BRICS development bank & local currencies: Financial Express 9th April, 2012

The concept of a BRICS development bank, prima facie, looks a jolly good idea. The top five emerging economies which account for around 40% of the world’s population and contribute to over 20% of world GDP and a quarter of world trade are putting together a bank which helps not just these nations but others too. Financing is proposed to be through local currencies which will add to the flow of trade and free borrowers/ traders from the vicissitudes of the euro-dollar movements, thus lowering transaction costs. This helps the nations at the time of crises besides supporting growth in normal times by providing finance for infrastructure and other projects.

One can intuitively see value as these nations start trading more among themselves, even if they are not doing so today. India’s exposure to this group is around 10% and 15% for exports and imports respectively. If hypothetically all trade is carried out in local currencies between these nations, then we would be net gainers. The bank would, however, be dealing with local currency loans for lending for projects and trade.

Will this work? There is a sense of déjà vu because when the euro was created it had similar and probably more far-reaching goals. Here the local currency acceptance would only affect their inter-group transactions. First, the political systems vary across the group from democratic republics to statist rules. Second, while these are the five largest emerging markets, economic conditions vary. Third, the economic discipline which has to go along with like-minded countries must be examined. This will be the necessary preconditions for Russia to accept the rupee or Brazilian real or China the ruble or rand.

The accompanying tables give two sets of comparable indicators for these nations – the basic economic indicators and more fundamental variables for seeking common ground.

Three of the 5 nations are at a different level of growth rate, being moderate. Further, unemployment levels are much higher for South Africa and India, which compels governments to play a more active role in social programmes. Inflation appears to be fairly high in 4 of the 5 nations, with India topping at 8.1%. Differential inflation will provide an advantage to the country with high inflation as it can use other currencies to procure cheaper goods. Hence, India can borrow in renminbi and buy goods from China, and the rupees that they get will then have to be used to buy goods at a higher price from India. Therefore, the conversion rates need to be determined in a meaningful manner. Interest rates are again high in 3 of the group countries and low in China and Brazil, which will make it attractive for the others to borrow from these markets and currencies.

The common meeting ground should ideally be closer for these nations if they were to borrow in local currencies, as policy stance domestically will be driven by these considerations. Fiscal deficits are high for India and South Africa, while China and Russia have current account surpluses. The rupee is the weakest currency vis-à-vis the dollar, followed by the ruble. The real is the strongest currency here. But, ultimately we need to have a converter for currency, which means that all of them have to be flexible to be credible. Today, all currencies are pegged to the dollar, with central banks taking a conscious decision on their currencies. It is here that China has gotten into a controversy with advanced nations believing that the renminbi is undervalued. Lastly, forex reserves are high for all except South Africa.

China is evidently the strongest nation and would be most forthcoming to lend renminbi, which has to be used to import more from China, which in turn will help its own economy. In fact, it may have the clout to ensure that its own currency becomes the favored currency for trade. Here interest rates have to be tuned to the local currency interest rates and the fact that the renminbi is controlled can pose some issues for the others. Brazil also appears to be attractive given lower interest rates though it would on its own part be looking for funding for its growth from the other nations.

Hence, we need to iron out all these issues before creating a development bank that facilitates lending in local currencies. While it is true that the dollar world has created uncertainty, the US still remains the dominant trade partner individually for the BRIC nations. Getting preliminary economic conditions right and maintaining similar prudent economic policies will be a challenge. The exchange rate conversion will hold the clue to which currency ultimately gets to dominate the transactions and payments architecture.