A strong dollar need not necessarily be the making by the Fed policies. Countries when engage in currency wars through what is known as beggar thy neighbour policy, also ends up strengthening the dollar.
What is beggar thy neighbour policy?
Beggar thy neighbour policy refers to a policy that aims at addressing one's own domestic problems at the expense of others — trading partners in particular, largely through competitive devaluation of their currencies by the central bank.
How does this policy work?
Conventionally, countries often impose tariff barriers and restrict imports to protect their domestic industries. However, with globalisation, such practices are not popular. Central banks devalue or encourage the depreciation of their own currencies compared to its trading partners by intervening in the local currency markets to retain their respective competitive edge and price advantage in exports and end up in currency wars in the process. A weak local currency ends up strengthening the dollar which is the preferred currency of cross-border transaction. Sometimes economies compete in encouraging appreciation of their currencies to tame inflation at the expense of hurting income in the exporting countries.
How has this policy been playing out currently?
After China devalued its currency by nearly 0.5% to the dollar earlier in January this year, many emerging market currencies have started weakening against the US dollar. Indian rupee too has lost close 4% to the dollar since January. The immediate cause of a weak emerging market currency is pull out of foreign investors from these economies resulting in a pressure on local currencies. But the central banks in these countries have also allowed their currencies to depreciate by restricting their intervention.
What is the current policy thinking within RBI
The Reserve Bank of India has been warning against such a practice of competitive devaluation by central bank. Governor Raghuram Rajan underscored the need to avoid beggar-thy-neighbour policies, such as unconventional monetary policy or sustained exchange-rate intervention, that primarily induce capital outflows and competitive currency devaluations in a recent speech. According to Rajan, multilateral institutions like the International Monetary Fund should exercise their responsibility for maintaining the stability of the global system by analysing and passing careful judgment on each unconventional monetary policy (including sustained exchange-rate intervention).
What are the limitations of such a practice?
In the current situation of global economic slowdown and weak demand, a price advantage on goods and services need not necessarily prop up exports. In certain cases, such a policy may prove counter productive. If, for instance, even the competing country counters one policy move, of say, depreciation (to protect exports) then such a practice may not have desirable results, especially the country's imports are not price elastic (the imports are essential and not dependent on prices) and instead could end up hurting the trade balance through higher import price and resulting in inflation in such economies.
