Economic Highlights

New Delhi, 9 September 2011

Deepening Crisis

FIXED CURRENCY RATES CRUCIAL

By Shivaji Sarkar

The world is going through a severe crisis and India is not out of the woods, says United Nations Conference for Trade and Development (Unctad). The UN agency finds a fundamental flaw with the floating rate exchange system of currencies. 

In its Trade and Developemt Report 2011 (TDR), the Unctad states the new financial turmoil should be a wake-up call for the international community and its institutions. Further, it warns that developing and emerging (extreme poor) economies have been affected and might be hit more by the crisis that is seen in the developed countries – Europe and the US.

Importantly, Unctad has disagreed with Barack Obama administration-type shift from fiscal stimulus towards fiscal tightening. It is self-defeating, states the report, especially in the most developed economies which were severely hit by the financial crisis. In such a situation, a restrictive fiscal policy may reduce GDP growth and fiscal revenues, and is therefore counterproductive in terms of fiscal consolidation.

Economic recovery may come to an end in developed economies because private domestic demand remains weak and supportive macroeconomic policies are being replaced by austerity measures as governments try to regain the confidence of the financial markets. By contrast, developing economies have sustained their growth path mainly based on domestic demand. However, they face financial instability and speculative capital flows generated in developed economies and would not be spared by a new recession in the North.

The latest warning by rating agency Fitch warning a possible downgrade of Chinese and Japanese economy supports the Unctad contention. The Fitch says that the US and European crises have hit the two large Asian economies and might slow down the growth of China and may lead Japan to a recession.

What should concern India is the warning that uncertainty in commodity markets is increasing. It is coupled with low investment in production, infrastructure and research into ways of improving growth in commodity supply over the past few decades. Another concern is high unemployment and erosion in private investment.

As the initial impulses from the inventory cycle and fiscal stimulus programmes have gradually disappeared since mid-2010, the fundamental weakness of the recovery in developed economies comes to the fore, TDR states. 

Private demand alone is not sufficiently strong to maintain the momentum of recovery, as unemployment remains high and wages are stagnating. Moreover, household indebtedness continues to be high and banks are reluctant to provide new financing. Here, the shift towards fiscal and monetary policy tightening represents a major risk of a prolonged period of mediocre growth in developed economies – if not of an outright contraction.

In the US, recovery has been stalling, as domestic demand has subdued due to stagnating wages and employment. The report says a quick return to a satisfactory growth trajectory is highly unlikely.

In Japan too, recovery has been delayed by the impact of unprecedented supply-chain and energy disruptions due to the massive earthquake and the Tsunami in March. Likewise in the EU, wage earners’ incomes remain very low, as does domestic demand. With the unresolved Euro crisis, the reappearance of severe debt market stress in the second quarter of 2011 and the prospect of fiscal austerity measures spreading across Europe, there is a high risk that the Eurozone will continue to act as a significant drag on global growth. In fact, recent plunges in stock markets largely reflect worsening growth perspectives.

The TDR examines currency, commodity and financial markets and shows that speculation and herding destabilizes prices moving them far beyond sustainable levels and has created most of the systemic risks that have led to their collapse in financial crises.

A major reason for speculation not only in currency but also in major commodities is based on the currency fluctuation. The report says currency exchange rates have become excessively volatile and actually disrupt the functioning of the real economy.

Secretary General of Unctad S Panitchpatdi says that fundamental greater stability of real exchange rate could be achieved by a system of rules-based managed system – the return to a kind of fixed rate for a given period. In other words, it has attributed the present crisis to the speculators and impliedly it believes that individual or groups have raked in huge profits though many national economies were devastated.

The TDR presents the rationale for, and outlines the functioning of, an exchange-rate system of rules-based managed floating against the background of recent experiences with global current-account imbalances that contributed to the build-up of the financial crisis and the post-crisis surge of carry-trade financial flows to emerging economies.

As pointed out by Panitchpakdi in his overview to the TDR, “Even after the breakdown of the Bretton Woods system and the adoption of widespread exchange rate floating in 1973, international economic policy making has often assumed that it is mainly real shocks, rather than monetary shocks, that need to be tackled by the international system. However, after several decades of experience it has become clear that monetary shocks, particularly in a system of flexible exchange rates, are much more significant and harmful.”

To avert such monetary shocks, the TDR discusses two approaches for the design of a ruled-based managed floating currency regime. Such a system could be built on the adjustment of nominal exchange rates to inflation differentials or to interest rates differentials. The first principle addresses more directly the need to avoid imbalances in trade flows, while the second is more directly related to limiting financial speculation of the kind of carry trade which typically leads to currency misalignment. However, both approaches tend to lead to similar outcomes.

Such a system would be able to achieve sufficient stability of the real exchange rate to enhance international trade and facilitate decision-making on fixed investment in the tradable sector; and it would be sufficiently flexible to accommodate differences in the development of interest rates across countries.

Rules-based managed floating can be practiced as a unilateral exchange rate strategy, or, with much larger scope for symmetric intervention in foreign-exchange markets, through bilateral or regional agreements. However, the greatest benefit for international financial stability would result if the rules for managed floating were applied at the multilateral level as part of global financial governance. But this is a long-term solution. According to Unctad, growth has to come away from the West – from Asia that means India and China. A big hope, indeed!