate increases.
Thailand has also imposed a tax on foreign holders of domestic securities, and Indonesia is considering
capital inflow controls. Singapore has widened its exchange-rate band. Countries from Israel to India and
South Africa are facing similar pressures: large short-term capital inflows, exchange-rate appreciation,
and inflationary risks.

In late June, China took steps to allow more movement in its currency, the Yuan, but the currency has
only appreciated about 2% vs. dollar since then.
Central banks that have already intervened to slow currency gains include those in Colombia, South
Korea, Peru and Taiwan. Further actual or verbal intervention efforts are likely to come from the Czech
Republic, Poland and South Africa. Israel, which was also on the list, has said it will continue buying
dollars to stem the rise of its shekel.

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Reserve Bank of India seems to have succumbed to watchful

inaction. As can be pointed out, since March 2009 the rupee
has been allowed to rack up the sharpest appreciation (by a
long margin) in real effective exchange rate terms in our
recorded history: about 25 per cent up until September 2010
according to the six-currency index (major trading partners)
and 15 per cent according to the 36-currency index (includes
significant competitor countries).
Unsurprisingly, the share of merchandise exports in GDP has stagnated, the share of imports has risen
markedly, the share of net invisible earnings has dropped and both the trade and current account deficits
have widened significantly, with the latter likely to attain a record 4 per cent of GDP in the current year.
As stated by Pranab Mukherjee, “While emerging market economies have voiced concerns over the surge
in capital flows that is driving up their currencies, India has said there is no need to intervene in the
foreign exchange market or cap foreign portfolio inflows. He added that huge surpluses in some countries
and large deficits in others are "unsustainable" and should be addressed in multilateral discussions.
He said it is the responsibility of the central bank of every country to watch inflows that may make it
vulnerable to currency appreciation, and intervene ''as and when it is necessary.'' The rupee has gained 5.3
per cent against the dollar in the past month, making it Asia's best performer, as foreigners added about a
net $20 billion to holdings of local stocks this year. International investors' purchases of Indian shares this
year have also helped drive the Bombay Stock Exchange's Sensitive Index close to a record.
Economic Analyst surveyed and reported in november 2010- Despite the official pronouncements
favouring “inclusive growth” and “financial inclusion” our exchange rate policies have contributed to
significant job losses in labour-intensive sectors producing traded goods and services. And the
encouragement of external borrowing (including the recently raised caps for foreign institutional
investors’ investment in bonds) and surging portfolio inflows have refuelled asset bubbles in equities and
real estate, which, if they reverse, could stress parts of our financial system in a replay of what happened
in 2008/2009. The sharply appreciating rupee has, of course, weakened the medium-term viability of our
balance of payments. We have failed to reduce significantly the collateral damage from the ongoing
international currency/monetary wars.)}

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What Should Be Done?
Some of the damage is irreparable. But looking ahead, the RBI should actively intervene in the forex
market to counter excess capital inflows and contain further real rupee appreciation (preferably roll back
some of the huge increase that has already occurred). Of course, the liquidity consequences of the forex
purchases should be sterilized through the standard techniques deployed so effectively in 2004-2007.
Second, we should deploy whatever tools for capital account management that are at hand to contain
surging flows. Third, the government should seriously consider levying temporary taxes of the kind
imposed by Brazil and Thailand. : (Brazil has doubled its tax (levied a few months ago) on debt inflows;
Thailand has announced a new 15 per cent withholding tax on bond purchases by foreigners; to moderate
their currency appreciation). Taiwan has placed restrictions on portfolio inflows; and several EMEs (and
Japan) have intervened in currency markets to moderate their currency appreciation).
The central bank (RBI) at such times tries to intervene — buy dollars and create an artificial demand for
the dollar, devaluing the value of the rupee in the process and retain some price advantage for the exporter
. But buying dollars involves a fiscal cost as the central bank has to pump in equivalent amount of rupees
and again mop it up by selling bonds. These bonds need to be serviced by the government. This would in
turn worsen the fiscal position.

India’s Take On Currency War

Whenever the countries of world are confused between two options India has been showing that there
exists a third one, the way it did by adopting a mixed Economy pattern and is doing so to evade Currency
Since two years, India has stopped intervening in markets to manage its exchange rate. Instead, India
manages its economy as the textbooks say a developing country ought to. It runs a trade deficit, thereby
contributing to the rich world’s recovery; and it imports capital to help lift its people out of poverty,
registering growth of 8 per cent or so a year.
India has become surprisingly open, but will it remain so in the face of today’s strains. China’s exchange-
rate manipulation encourages its trade rivals to hold down their currencies; the manipulators drive capital
into the economies of non-manipulators, pushing up their exchange rates and threatening them with asset
bubbles. The more some governments intervene, in other words, the harder it is for non-interveners to
stick to their principles. And yet, at least so far, India appears committed to its open model. The reserve
bank of india acted the part of the anti-currency warrior recently, raising interest rates even at the risk of a
stronger rupee.

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Most Indian leaders see the case for sticking to the country’s open model. They do not want to impose
new capital controls, because they know that these leak and are a nightmare to administer. They are
reluctant to intervene against the rise of the currency, because they see that the best way to staunch
inflows of hot money may be to allow it to appreciate – at a certain point, investors will fear that the rupee
may reverse direction and hit them with losses.
Today’s eager interventionists should take note. Far more than they realize, they are setting up one-way
bets for traders. Hedge funds know that South Korea’s won is being artificially held down by the
government and is therefore more likely to rise than to depreciate, so they are hosing Seoul with capital
and compounding the problem of hot inflows that Korea is desperate to alleviate. If India’s leaders stick
to their open policies, and if the neo-interventionists meet their comeuppance, the current dirigisme may
prove mercifully short-lived.

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If China allows a floating rate on its currency i.e. allows the market forces to determine the value of Yuan
the price of its exports would increase considerably and thereby reduce demand for them. This is because,
as of the Chinese currency is highly undervalued. India being the next favorite for companies who are
currently importing from China is expected to benefit the most. The foreign currency earned from the
same shall greatly strengthen India`s position in the World Economy

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