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Why is the Dollar the World’s Reserve Currency?

By Anupam Manur and Varun Ramachandra

Strength, stability, universal acceptability, and a lack of a viable alternative to the dollar makes it the global reserve currency. 

Global trade and businesses function best when there is a currency that is widely accepted. This doesn’t imply a common currency, instead, it refers to the usage of a widely acceptable currency for international transactions. Such a currency reduces the transaction costs of converting one currency to another and enables easy invoicing of traded goods and services. This common currency is referred to as the reserve currency.

The brief history of reserve currencies:

Historically, a reserve currency implied a currency that was in wide circulation even outside the issuing state’s borders. Currently, the US dollar is the world’s reserve currency but this hasn’t been the case forever. The silver Drachma issued by the ancient Athens was probably the first reserve currency. The Roman Aureus and Denarious coins, the Byzantine Solidius coins, the Arabian Dinar, the Florence Fiorino, and the Dutch Gulden have at various points had the status of being the world’s reserve currency.

History of money


In 1717, Britain adopted the gold standard – a system where central banks had to back each paper currency note they printed with an equal or proportional amount of gold — and simultaneously built a vast empire. At the height of its power, more than 60% of world trade was invoiced in pounds and this led to the pound sterling becoming the world’s reserve currency. At around the end of the 19th century, America’s economic significance rose and this resulted in the US dollar toppling the pound as the most sought-after currency. Today, more than two-thirds of foreign exchange reserves held by central banks around the world are in US dollars (see figure).



Why do central banks maintain reserves?

Two important reasons for holding reserves are as follows:

First, safety. Reserves act as savings, and central banks can benefit from this in hours of need. When a country faces a balance of payments crisis or some other form of financial crisis, the central bank can use its reserves to alleviate the situation. Typically, central banks manage enough reserves to cover for three months’ worth of imports to maintain continuity of trade in times of crises. Reserves also act as positive assurance to debtors.

Second, reserves are maintained to manage a country’s exchange rate policy (the previous post explored this aspect). Whenever a country’s currency appreciates or depreciates, and moves away from the target exchange rate set, the central bank steps in and uses its reserves to maintain exchange rate stability. The Reserve Bank of India has done this on numerous occasions when the rupee has appreciated or depreciated.

Why is the US dollar the reserve currency?

Since the United States boasts of the world’s largest economy (around $18 trillion) and has a stable political environment, most international trade is invoiced in dollars and about 50-60% of US dollars circulate outside US borders. Since there has been no default or major devaluation of the dollar in the past few decades, the USD and the US government’s treasury bonds are thought of as the safest assets in the world; this inherent stability and risk-free nature of the dollar is attractive to investors and has therefore ensured that the US dollar is the world’s reserve currency.

According to economist Ewe-Ghee Lim, there are five factors that facilitate international currency’s status: a large economic size, the existence of a well-developed financial system, confidence in the currency’s value, political stability, and network externalities. Additional features for currencies that assume reserve status are large-scale current account and financial account convertibility, an independent central bank, a high degree of capital mobility, surveillance of economic policies, and cooperation of monetary policymaking at regional and multilateral levels. The dollar checks almost all of these boxes.

The rise of China since the 80s has made the Chinese Yuan an important world currency, but since the Yuan has been deliberately undervalued to aid exports, the real exchange rate of Yuan is unknown. Japan and Britain are waning economic powers, the emerging markets are too volatile, the Euro has many internal problems, and gold is too static a commodity to be held as the reserve currency. This leaves the dollar as the only viable option for the time being, and probably for some more time to come.

Anupam Manur is a Policy Analyst at Takshashila Institution  and tweets @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and tweets   @_quale

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The Murky Connections between Trade and Exchange Rate

A positive trade balance should result in appreciation of the currency. However, it is in the interest of countries that export large volumes of goods to have a weaker currency.

By Shobitha Cherian and Anupam Manur

The relationship between the strength of an economy and the strength of the currency was discussed in a previous post. The aim of this post is to discuss the conditions under which economies would want to have a weaker currency. Generally, it is in the interest of countries that export large volumes of goods to have a weaker currency.

The exchange rate of a particular currency is determined mainly by the demand and supply of the said currency. By this logic, countries which export large volumes of goods, or which have higher international demand for their goods, would have stronger currencies, or would have a higher value when compared to the reserve currency or the U.S Dollar. This is due to the fact that since their goods are high in demand, so will be their currency. However, in actual practice, one can see that it is favourable for certain countries to have weaker currencies.

Table showing the relationship between trade balance and exchange rates

Table showing the relationship between trade balance and exchange rates

Source: Calculations based on data from World trade organisation and the International monetary fund database.  Note: Since the countries belonging to the Euro zone use a common currency, they have been eliminated from this analysis.

The above set of countries shows the volume of exports as a percentage share of total world exports, the current account balance (difference between exports and imports) and their exchange rate with respect to the US$. The chosen countries are amongst the top 20 exporters.

From the above data set, it is apparent that countries with a significant share of the world export market have currencies that are weaker than the dollar, i.e., more of that currency is required to buy one dollar. The Korean Won and more so the Indonesia rupiah stand out; around 12800 rupiah is required to buy 1US$.

However, merely looking at export data and the exchange rate gives an incomplete picture. Since the exchange rate is determined by a country’s exports and imports, the relevant data to look at is the trade balance (second column). Further, the strength of a currency has to be looked at in terms of changes. The third column gives the percentage change in the value of the currency since 2010 (a positive number reflects appreciation and a negative number means that the currency has depreciated/weakened).

The table above shows the rather murky lines between economic principles and reality. As explained above, a positive trade balance should result in a currency appreciation and vice versa. Only five of ten countries (highlighted in green) follow this rule. Saudi Arabia and the UAE have fixed exchange rate regimes and thus, show no change in the five years despite having a positive trade balance. Japan, Russia and South Korea have very strong trade surpluses, yet their currencies have depreciated during this period. The Russian rouble has depreciated by over 175%.

Why is this so?

The regulatory authorities of a country may actively keep their currency weak in order to boost exports; if the currency is weaker, the goods produced domestically for export become cheaper for the rest of the world, and by the simple principle of demand and supply, the demand for its goods increases.

Monetary authorities achieve this using a variety of instruments at their disposal. It can impose foreign exchange controls – artificially restrict the movement of the currency. The central banks also participate in the foreign exchange markets to keep the currency at the desired level. For example, if the rupee begins to appreciate against the dollar, RBI steps in, sells rupees and buy dollars, which will devalue the rupee.

Devaluation is sometimes used deliberately as a policy action in times of contraction, where the country would want to get back to the growth path through exports. However, continued devaluation can be seen as a manipulative path of action which seeks to keep a currency artificially weak and will usually face outrage by the international community. This might also result in a competitive devaluation amongst competitors, which can have grave consequences for global financial stability.

Shobitha Cherian is an intern at Takshashila Institution and studies B.Sc economics at Christ University

Anupam Manur is a policy analyst at Takshashila Institution and tweets @anupammanur


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Using Price Discrimination to ensure Net Neutrality

The main reason that telecom companies are unable to ensure higher profits is essentially a pricing problem and the answer would lie in using price discrimination and charging higher for data.

Airtel claims that its revenues are falling due to free internet based services like Skype and Viber. It feels that it is missing out on its share of the pie as people can call each other for no charge using their data packages. To grab their ‘fair’ share, they want to charge the internet companies for allowing their service through their networks. This is a critical blow to net neutrality. However, if they are truly worried about their profits, they can instead resort to pricing their data services higher by using price discrimination.

The new plan proposed by the TRAI backed by Airtel and co. is trying to create a scenario where producers are given preferential treatment. The plan proposes that sellers can pay the internet service providers to ensure that their products get priority over other products. In essence, the data packets that come from their servers should be given precedence over the data packets coming from their competitors. It is this that has been driving the internet activists over the wall, as it breaks the quintessential property of the internet: that of being neutral. Lots of other writers have spoken about how the absence of net-neutrality will throttle small start ups. Others have addressed this issue in terms of the detrimental effects on our national interest. Most of them, though, take issue with the impingement on their personal liberty. If my service provider makes a deal with a company, agreeing to prioritize its data compared to its competitors, I am being robbed of my choice. The prioritization by the service provider is making a choice on my behalf.

The main reason that is given for pushing discriminatory internet services is that the revenues of the telcos are falling: they have previously invested a lot in buying spectrum, investing in infrastructure, etc, but are finding that their main voice and messaging services are being replaced by internet companies who offer the same services for free through the telcos’ infrastructure.

The numbers on the balance sheets of the telcos suggest that the revenues are far from falling. It has seen steady growth in the past few years and what’s more, there is ample scope for them to tap into the ever growing market of mobile internet users. Then, we can assume that they are normal companies wanting more profits through vertical collusion and cartelization. The reason they have not been able to profit as much as they want from the data services that they provide is essentially a pricing problem. If they felt that the internet services like Skype or Whatsapp were free riding on their data, they can easily increase the amount they charge for data. The reason that the telcos are not increasing their prices is perhaps because of the competition between themselves. Despite the market having few sellers, they face an elastic demand curve, where the slightest increase in prices will drive users to other competitors. This is basic market mechanics based on the Bertrand model of competition.


The telcos can practice a form of reverse second degree price discrimination. Price discrimination is a concept in economics which refers to the act of charging different prices for similar or same goods to different consumers. There are various types of price discrimination that is followed in the market – based on geographical location, based on income elasticity of demand, based on the quantity bought and so on. When the price charged is based on the quantity bought, it is known as second degree price discrimination. It basically refers to the discount one gets with bulk purchases. However, the telcos can practice reverse second-degree price discrimination, where they charge lower prices for lesser usage and a progressively higher price for large data consumption.

This will ensure that VoIP services, which uses a lot more data is charged higher, as against text only messaging services. This scheme is still neutral in the sense that differential rates are being applied based on quantity and not on type of service. However, the solution of a blanket ban on prioritizing certain services might reduce economic freedom of the consumer. If service based discrimination has to be made, the choice has to be with the consumer. If a person runs his business solely based on international VoIP calls and doesn’t mind paying extra for ensuring reliability and speed, he should be able to access that privilege. Or, for that matter, a Facebook or Twitter addict who wants these apps to be quick such that they can post real time selfies, should be able to choose these apps over say, apps which give real time updates on political happening in Nicaragua. Thus, people can be given a choice as to which data packets have to be prioritized within their limited bandwidth. This will ensure that there is a high degree of net-neutrality, while ensuring economic freedom to the individual consumer.

Anupam Manur is a Policy Analyst at Takshashila Institution and can be reached on Twitter @anupammanur


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Does a strong currency mean a strong economy?

by Anupam Manur & Varun Ramachandra

Exchange rates have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.

In their book The Dollar Crisis, Paul Simon and Ross Perot famously said that “A weak currency is the sign of a weak economy, and a weak economy leads to a weak nation”. The quote was mentioned in the larger context of American military and economic might, but the feelings espoused in the quote are shared by many. For instance, this article in the Economist describes the feeling of despair amongst the citizens of Hong Kong when the value of their currency (Hong Kong dollar) slipped below that of Mainland China (Yuan). Politicians, central bankers, economists, and policy makers often share the ‘blame’ for a weak currency. But is a ‘weak’ currency truly an indicator of a ‘weak’ economy? Consequently does a ‘strong’ currency necessarily imply a ‘strong’ economy? This post aims to answer these questions.

The strength of a currency, in economic terms, implies the price (or the exchange rate) of one currency in terms of another foreign currency; this is usually measured with respect to the US Dollar, which is considered as the world’s reserve currency. (We will discuss why the US dollar is the world’s reserve currency in our next post). An exchange rate higher than one implies that the currency is stronger than the dollar and an exchange rate lesser than one implies that it is weaker.

The strength of an economy is measured by various means and the most used measure is the value of its Gross Domestic Product (or GDP).  The GDP measures the level of economic activity within a country and is the final monetary value of all the finished goods and services produced. It is a comprehensive measure of economic strength of a country[1]. The table below illustrates the metrics discussed thus far.


Source: GDP, GDP per capita and the ranks from IMF database. Exchange rate is obtained from IMF and XE.com

Note on exchange rate rank:  It is obtained by sorting, in ascending order, the dollar value of domestic currencies. This is a metric derived purely for understanding the ideas discussed in this post and is not a robust measure.

Note on US$, per unit: This number indicates the number of US dollars that can be bought using the domestic currency. Example, exchange rate of 0.0160 for India means that one Indian rupee can buy 0.016 US dollars.

It is clear from the table that China, India and Japan are the second, third and fourth largest economies in the world, but their currencies are relatively weak. In fact, the per-capita GDP and exchange rates are also not comparable variables.


According to economics textbooks, the exchange rate is determined by the demand and supply for a currency relative to another foreign currency. This exchange rate arises out of three major factors:

First, the demand for a currency comes from people acquiring more of a particular currency to pay for foreign goods that they wish to buy (imports). Therefore, the exchange rate is determined by the volume of exports and imports of a country. If a country exports more than it imports, the demand for the exporter country’s currency and its exchange rate rises. Generally, an exporting country would want all or some of its payments made to it in its local currency, which would increase the demand for its currency.

Second, the demand for currencies arises from the financial markets and interest rate regimes. London is the one of the biggest financial centres — measured in terms of the volume of foreign exchange turnover– in the world and hence there is high demand for the Pound Sterling, as is the case with Swiss Francs. Further, countries with higher interest rates normally tend to have stronger currencies, as investors hope to get higher returns on their investments. A high interest regime encourages conversion into these local currencies and helps attain larger returns.

Third, it is in the interest of certain countries to have a weaker currency. A weaker currency will make exports cheaper and imports expensive giving these countries a competitive edge in the world market. Thus, the central banks and governments of different countries deliberately try to have a weaker currency.

The three factors discussed are not comprehensive and do not possess equal weightage; the eventual exchange rate dynamics depends on several other parameters.

Market determination of exchange rate does completely explain the exchange rate determination. There are more exceptions to this than adherents. For example, the Bahamian Dollar is exactly on par with the US dollar, despite playing a negligible role in world trade. This is due to the fact that the central bank of Bahamas has artificially pegged its currency 1:1 with the US dollar. That is even an infinitesimal change in the US dollar is directly reflected in the Bahamian dollar. Currency pegging (either 1:1 or some other predetermined ratio) is done by many countries to maintain stability. For example, Nepal and Bhutan have pegged their currency to the Indian rupee.

In conclusion, it is flippant to estimate the strength of an economy solely through the value of a currency. The strength of an economy is dependent on several variables that exhibit multi-causal relationship amongst themselves. Exchange rate have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.


[1] For simplicity, this post considers the GDP as the measure of strength of economy; to eliminate large country/ population bias we must consider the per-capita GDP (total GDP divided by the population) to arrive at a precise figure. Countries like India rank high in terms of GDP but, thanks to its population, rank much lower in per-capita GDP. Kuwait, on the other hand, ranks high in terms of per-capita GDP.

Anupam Manur is a Policy Analyst at Takshashila Institution  and can be found on twitter @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and can be found on twitter  @_quale


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Making Sense of India’s Latest GDP Figures

The new methodology to compute India’s GDP numbers is more comprehensive, accurate and in tune with international standards

The Ministry of Statistics came out with India’s GDP growth rate figures for the fiscal year 2013-14. Much to everyone’s surprise, the growth rate came out at 6.9 percent, much higher than the anticipated 4.7 percent. The 2.2 percent difference baffled everyone, including the RBI governor Raghuram Rajan, and the Chief Economic Advisor Arvind Subramaniam. The difference has raised a lot of questions and invited skepticism from both within and outside the government. Business newspapers have claimed that radical changes have been introduced in computing the GDP numbers, which explains the more positive numbers.

The Central Statistical Organization has introduced two big changes in computing GDP numbers: base year revision and using GDP at market prices. Before going into the technical aspects of these two changes, it should be mentioned that neither change is radical. The first of them is the change in base year from 2004-05 to 2011-12. The changing of the base year is a rather routine exercise carried out by the statistical offices around the world. In India, the base year has been changed numerous times and will henceforth be changed once every five years[1]. The other change is the adoption of a universal standard: that of using market prices instead of factor costs to make the GDP computations. This is mainly done to keep India’s numbers comparable with the rest of the world.


Base year analysis is mainly done to eliminate the effects of inflation and to give a more meaningful picture of the data. GDP measures the sum total of all economic activity within a country. This monetary value is first calculated in nominal terms or at current prices. It is then adjusted for inflation or the changes in the general price level over time and is thus, expressed in terms of the general price level of some reference year, called as the base year.  To make this slightly clear, assume that a country is producing only one commodity, say books. So, the GDP of that country would be the total quantity of books produced times the price of the book. Changes in the nominal value of the book over time can happen either due to a change in quantity or a change in prices. Change in real values captures only the change in the quantity of books produced.

Choosing the Base Year: Almost any year can be chosen as the base year, but ideally it should be a recent year to give a more meaningful idea. Since the index number of any series is set to 100 for the base year, it should also be relatively normal. Normal here means the absence of any large aberrations and upheavals in the economy (like extremely high inflation rate or an economy wide downturn).

The base year that was previously used in India was 2004-05. However, since then, there have been significant structural changes to the economy (as in any 10 year period) and a new base year had to be chosen to reflect these changes. The CSO has chosen 2011-12 as the new base year.


The bigger change that has been adopted by the CSO is the change from calculating GDP at factor cost to GDP at market prices. GDP at factor costs is a measure of national income that is based on the cost of factors of production. It is essentially looking from the producers’ side. It does not include the indirect taxes paid by the consumer but includes the subsidies given by the government. GDP at market prices essentially looks at economic activity from the consumers’ angle. It measures GDP at the last step of the transactions, which is the market price paid by the consumer.

It is clearly visible that GDP at market prices is always bound to be higher than GDP at factor cost. Removing subsidies and adding indirect taxes adds a significant part to the GDP numbers (as much as 7% in 2012-13). Thus, moving to GDP at market prices was always bound to give a different number.

Table showing the difference in GDP at factor cost and GDP at market prices (in Rupees trillions)


(Source: RBI Database on Indian Economy)

The Growth rates show a significant discrepancy as well. Look at the difference between the two approaches in 2008-09 and 2010-11.


(Both tables are based on the previous base year 2004-05).

The move to market prices can broadly be seen as a good move in terms of being comparable with world standards. IMF, World Bank and various international databases apart from the statistical organizations in different countries use the market prices measure. Market prices are usually a more comprehensive measure and give a better picture of economic activity. The CSO has also decided to include a range of previously not included sectors and activity. They have covered more sectors, more amount of financial intermediation, revision of labour activities, then also looked into the organized sector and the unorganized sector activity. It has also expanded its coverage of manufacturing and included under-represented sectors and data from the corporate database of the government in arriving at the growth figure. Overall, economists and statisticians would agree that the changes in the data measurement approaches are in a positive direction. A case in point is a statement by former CSO chief Pronob Sen “What has happened when we moved to the new base year is we’ve actually got better data. Basically if you look for instance in the corporate sector, we were earlier going with the RBI forecast and which were based on 2500 corporates. This time around we are using the MCA21data base which is five lakh companies as compared to 2500. So the quality of data has improved”.


However, the skepticism from different corners comes from the fact that the higher GDP growth numbers do not quite tie in well with numbers from other leading indicators of economic activity. For example, Index of Industrial Production numbers are down, so is the rate of gross fixed capital formation (investments). To bridge this gap and understand the discrepancy, we will have to wait a bit longer and wait for the revisions in the data of the other indicators, but for now, there does not seem to be much reason for complaints against this move by the CSO.


[1] The base years of the National Accounts Statistics series have been shifted from 1948-49 to 1960-61 in August 1967; from 1960-61 to 1970-71 in January 1978; from 1970-71 to 1980-81 in February 1988; and from 1980-81 to 1993-94 in February 1999. Thereafter it was changed to 2004-05 in 2006.

Anupam Manur is a Research Associate at The Takshashila Institution

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Snapshot of India’s Export Industries

This is written as a small addendum to Pavan’s insightful article on India-US trade. I shall aim to give a small snapshot of these commodities and their significance in the world trade.



The charts and tables above give a closer look at the top commodities traded with the US between 2009 and 2013 and their trends. The numbers above each bar represent the change in percentage terms over that period.

With a market share of about US$ 41 billion in 2013, the Gems and Jewelry industry in India is becoming one of India’s top foreign exchange earners. India imported US$ 3.9 billion worth of gem diamonds from the United States in 2013 and exported US$ 7.4 billion. Globally, India imported 163.11 million carats of rough diamonds worth US$ 16.34 billion and exported 36.46 million carats of polished diamonds valued at US$ 20.23 billion in 2013. The difference can be roughly seen as the value added by India. The country exported gems and jewelry worth about US$36 billion in 2013, significantly contributing to India’s foreign exchange earnings.

Exports of pharmaceutical products are also on the rise (132% over 5 years). Globally, the Indian pharmaceutical industry is ranked third largest in terms of volume and 10th largest in terms of value.  During 2013-14, pharmaceutical exports stood at Rs 90,000 crore (US$ 14.55 billion) globally.

The Indian chemical industry is also performing well. Basic chemicals and their related products (petrochemicals, fertilisers, paints, varnishes, glass, perfumes, toiletries, pharmaceuticals, etc.) form a very significant part of the Indian economy and account for about 3 per cent of India’s GDP. The Indian chemical industry is the second largest in the world. In 2012-13, India exported dyes and related products worth US$ 1.32 billion, organic chemicals worth US$ 619 million, and agro chemicals worth US$ 967 million.

Petroleum products mainly refer to India’s plastic industry. In 2012–13, exports of Indian plastics stood at over US$ 7.2 billion and have increased at about 20% each year.

The Indian textile and apparel industry is one of the largest in the world with an enormous raw material and manufacturing base. The present domestic textile industry is estimated at about US$ 33billion and unstitched garments comprise US$ 8.3 billion. The industry is a significant contributor to the economy, both in terms of its domestic share and exports; it accounts for a phenomenal 14 per cent of total industrial production, contributes nearly 30 per cent of the total exports and employs around 45 million people.

Coming over to imports, it is noteworthy that Indian imports of non-monetary gold have reduced since 2012. Non-monetary gold refers to an individual’s purchase of gold as against the gold held in the Reserve Bank’s vaults as a reserve asset. Gold imports peaked in 2012, which severely dented the current account balance and weakened the rupee. In late 2013, the RBI stepped in and took corrective measures like raising the import duties on gold. Generally, when inflation is very high (India’s CPI was about 9-10%), people rush to invest in alternative channels. When bank deposits gave you negative real returns, gold seemed like a good option for investment. The astronomical increase (115200%) in the imports of military aircrafts can be ignored as the data is zero for 2009 and about 1.2 billion in 2013.

Note: Industry specific data has been taken from http://www.ibef.org/exports



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Deflationary trend in the world economy

Falling prices and declining growth in China and Europe is adding further uncertainty in the fragile economic landscape.

China’s Consumer Price inflation figure rose to a measly 1.5 percent for December 2014, nearing a five year low. This was considerably lesser than the 3.5 percent rise expected by the government. Elsewhere, official inflation figure for the Eurozone was hovering in the negative at minus 0.2 percent, slipping the large economic area into a deflation. These, along with the falling oil prices, triggered a market collapse across the world.

Wait, falling prices are good right? Well, not quite and not for everyone. Signs of falling prices in India would indeed be greeted by great cheer, but that is because we have had an average CPI inflation rate of over 9 percent for three years running. However, falling prices in China or Europe is not necessarily a good sign.

For China, which has been showing sluggish growth in the past few quarters, reduced inflation rate means weak demand in the domestic economy. The phenomenon of a long-term decline in prices can cause consumers to sit on their money in the hope of lower prices to come, depressing the dynamism of consumption, investment and consequently, economic growth. Consumers are not willing to spend their money on goods and services, which will affect the sales and thus, profitability of the manufacturing sector. They will, in turn, reduce investment and job creation. This will ultimately lead to further reduction in growth. It is not as dire as this for China yet, but the low inflation number has sparked concerns in this direction.

Back in Europe, falling energy prices and a slight decline in Germany’s manufacturing sector has started a deflationary trend and correspondingly, a falling Euro. Deflation in Europe (along with massive debts) brings back nightmarish visions of Japan’s debt deflationary period in the 1990s and 2000s, which is often referred to as the ‘lost decades’.

Declining prices and a falling currency is bad news for the debtors. While prices and incomes might be falling, the debt does not. With the amount owed remaining the same, a household with falling income feels the burden of the debt much more. In the same vein, governments can fall prey to the same trap. If the prices and incomes are falling, so is the tax revenue, with which it was hoping to repay the debt.

Without resorting to stating the plain obvious, there is a lot of debt going around in Europe.

Add to that the fact that deflation brings along currency depreciation along with it. For countries with large international debt (debt denominated in foreign currency), such as Greece, the debt burden increases further. Greek’s foreign debt is 252 percent of its GDP (or a staggering € 400 billion). The government debt to GDP ratio is 166 percent. It is fair to say that Greece is in a soup and it will only worsen if the deflationary trend continues. Now, Greece has to pay a higher amount of Euros to convert them to, say, dollars to repay the debt.

What’s to be done? The People’s Bank of China has an easier solution than the European Central Bank. Current policy interest rate in China is hovering around 5 percent, which gives it ample flexibility to lower rates. Apart from that, the central bank is aiming to play a more proactive role in the economy by influencing lending rates by banks to businesses and by credit rationing into selective channels. It has also repeatedly made short term injections into the money market at the slightest hint of liquidity tightening.

The ECB on the other hand cannot possibly lower rates any more as real rates are already in the negative territory. The only viable medium term solution is to follow the footsteps of the Federal Reserve and have a go at Quantitative Easing (QE). QE refers to a process where the central bank of a country buys certain financial assets from the commercial banks in order to increase the monetary base and decrease the interest rates in the banking system. The Federal Reserve, after lowering the policy rate to zero percent, resorted to buying Treasury Notes and Mortgage Backed Securities from the commercial banks in the aftermath of the 2007 recession. With no significant impact on the economy, the Fed was forced to increase its monthly purchases of assets from $30 billion to $85 billion, until it had accumulated around $4.5 trillion in assets.

I shall reserve my thoughts regarding the effectiveness of QE as a policy instrument to another day. For now, good luck to the Greeks.

Anupam Manur is a Research Associate at the Takshashila Institution. 

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