Recently, RBI Governor Urjit Patel warned that the global trade war could escalate into a currency war. Trade wars erupt when countries impose tit-for-tat tariffs on imported goods, ostensibly to protect domestic manufacturers.
What is a currency war?
Currency wars are triggered when nations either allow their currencies to weaken appreciably or devalue them to gain a competitive advantage over trade rivals.
If other countries react by devaluing their respective currencies to retain competitiveness, this could lead to instability in markets.
What is devaluation?
Devaluation is a policy tool to reduce the value of a currency, relative to other currencies, in a fixed exchange rate. It is used to set the relative prices of domestic and international goods and services at a new footing. Devaluation is different from depreciation, which is a decrease in the currency’s value due to market forces of demand and supply when the exchange rate of the currency is floating.
Does devaluation help?
Governments may resort to devaluation for any one of three major reasons:
To boost exports. The lowered value of the domestic currency will make it less expensive for foreign buyers (holding the currency whose value has become relatively stronger) to obtain the local currency to buy locally produced goods or services.
In principle, more goods and services would be sold abroad, helping domestic businesses reliant on export markets such as software services companies, pharma firms and seafood exporters.
To shrink a trade deficit — a devaluation while making exports more competitive also makes imports more expensive and hence less affordable. This helps reduce the volume of non-essential imports thus helping to narrow the trade gap. To reduce the debt servicing burden — nations with significant sovereign debt sold domestically may find it advantageous to let the currency weaken as it helps lower the notional cost of debt servicing.
Was the rupee ever devalued?
In June 1966, hit by drought after two major wars (with China and Pakistan), India devalued the rupee by 36.5%. Again, in July 1991, a Balance of Payments crisis exacerbated by the sharp spike in oil prices in the wake of the Gulf War spurred India to devalue the rupee in “a two-step downward adjustment of 18-19%.”