Currency War-Causes and Impacts

Currency war is all about nations deliberately devaluing their currency. Currency devaluation is different from currency depreciation. The term currency war came in to public attention in India, when Reserve Bank of India (RBI) Governor Mr. Urjit Patel indicated that the ongoing Global Trade War could lead to a currency war. 

Currency war 

Currency war begins when a nation devalue the national currency or deliberately allow to weaken the currency. The purpose of devaluation is to gain competitive advantage over other trade rivals.  If other countries too react to this action by devaluing their respective national currencies, chain of these actions leads to currency war and instability in markets. 

Difference between currency devaluation and currency depreciation. 

In modern era, the exchange rate of the currency of majority of developed countries follows floating rate system. In this, the value of a currency changes according to the market forces of supply and demand. Depreciation is decrease in the currency value based on these forces without any intervention by government or central bank of the respective country. 

Devaluation on other hand is a deliberate attempt by the country of the currency to reduce the value in relation to the currencies of other nations. This is a policy tool mainly used in a fixed exchange rate regime. The purpose of devaluation is to set the relative prices of domestic and international goods and services in favour of the country.   

What are the purposes of devaluation of currency? 

Government of a country, devalues its currency to achieve any of the following three major targets.

a.    To promote exports:  Lower value of domestic currency will make goods and services exported by the country cheaper for the foreign buyer. A foreign buyer gets more purchasing power for his currency. This happens because strong foreign currency gets more devalued currency. This enables the exporter of software, pharma, textile, seafood or other exporters to sell more goods and services abroad.    

b.    To discourage imports: The devalued currency makes imports costly as more currency needs to be given for settling import. This discourages import of non-essential items there by helping to reduce outflow of foreign currency from the country and reduce trade gap. This also encourages purchase of domestic substitutes indirectly. 

c.    To reduce the debt servicing burden: Nations having substantial borrowing in domestic currency find devaluation advantageous as the weakened currency helps reduce the notional cost of debt servicing. 

History of Indian rupee devaluation:

Indian rupee was devalued twice in the recent history. In 1966, India was hit by a major draught. This was after two major wars with China and Pakistan.  In June 1966, India devalued the rupee by 36.5%. Again India faced a balance of payment crisis in 1991 because of the sharp jump in oil prices due to Gulf war. Historically, two major imports of India are oil and gold. To face the crisis, India devalued the rupee in July 1991 by 18-19% in a two-step downward adjustment.