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Science & Technology
- GS 3 || Economy || External Sector || International Monetary Fund
Why in news?
In today’s world around 80% world trade take place in dollars. About 39% of the world’s loans are given in US dollars and 65% dollar supply is used outside of the United States.
What is currency war?
- A currency war is a tit-for-tat escalation of currency devaluation aimed at boosting one’s global economic standing at the expense of another.
- Currency devaluation entails taking steps to reduce the purchasing power of a country’s own currency in a strategic manner.
- Countries may pursue such a strategy in order to acquire a competitive advantage in global commerce while also lowering their sovereign debt burdens.
- Devaluation, on the other hand, might have self-defeating unintended consequences.
Why is a currency depreciating?
- It may seem counterintuitive, but a strong currency is not always in the best interests of a country.
- A weak native currency makes a country’s exports more competitive in global markets while also raising the cost of imports.
- Higher export volumes stimulate economic growth, whereas high import costs have a similar impact since customers prefer to buy locally produced goods over imported goods.
- This increase in trade terms usually correlates to a smaller current account deficit (or a larger current account surplus), more jobs, and quicker GDP growth.
- Stimulatory monetary policies, which usually result in a weak currency, have a beneficial impact on the country’s capital and housing markets, which promotes domestic consumption via the wealth effect.
Historical perspective on the dollar’s strength:
- The value of gold was used to determine the exchange rate of most countries’ currencies prior to the 1944 Bretton Woods Agreement.
- The dollar gained widespread acceptance after the Bretton Woods Agreement was signed in 1944, and member countries agreed to determine their currency’s exchange rate in terms of the dollar.
- However, in the early 1970s, most countries began demanding gold from the United States in exchange for their currency, depleting the United States’ gold stockpiles.
- As a result, beginning in 1971, US President Richard Nixon shattered the dollar-gold exchange Many currencies’ exchange rates have been governed by demand and supply dynamics since then.
- However, prior to this new beginning, the dollar had established itself as the world’s accepted currency, and this practice has continued to this day.
Currency war’s negative consequences:
- Capital equipment and machinery: Long-term productivity may be harmed as a result of currency depreciation, when imports of capital equipment and machinery become prohibitively expensive for local enterprises.
- Currency devaluation: Productivity will suffer if currency devaluation is not backed by meaningful structural improvements.
- Higher inflation: The degree of currency depreciation may be more than planned, resulting in higher inflation and capital outflows in the long run.
- Obstructing global trade: A currency war might lead to further protectionism and the construction of trade barriers, obstructing global trade.
- Increased hedging costs: Competitive devaluation may increase currency volatility, resulting in increased hedging costs for businesses and possibly discouraging foreign investment.
The Dollar’s Strength in the United States:
- Impact of a stronger dollar on their profitability: The US economy has so far mostly escaped the repercussions of a stronger dollar, however one significant issue is the large number of American multinationals that have expressed concern about the impact of a stronger dollar on their profitability.
- “Strong dollar” policy with varied degrees of success:The United States has usually adopted a “strong dollar” policy with varied degrees of success throughout the years; nevertheless, because it is the world’s largest economy and the US dollar is the global reserve currency, the US situation is unique.
- Foreign direct investment (FDI): The US’s attractiveness as a destination for foreign direct investment (FDI) and foreign portfolio investment (FPI) is boosted by the strong dollar.
- Frequently a top destination in both categories: Unsurprisingly, the United States is frequently a top destination in both categories. Because of its massive consumer market, which is by far the largest in the world, the United States is likewise less reliant on exports for economic growth than most other countries.
The following are some of the factors that have made the dollar the strongest currency:
- The global adoption of various currencies:There are a total of 185 currencies in the world, according to the International Standards Organizations. The majority of these currencies, however, are only usable within their home country. The global adoption of various currencies is determined by the country’s economic situation. Because the United States has the world’s largest economy, its currency is widely accepted.
- Global trade is conducted in dollars: In today’s world, 80 percent of global trade is conducted in dollars. Around 39% of global loans are made in US dollars, with 65 percent of the dollar supply being used outside of the US. Most trading countries throughout the world only accept payment in dollars, which is shocking. That is why, in order to participate in international trade, foreign banks and governments require the dollar.
- The IMF currently has 189 members, and according to IMF rules, each member country must deposit a specific percentage of its quota in US dollars, so increasing the dollar’s international demand.
- US currency in foreign exchange:Central banks around the world own 64 percent of the US currency in foreign exchange reserves.
- Non-American countries trade:When two non-American countries trade, they prefer to pay in US dollars because they know that if they have dollars in their hands, they may import items from any country at any time.
- US dollar does not fluctuate: Because the value of the US dollar does not fluctuate frequently, every country in the world accepts it without hesitation.
- US dollar and receives repayment in the same currency:Because America is the world’s largest economy, it lends money to many poorer countries in the US dollar and receives repayment in the same currency, the demand for the dollar in the international market is constant throughout the year.
- World’s total exports: According to a report from the European Union, the United States exported roughly 14 percent of the world’s total exports in 2016, while importing around 18 percent of the world’s total imports.
- International Monetary Fund’s treasures:Because the United States provides the most to the World Bank Group’s and the International Monetary Fund’s treasures, the US oversees their operations. As a result, these two global institutions lend money to their members in US dollars, bolstering lenders’ confidence in the US dollar.
Dollar’s dominance is threatened by a number of factors:
- Second most powerful currency: The Euro is the second most powerful currency in the world, after the US dollar. The euro accounts for around 20% of global central bank foreign currency reserves. Because the European Union is one of the world’s most powerful economic blocs, the euro is also strong. Some experts believe that the Euro will be able to replace the dollar in the near future.
- China and Russia demanded a new international currency in March 2009. They intend to establish a global ‘Reserve Currency Fund.’
- China wants its currency, the yuan, to be treated equally to the dollar. It’s worth noting that the Chinese Renminbi was included to the IMF’s SDR basket in 2016.
- Based on the data above, it can be stated that the most important reason for the global acceptability of the US dollar is America’s role in global trade and the lack of acceptance of any other currency for international trade.
Measures like China’s Belt and Road Initiative and bilateral trade links with countries, particularly in the Southeast Asian region, complement the potential prospects afforded by a digital renminbi for strengthening China’s influence in global financial markets. Through trade and investment links, this region is inextricably linked to China, and Beijing will most likely utilize these to fuel demand for a digital renminbi. Some argue that a digital currency will allow China’s CBDC infrastructure to sidestep US sanctions while also allowing users to avoid the SWIFT system’s monitoring.
Mains oriented question:
Many people are wondering if the digitization of China’s currency, together with other economic changes there, will represent a threat to the US dollar’s monopoly as a reserve currency. Explain. (200 words)