The new buzz word in the world of international finance is currency wars. The rhetoric about cooperation to boost global economic growth has been replaced by a combative tone. Countries blame one another for distorting global demand by printing money, intervening in the currency markets or restricting capital flows. Central banks in India, Japan, South Korea and Taiwan have intervened in the currency markets in an effort to make their currencies cheaper. Brazil recently doubled a tax on foreign purchases of its domestic debt. Thailand has announced a new 15 per cent withholding tax for foreign investors in its bonds.

The obverse side of globalisation is coming to haunt policy makers over the world. In a world of interlinked economies and financial markets, it is impossible for any country to follow a truly independent economic policy. Macroeconomic strategies of one economy impinge on another through the exchange rate between their currencies. With the spectre of a double-dip recession still haunting large parts of the global economy, monetary authorities around the world are resorting to competitive devaluation of the currency or other measures which also weaken the currency. The objective is to keep economic growth going by making their exports more competitive at the cost of other economies.

The war is being fought on three fronts.

At the centre of the heated debate on manipulation of exchange rates is China. For several years now, China has essentially pegged its currency to the dollar while most other currencies fluctuate more or less freely. China has a strict control over its capital account; most other currencies do not distinguish between current and capital accounts. This makes the Chinese currency chronically undervalued, imparts a sharp competitive edge to its exports, and assures China of a persistent large trade surplus. China has used this trade surplus to build up massive foreign exchange reserves of $2800 billion, which gives it a strong leverage over other countries, including US.

Domestically, this arrangement allows the Chinese government to skim off a significant slice from the value of Chinese exports without interfering with the incentives that make people work so hard and make their labour so productive. It has the same effect as taxation, but it works much better.

Another front is the extremely loose monetary policy followed by the US, and Japan. Indeed, the crux of the problem is the stubborn refusal of the US economy to look up significantly, despite all the mega-doses of stimulus medication. With unemployment in double-digits, the recovery sluggish, and the public mood darkening, the US has responded with two sets of measures.

The US follows a policy of passive devaluation of the dollar to export its way out of a recession. It does this by keeping its interest rates near zero and flooding the global markets with cheap dollars. The broad thinking is that loose money will encourage consumption, facilitate and encourage investment, check unemployment and lift the economy by the scruff of its neck. The US central bank, the Federal Reserve, seems reconciled to another round of quantitative easing (read printing more greenbacks) and that could lead to a further fall for the dollar.

At the same time, the US is trying to bring diplomatic pressure on China to ‘adjust’ its currency in a way that suits America. Its demand is being echoed by the usual gaggle of American groupies in the EU. Even the IMF, which usually forces countries to devalue their currencies, is asking China to revalue. Everyone is saying that unless China exports less, saves less and imports more, the world economy will take longer to revive.

The Chinese, however, are in no mood to oblige. China stands firm on its policy of the last few months, of a more flexible exchange rate for the yuan, which, in practice, means a deliberately gradual appreciation of the currency to give time to domestic industry to adjust. Yuan was 6.79 to a dollar three months ago; it is now 6.65. China says that it also has to protect its national interests and that if it was forced to revalue, the consequences could be as bad for the world as if it did not, because it could create socio-political problems in China. With China refusing to be hurried, the US Congress has passed a legislation authorising the President to impose a duty of 20 per cent on Chinese imports.

The third front of the currency war is the emerging markets economies, which are at the receiving end of this tug of war between the two giants. The cheap dollars created by Federal Reserve (instead of stimulating production, jobs and incomes at home) find their way into emerging markets like China and India whose asset markets offer better returns. This has led to a sharp appreciation of the Indian rupee and many other Asian currencies (China manages its currency much better), erosion of their export competitiveness and unconscionable rise in prices of assets such as stocks and real estate. Commodities like gold and oil, whose prices are denominated in dollar, have shot up world wide. The dollar has become the principal “carry currency” that investors borrow in (at virtually zero cost) and fund investments in higher-yielding assets of the emerging markets. Europe and Japan are caught in the middle: their economies are sluggish but currencies are witnessing a rapid rise against the dollar.

America and its friends are barking up the wrong tree in blaming China for their economic plight. The global debt crisis was not created by China but by their own banks, which got greedy in an atmosphere of loose regulation and supervision, and pushed the entire financial system to the verge of collapse.

More to the point, even if China complied and revalued its currency (which it would not), it is not going to create many more manufacturing jobs in the US. If anything, imports from China may be replaced by those from other countries and American consumers may end up paying more at least in the short run. The problem is not oversupply by China, but over-consumption by Americans.

Indeed, there is little that US can do to address the yuan undervaluation issue beyond a point. American businesses exporting out of China also enjoy the benefit of an undervalued yuan. Besides, given America’s plight today, any drastic revaluation of the yuan will further reduce real incomes of the middle class in the US. An undervalued yuan has, over the years, helped the American middle class enjoy cheap clothing and other accessories of daily use. This gives the Chinese a special hold over American day-to-day consumption needs. Finally, American businesses have virtually vacated the manufacturing space globally in favour of China. If anything, American CEOs now talk about relocating large parts of their business in this part of the world.

The Chinese know all this only too well and are not unduly worried about America’s saber-rattling over yuan. The G-20 also knows this. Yet, it is now fairly certain that at the Seoul Summit due on November 11 and 12, the focus will be on China’s exchange rate policy. America will try to garner support from countries like India, Brazil, South Korea, etc, to keep the pressure on China at the G-20 on the currency issue.

Beyond G-20 meet, the emerging economies will rightly fight the loss of exchange competitiveness by attempting to curb inflows. Like Brazil and Thailand, other emerging markets, including perhaps India, are also likely to use capital controls. Protectionist voices in the US and EU may become louder.

In the long run, however, global (trade) imbalances can be fundamentally resolved only by reinvigorating the dynamism of the American economy. On their part, economies that drive global growth, particularly those in emerging Asia, will have to be ready for sustained inflows of capital and a secular tendency for their currencies to appreciate against the dollar, the euro and the pound sterling. The competitiveness of their exports will then depend on their ability to enhance domestic productivity. Capital controls can only provide temporary breathing space.

The author is Executive Editor, Corporate India, and lives in Mumbai