Medical tests often have false positives and false negatives and those cause paradoxes. Say, an HIV test has a false positive rate of five per cent, a false negative rate of five per cent and it picks up 95 per cent of real HIV cases. (This data is not medically correct).
This test is given to 10,000 people with an infection rate of one per cent (this is unknown, of course). The test finds 95 of the 100 HIV-positive persons and misses five of them. It falsely indicates 245 people are HIV-positive. Only 28 per cent of those testing HIV-positive (95 out of 340) are really infected.
The positive/negative rates are correct in isolation but lead to surprising results when applied to a broader population. An odd situation with some similarity is brewing in currency markets. A nation with slow growth and low inflation might seek currency devaluation to improve export competitiveness, induce business activity, etc. A combination of rate cuts and looser money supply is usually enough to push a currency down. But that is in isolation. Now, many nations are trying variations of this formula at the same time and that means confusion and volatility. Taken together, it's hard to say which currency will eventually devalue, and by how much, and which currency will actually gain.
The European Central Bank and the Bank of Japan have launched quantitative expansions to ensure liquidity and induce inflation. This "should" lead to a weaker euro and yen. Then, Britain might be forced to loosen up to maintain competitiveness. China's yuan is fixed with a peg to the dollar and it is also likely to devalue, with the People's Bank of China very likely to lower the dollar-peg. America contributes roughly one-fifth of world gross domestic product (GDP). The euro zone, Japan and the UK together contribute about a-third of global GDP. China contributes about 12 per cent. So, this currency set controls two-thirds of global GDP (with many more transactions being denominated in these currencies as well).
Even if the dollar gains against every other currency (it might not), what happens to all non-dollar currency pairs and baskets? Does the yen decline against euro or vice versa? Does the yuan decline against the yen and euro? There are other convertible currencies like the Swiss Franc, Australian dollar, Singapore dollar, rouble, etc.
In theory, each currency can be checked against a basket of other currencies, assessing variables like trade balances, government debt, external debt, interest rates differentials, money supply, etc. But such "competitive devaluation" has not happened before. There will eventually be a new equilibrium in forex rates. But there could be multiple crises and cross-winds before such a new equilibrium is reached.
A rupee investor will inevitably be affected by this unprecedented situation. The rupee has hardened against every currency, including the dollar. This affects export competitiveness. The latest monthly trade balance indicates December 2014 saw lower exports than November 2014. However, the overall trade balance improved because oil imports dropped in value. There could be a trade surplus in 2015-16 if crude oil remains cheap. The current account deficit will also be well below two per cent. In relative terms, India's GDP growth is healthier than most countries. This means reasonable forex inflows will arrive via both the foreign direct investment route and also by portfolio investment into government rupee-debt and into equities.
There is a good chance the rupee will continue to harden against most currencies if the external situation remains the same. The Reserve Bank of India (RBI) can cut rates again but the rupee might still remain relatively stronger than most currencies. In fact, the RBI could have to cut policy rates simply to prevent currency over-appreciation. The central bank is buying lots of forex, which has the dual effect of boosting reserves and pushing the rupee down. Reserves are already at record levels and RBI also has forward dollar buying commitments.
The fact that so many nations are doing "competitive devaluation" introduces a new element of unpredictability to already-volatile currency markets. There could be negative effects on global trade. In the Great Depression (1929-1937), most nations tried to boost exports and domestic manufacturing by raising import barriers, including import bans and setting very high customs duties.
Weakening a currency creates import barriers of a different kind. The Depression tactics of high import barriers led to global trade being utterly stifled. We can only hope this new method of competitive devaluation doesn't lead to similar problems.
