:: Jayati Ghosh

Slide of exchange rates

Jayati Ghosh

June.2 : To say that the world economy has been through a bumpy ride in the past two years would be a major understatement. The economic travails are particularly extreme in certain regions, such as eastern and central Europe, which were until recently the "beneficiaries" of large amounts of hot money inflows that created domestic bubbles not unlike the larger and more dramatic one in the US.

But even developing Asia, the region of the world that has been generally recognised to be the most "prudent" in terms of macroeconomic policies, which had been running current account surpluses for the most part, and whose growth (for many countries at least) has been based more on exports than on speculative bubbles, has not remained immune to the downturn in other countries.

Within Asia, the newly industrialising countries (NICs) and the Asean-5 (Indonesia, Malaysia, the Philippines, Singapore and Thailand) appear to be the worst affected, but even China and India, where growth is still positive, show significant parallelism in growth patterns. Why has the movement in Asia been quite so sharp?

At one level, the answer appear obvious: cross-border trade and capital flows have caused the downswing to spread rapidly. World exports have been falling for the past half year and are estimated to decline by anywhere between 11 per cent (IMF) and 15 per cent (WTO) in 2009. And capital flows have shown sharp reversals as finance capital flows back to the US and Europe.

The downswing in global trade is well known by now, but one particular aspect of it deserves more discussion. Global trade values decelerated from the middle of 2008 and started falling from late 2008. But what is interesting is that this has reflected declines in both unit values and volumes. In other words, competitive pressures have forced exporting countries to bring down prices in an effort to retain or expand market share, but this has not led to any recovery in export volumes in the aggregate. As a result, trade values are falling even faster then would be determined by the volume index alone.

One mechanism through which this decline in export unit values has occurred is exchange rate devaluation. This is not the competitive devaluation that was associated with earlier global depressions. Nor is it even always justified by the extent of trade or current account deficits of the countries concerned. Rather, in most cases, it is an involuntary process reflecting the movements of highly mobile capital.

Nominal exchange rates in developing Asia have depreciated quite significantly compared to the peak of July-August 2007 — an average decline of 12 per cent in less than a year. Real exchange rates have shown less movement, appreciating by five per cent until the peak followed by almost equivalent depreciation. In a global context of low and falling tariffs and very low margins in exports, even relatively small changes can make a lot of difference to export markets.

However, this aggregate picture does not capture the story in much of Asia, simply because it is dominated by China. And the Chinese currency is one of the few in the region that has actually appreciated — and quite sharply — over this period, by as much as 18 per cent in real terms between January 2007 and January 2009. This means that the actual depreciation in most of the rest of Asia must be much greater. This is confirmed by the experience of the Indian rupee, which has had a nominal depreciation against the US dollar of more than 30 per cent over the same period.

This is similar to the experience of other developing regions as well: in Latin America, both nominal and real exchange rates have depreciated by nearly 20 per cent between June 2008 and March 2009, while in Africa the depreciation has been of the order of 10 per cent. Only in West Asia — dominated by oil exporting countries — have exchange rates appreciated.

But what exactly has been happening to the dollar? It could be expected that since the US economy is where the current global problems started, and since the crisis in the US is yet to fully unfold, and still shows no immediate signs of resolution, the dollar would actually depreciate over the course of this crisis. Indeed, that is what must happen if the global macro imbalances, that are also very much part of the crisis, are eventually to be resolved. Surely, if fundamentals are at all a guide to market behaviour, then the big mess in US economic fundamentals would also reflect in capital movements and thereby in exchange rates?

Remarkably, that seems not to be the case. Instead, the trajectory of the US dollar shows a definite V-shape, much like the hoped-for V-shaped recovery that optimists are predicting for the US. The currency plummeted — in both nominal and real terms — between January 2007 and June-July 2008. But since then it has risen equally sharply, and even more rapidly, so that in just six months it has regained it earlier value and even exceeded it.

The euro — the currency of currently depressed Europe — appreciated while the dollar fell, and subsequently has depreciated even as the value of the dollar has gone up.

So what exactly is happening? What is clear is that movements of exchange rates — which are no longer affected by policy other than in a few exceptional countries — cannot be explained by either trade patterns or "fundamentals" such as the inherent strength or future prospects of an economy. They are much more likely to be affected by what could broadly be called "political economy" factors, and perceptions of current and future power, that determine the capital flows that actually decide their values.

But what that means is that the developing countries at the receiving end of this process, including those in developing Asia, face a double whammy because of depreciating exchange rates even as their export volumes collapse.