- A currency war refers to a situation where a number of nations seek to deliberately depreciate the value of their domestic currencies in order to stimulate their economies.
- Although currency depreciation or devaluation is a common occurrence in the foreign exchange market, the hallmark of a currency war is the significant number of nations that may be simultaneously engaged in attempts to devalue their currency at the same time.
Are We in a Currency War?
- A currency war is also known by the less threatening term “competitive devaluation.”
- In the current era of floating exchange rates, where currency values are determined by market forces, currency depreciation is usually engineered by a nation’s central bank through economic policies that may force the currency lower, such as reducing interest rates or increasingly, “quantitative easing (QE).
- This introduces more complexities than the currency wars of decades ago, when fixed exchange rates were more prevalent and a nation could devalue its currency by the simple expedient of lowering the “peg” to which its currency was fixed.
- “Currency war” is not a term that is loosely bandied about in the genteel world of economics and central banking.
Why Depreciate a Currency?
- It may seem counter-intuitive, but a strong currency is not necessarily in a nation’s best interests. A weak domestic currency makes a nation’s exports more competitive in global markets, and simultaneously makes imports more expensive.
- Higher export volumes spur economic growth, while pricey imports also have a similar effect because consumers opt for local alternatives to imported products.
- This improvement in the terms of trade generally translates into a lower current account deficit (or a greater current account surplus), higher employment, and faster GDP growth.
- The stimulative monetary policies that usually result in a weak currency also have a positive impact on the nation’s capital and housing markets, which in turn boosts domestic consumption through the wealth effect.
Beggar Thy Neighbor
- Since it is not too difficult to pursue growth through currency depreciation – whether overt or covert – it should come as no surprise that if nation A devalues its currency, nation B will soon follow suit, followed by nation C, and so on.
- This is the essence of competitive devaluation.
- This phenomenon is also known as “beggar thy neighbor,” which far from being the Shakespearean drama that it sounds like, actually refers to the fact that a nation which follows a policy of competitive devaluation is vigorously pursuing its own self interests to the exclusion of everything else.
- The US economy has withstood the effects of the stronger dollar without too many problems thus far, although one notable issue is the substantial number of American multinationals that have cautioned about the negative impact of the strong dollar on their earnings.
- The US has generally pursued a “strong dollar” policy with varying degrees of success over the years.
- However, the US situation is unique since it is the world’s largest economy and the US dollar is the global reserve currency.
- The strong dollar increases the attractiveness of the US as a destination for foreign direct investment (FDI) and foreign portfolio investment (FPI).
- Not surprisingly, the US is often a premier destination in both categories.
- The US is also less reliant on exports than most other nations for economic growth, because of its giant consumer market that is by far the biggest in the world.
How It Affects You
- Currency wars lower export prices and spur economic growth.
- But they also make imports more expensive.
- That hurts consumers and adds to inflation.
- In 2010, currency wars between the United States and China resulted in higher food prices
- China buys U.S. Treasurys to keep its currency’s value low.
- These purchases keep U.S. mortgage interest rates affordable. Treasury notes directly impact mortgage interest rates. When demand for Treasury’s is high, their yield is low.
- Since Treasury’s and mortgage products compete for similar investors, banks have to lower mortgage rates whenever Treasury yields decline.
- Currency wars do create inflation, but not enough to lead to violence as some have claimed.
- The 2008 food riots were caused by commodity speculators. As the global financial crisis pummeled stock market prices, investors fled to the commodities markets.
- As a result, oil prices rose to a record of $145 a barrel in July, driving gas prices to $4 a gallon.
- This asset bubble spread to wheat, gold, and other related futures markets. Food prices skyrocketed worldwide.