Currency Economics

In 1944, the famous Bretton Woods Conference took place in US wherein a pegged & fixed exchange rate was decided for the USD, and the task for its monitoring was entrusted to a new body called IMF. By ‘fixed’ exchange rate we mean that the exchange rate of USD & any other currency (say INR) was fixed by agreement between US & India. So that a country like India could trust this fixed rate and also trust using the USD for global trade, US pegged 1 USD = 35 ounce gold. This means for every dollar printed, 35 ounces of gold were present in the US treasury to back it up.Thus it was also a ‘pegged’ exchange rate. This arrangement continued only so long as there was no economic shock (either strong inflation or deflation), ie. till 1973. In 1973, the oil crisis in the Middle East resulted in an embargo which shrunk the supply of oil to US. Thus (demand/supply) ratio increased due to decrease in supply. This created a demand-pull inflation in oil prices in the US. This was extra-economics stuff and only a political peace in the Middle East could remove this inflation. But this article doesn’t end here. What’s interesting is the aggravation of this inflation caused due to the ‘fixed’ exchange rate. Consider the following situation : Some Indian investors had bought USD/USD-denominated debt instruments by selling their Rupees at the ‘fixed’ exchange rate (say 1 USD = 20 INR). When this 1973 oil crisis happened,there was inflation in US and the same amt. of USD could now buy lesser oil, ie. the ‘worth’ of USD reduced. Sensing this reduction in worth, Indian Investors wished to return back/sell their USD. So they sold say x USD into US and got back 20x INR. When this selling exercise started, US economy started getting filled with USD which further aggravated inflation. Under ‘fixed’ exchange rate, all USD would return back to US creating hyperinflation due to abundance of USD. The only solution was to let go of the fixed rate and adopt a ‘floating’ exchange rate where USD would be ‘devalued’ since its ‘worth’ had reduced. So by market forces, let the devalued USD be 1 USD = 10 INR. Now Indian investors would get only 10x INR on disinvesting $ instead of the 20x earlier. So they’ll disinvest less USD. This saved some outside-of-US dollars (called eurodollars) from being dumped into US and aggravating inflation. Well this is what happened & US adopted the ‘floating’ regime in 1973. But the story isn’t over yet. Remember the demand-pull inflation discussed earlier. That would go only with political peace and therefore still plagued US. Infact USD devalued to the extent that it now took several \(to buy 35 ounce gold. The inflation was boosted because US Fed now printed new notes to fund army operations. Printing new notes increases purchasing power in the short-term but leads to inflation in the long-term when the supply-demand curve adjusts. So inflation further increased. Infact its reported that gold merchants bought several\) by selling 35 ounce gold (because the Fed needed gold badly for printing new notes) and then re-bought the gold back for $1 because of the ‘pegged’ rate. This way the US treasury gold could have fully depleted away. Thus US govt. intervened & ‘un-pegged’ the USD. Floating + Unpegged Currency -> called Fiat currency.

Export-led vs. Investment-led growth

I’ll begin this section by quoting Paul Krugman :

“The balance of trade is part of the balance of payments, and the overall balance of payments of any country—the difference between its total sales to foreigners and its purchases from foreigners—must always be zero. Of course, a country can run a trade deficit or surplus. That is, it can buy more goods from foreigners than it sells or vice versa. But that imbalance must always be matched by a corresponding imbalance in the capital account. A country that runs a trade deficit must be selling foreigners more assets than it buys; a country that runs a surplus must be a net investor abroad. When the United States buys Japanese automobiles, it must be selling something in return; it might be Boeing jets, but it could also be Rockefeller Center or, for that matter, Treasury bills. That is not just an opinion that economists hold; it is an unavoidable accounting truism. So what happens when a country attracts a lot of foreign investment? With the inflow of capital, foreigners are acquiring more assets in that country than the country’s residents are acquiring abroad. But that means, as a matter of sheer accounting, that the country’s imports must, at the same time, exceed its exports. A country that attracts large capital inflows will necessarily run a trade deficit.”

When a country attracts a lot of foreign investment, I call it investment-led growth (ILG). When a country exports a lot, I call it Export-led growth (ELG). ILG includes only foreign-investment (in forex or $) and not domestic investment. As Krugman explained both ILG & ELG can’t happen simultaneously for a country since BoP = 0 .

When does ILG happen ?

ILG happens in a country which is a prospective economy where global players wish to invest. Emerging economies like India are examples. These countries lack mature manufacturing facilities & hence need FDI/FPI to boost the same. FDI-led development leads to job creation and improvement in infrastructure & living standards.Consider India. When huge FDI/FPI happens, a lot of $ (or forex) flows into India thus tending to appreciate the INR. An appreciated INR is unfavourable for exports & so a trade-deficit is inevitable. Imports however become cheap making for easy buying of equipment for new factories built under FDI. Moreover to favour more FPI, India would keep its interest rates high which would further lead to a tight money ecosystem : strengthening the rupee & leading to high savings among Indians, but at the same time, preventing domestic players from borrowing to invest & substitute foreign players. The 2nd point doesn’t seem a good point for long-term self-reliance of India. Moreover when India is selling its assets to foreigners, isn’t it compromising a portion of India’s sovereignty to foreigners? In 2020, after the India-China skirmish at the LAC, Indians realized the extent of the Chinese investment in India & how difficult it was to get rid of the same. The subsequent Aatmanirbhar programme of GoI in the backdrop of the Covid crisis was India’s move towards greater self-reliance. Thus whereas ILG is a sort-of necessary evil for a developing economy like India, domestic investment esp. in MSME sector needs to be simultaneously encouraged to keep the foreign dependance under check. After a developing economy achieves a decent maturity in manufacturing facilities, it can decrease dependence on ILG and move towards ELG, which is a safer route to growing GDP, although it also has its own risks.

ELG :

ELG is seen in a country which has developed a strong manufacturing ecosystem & is exporting the products it makes. Its exported products must either be of high quality(eg.German automobiles) or low price (eg.Chinese electronics goods) or both in order to muster export-competitiveness(EC).Consider China. For cheap exports, the Yuan-USD exchange rate should be high, ie. Yuan should be a weak currency. A weak currency can be maintained only when there is abundant Yuan in China, ie. interest rates are low (loose money ecosystem), which will shun foreign investment & promote domestic investment. Lesser foreign investment means lesser forex which further ensures Yuan stays weak. But a weak Yuan means costly imports, ie. inflation. Low interest rates also mean the Chinese people won’t keep much savings in banks. Although ELG ensures that one isn’t dependant on selling one’s assets to foreigners, still one is dependant on foreign countries to import one’s export products. If India boycotts Chinese imports, Chinese exports will necessarily shrink which will hit their ELG hard. If India boycotts Chinese investments, China will tend towards a net receiver of foreign investments than a net outward investor itself. If its net FDI/FPI inflow does become positive, then their net exports will become negative (∵ BoP=0) which will crush their ELG model. So ELG also has its own risks. To expand its export regime, China launched the BRI initiative & AIIB credits so that it can enlarge its exports & investments in the future & reduce dependance on unpredictable importers like India. Moreover ELG is not an unending well, because exports lead to increase in the forex reserve which strengthens the currency which tends to reduce exports. So its a negative feedback which will ultimately lead to saturation of exports- ofcourse unless the country artificially devalues its currency, which is what China seems to be doing.

My Self-Reliant Growth (SRG) model

So ILG & ELG both have their downsides. In both, a country is dependant on the rest of the world for their growth. But that can be avoided to a large extent. The below figure depicts a 2-country model of imports & exports.

Suppose both ‘A’ & ‘B’ are parts of a single large country called ‘C’. Then theoretically ‘C’ will neither need to export abroad (of course it can export if it wants but it’ll not be dependant on exports for its growth as in ELG) nor need to import anything from abroad (G&S or investments). This stage can be achieved when an ELG economy matures so much so as to generate sufficient domestic demand for the G&S it produces. Such a country should also be ideally large with a large population. India fits the latter criterion & has the potential to fulfill the former one. But India is not even an ELG yet.A lot needs to be done at the policy level in India. The country ‘C’ discussed in the SRG will actually not be detached from all imports, as there is always a set of natural resources that every country lacks but requires. For a large & diverse country like India, this set is minimal but ≠ 0. But with development of alternatives, imports can be reduced (eg. substituting uranium import in India by domestic thorium). For man-made G&S, near-zero imports are reachable. Note that my SRG model will not be feasible for a small country like Singapore. Because of its size, ILG is timelessly the best strategy for its growth.

What happens when a country neither exports much nor attracts foreign investments ?

In such a situation, less exports would lead to high trade deficit. If there isn’t FDI/FPI to balance the deficit, how’ll BoP=0 ? Well actually trade deficit/surplus is a part of a larger concept called ‘Current Account’ of a country. But its the main part of current A/C. However FDI/FPI is a part of a larger concept called ‘Capital Account’ which has another important part called ‘External Borrowings’. Thus Trade Deficit should instead be balanced against the Capital A/C & not FDI/FPI only, as depicted in Fig 1 below.

Thus within Capital A/C, if foreign investments fall, then External Borrowings must rise in order to balance the trade deficit. External borrowings(or debts) may be borrowed by private players or by the govt. of the country. When borrowed by the govt., its called ‘Soverign debt’.
Thus Total External Debt = Pvt. ext. debt(ECB) + Govt. ext. debt
(Also note that Govt. ext. debt + Govt. internal debt = Sovereign debt
Also, ` Σ(fiscal deficit of that country from -∞ BCE till date) = Sovereign debt. ` I’ll discuss more on this later when I’ll talk about fiscal deficit.) But its clear for now that if a country is neither exporting nor attracting foreign investments that good, then it must resort to external borrowings in that FY. However this model isn’t sustainable for long due to two reasons :
i) Soon the country may become bankrupt repaying the loans (eg. Sovereign debt crisis of Greece), AND
ii) Lack of both exports & foreign investments for a long time will lead to drying up of the forex reserves of that country to pay for import bills (eg. India(1990)), thus leading to severe depreciation of currency (ie. currency crisis) leading to hyperinflation (eg. Zimbabwe).

What is an economic crisis for an emerging economy ?

An economic crisis for any economy is a depression. But it has 2 predecessors, recession & inflation. When inflation starts rising & goes beyond control, it dries up the purchasing power of most people. This drying up leads to recession in which many businesses shut down, layoff employees & cause widespread unemployment & a further drop in purchasing power (demand). This vicious cycle leads to a total collapse of the economy called depression wherein both demand & supply reach their minima. So its evident that inflation started it all. In an emerging economy (ILG by assumption), widespread inflation can only occur due to 3 main reasons :
(i) Increase in the price of items it imports due to extraneous reasons (eg.War, sanction, oil embargoes, etc.)
(ii) Drop in supply from some key domestic industries due to accident, weather, etc.
(ii) Flight of foreign investments out from that ILG country

Flight of foreign investments happens when foreign investors cease seeing the ILG country in question as very prospective for safe+high returns. This can happen due to many reasons. Consider India. During the Taper Tantrums of US Fed in 2013 & 2018 when it hiked up its interest rate, investors took their capital from India & invested in US. This caused a dip in India’s forex reserves which led to depreciation of the rupee. This depreciation inevitably leads to inflation. (nb. Some argue that this depreciation leads to more exports so the forex reserves should re-increase. But they should remember India is an ILG & not an ELG.)
What’s interesting is the steps GoI will take to fight this inflation. Alternatively, if the following steps are taken by GoI, it means they’re fighting a crisis (sort of like our immune system response). Here are the steps :
(i) Increasing the interest rates (to attract more foreign investment + to contain inflation) (ii) Both govt. & pvt. players will start buying cheap foreign loans to fund themselves. This leads to ↑Total Ext. Debt (ii) Increasing the (benchmark)10Y-bond yield (so that GoI can attract more bond-buyers to help it raise money) : this will cause dip in the bond prices