Will competitive currency depreciation result in increased economic growth?

Posted On Thursday, Oct 07, 2010

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The Common Wealth Games finally commenced on 3rd October amidst all the negative publicity, chaos and political drama. The stadiums now await their cheering audiences, the finishing lines their champions. And in the midst of this sporting fervor, economic conditions too are looking to have a race of their own – a race to devaluation.


It’s almost nostalgic to think of the times when a strong currency indicated a strong nation, and countries strived to achieve economic excellence. In the times that we stand witness to now, there seems to be a determined focus on weakening currency – “a race to devaluation”. During the previous year the race just got more intense, with anticipations of global banks announcing successive rounds of currency devaluations.


Before we proceed further, let’s focus on the intent for devaluation; on one side, devaluation seems almost like a compulsion while the other school of thought has chosen to devalue in a bid to protect the economy. A closer look at developed countries shows central bankers creating money out of thin air in a bid to prevent their economies from further degeneration. The fact that inspite of these measures these economies still seem lost is another topic of discussion in itself. However, the developing nations are focusing on keeping exports competitive and maintaining international demand, and thus have stepped up interventions to defy their currency appreciation.


False Logic


Logic can sometimes be extremely illogical. Consider this; the economy will grow if there is a healthy demand for goods and services – Now, a significant part of this demand would be from overseas, which would be crucial at times when the domestic economy is struggling – Because this international demand for a country`s goods and services is so important, logic says that these locally produced goods and services should be made more attractive to foreigners – And, one of the ways to make these goods more attractive is by making the prices of these goods more attractive – And, the easiest way to do that is by weakening the local currency.

 

Now, as a result of currency depreciation, all other things being equal, the overall demand for domestically produced goods should most likely increase – This in turn will give rise to a better balance of payments, indicating stronger economic growth.


Mainstream thinking would say: Great! More exports, Fewer imports – good news for economic growth.


Sustainability over the long term


Central bankers intervene in the currency markets by buying dollars and selling their local currency. When a central bank indicates / adopts a loosening in its monetary stance, market participants quickly respond to it by selling the domestic currency in favor of other currencies, thereby leading to domestic currency depreciation. In response to this, various producers now find it more attractive to boost their exports.

 

However, the so-called improved competitiveness on account of currency depreciation leads to less real imports for a given amount of real exports. So, while the country is getting rich in terms of foreign currency, it is getting poor in terms of real wealth, i.e. goods and services. As time passes, the effects of loose monetary policy filters through a broad spectrum of prices and generates domestic inflationary pressures pushing up input costs, and in turn undermining exporters’ profits. In short, the attempt to create economic prosperity out of thin air (currency) stands devastated by price rise.

The adjustment of domestic prices and wage rates require time to realign, and as such it would be evident that devaluation offers exporters only a short run advantage.


Not quite the Amazing Race


Strangely so, it appears that in a sluggish economy, a weaker currency seems to be the favourite resolution. Is competitive devaluation really a means to encourage economic growth?

 

Speculation that the US Federal Reserve would unleash the second round of Quantitative Easing has led to a fresh round of currency wars across the globe. Central bankers in Brazil, China, Chile, Japan, Russia, South Korea, and Thailand, have all stepped up their interventions, by injecting large sums of paper into the currency markets, while trying to prevent a steep decline in the value of the US Dollar versus their own currencies.

China is devaluing its currency by pegging it to the weak Dollar and countries like Vietnam are openly devaluing their currency in order to maintain a competitive edge, while Japan, Brazil, Korea, Russia, Thailand are intervening to protect exports.


Where’s the finishing line?


Competitive devaluation is the surest way of ruining the economy and calling for a global crisis. Experts actually call this devaluation a “beggar-thy-neighbour” policy.

 

In some ways, it is reminiscent of the 1930’s, when France, Japan, Spain, the UK, and the US engaged in successive devaluations while exiting the Gold Standard. And what happened then? – Increased exchange rates uncertainties, aggravated political tensions.

Did it contribute to relative competitiveness? Hardly!

Going by protectionist pledges made and Quantitative Easing policies adopted by many developed nations, competitive devaluation is a trend that unfortunately might just pick up steam.


It sure looks to be a race to the bottom of the pit, which can likely aggravate into a full blown currency crisis.

So where does gold stand in this race – a contender, a part of the cheering crowd, or just a benchwarmer?

In the race against current chaotic financial trends, and inflationary times, you may do well to keep cheering for gold. No, this is not an investment; it’s an insurance for your savings just in case a crisis materializes.



Disclaimer:


The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.

Above article is authored by Quantum.

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