From Market Curator
What is a Currency War?
A currency war is a ‘competitive devaluation’ of currency between a group of countries.
If the currency of any given country is devalued, then this means that their exports become cheaper for businesses in other countries to buy. This provides a boost to industry. At the same time imports from other countries become more expensive, forcing consumers to buy domestically produced goods and giving an additional boost to industry.
If the government of more than one country decide that they need to boost its domestic industry in this way, then a competitive downward spiral can emerge. Each new measure introduced in one country sparks reactive measures in the other countries who want their currency, and therefore their exports, to maintain their edge in relation to the others. This is what is known as a ‘currency war’.
Currency devaluation is not an entirely positive thing for a nation’s economy, however. In fact it is usually seen as a negative. This is because a devalued currency can reduce consumers’ spending power at home, and even more so if they travel abroad. It can also increase inflationary pressures.
In a currency war the negative aspects of devaluation are accentuated, because more and more extreme measures are needed to maintain the same advantages. Such situations can have a significant impact on global growth and economic stability.
Devaluation policies are usually pursued at times when unemployment is high and a country is struggle to stimulate domestic demand. At these times, and if inflation is not seen as an imminent problem, a government may try to stimulate growth through using devaluation to boost exports.
How Can A Country Devalue Its Currency
- A central bank can sell its own currency and buy other currencies (especially its competitors).
- Capital Controls can be put in place to limit the influx of capital into a country.
- Measures such as quantitative easing, or ‘printing money’.
- The central bank can lower its base interest rate.
- Propaganda – talking down a currency can cause the markets to devalue it for you.
Risk Indicators for an Approaching Global Currency War
Clearly many countries around the world are currently experiencing high unemployment and are struggling to return to the levels of growth seen prior to the global financial crisis of 2009. Inflation is also relativey low in most countries around the world. This means that the conditions are ripe for currency wars to develop. But even beyond these general conditions, there are specific signs that a large scale breakout of competitive devaluation is brewing.
One of the first world leaders to issue a warning was the Brazilian Finance Minister Guido Mantega in 2010. His warning of the possibility of a global currency war came after a large inflow of capital led to a sudden spike in th value of the Brazilian Real. This had a substantial impact on the country’s export sector. Around this time a range of emerging economies began implementing capital controls to prevent a similar thing happening to them.
More recently the incoming Japanese Prime Minister Shinzo Abe has pressured the Bank of Japan to raise its inflation target and has announced unlimited measures to buy government securities. The Yuan has already declined in value significantly since he took office.
There are also signs that Britain is pursuing a policy of devaluation, although Prime Minister David Cameron is less vocal about his intentions that his counterpart in Japan. Britain has already experience a ‘double-dip’ recession, and may be about to enter a third recessionary period since the start of the world economic crisis. The governments policy of pursuing austerity measures seems to be failing, but Cameron is politicaly unable to back out of it. Devaluation may be the only choice which is left. The British pound has already decline by 3.5% against the dollar in 2013, and this could go even further when Mark Carney replaces Mervyn King at the head of the Bank of England in June, as he is known to have a much looser approach to inflation targets than his predecessor.
A range of smaller countries are also either taking or planning measures to prevent the appreciation of their currency. Switzerland has blocked the Franc’s appreciation against the Euro. Meanwhile Bank of Korea Governor Kim Choong Soo said on Jan. 14 that a steep drop in the Japanese yen could provoke his country to take an “active response to minimize any negative impacts on exports and investor confidence.”
The Dangers of a World Currency War – Who Would Lose?
Europe, much of which is still struggle to return to growth following the finanical crisis, is particularly vulnerable. The European Central bank has made it clear that it has no plans to use the interest rate to devalue the Euro, and in any case the diverse nature of the European economies, each controlled by different soveriegn governments despite sharing the same currency, would make devaluation more difficult. With Europe’s economy already struggling, a decrease in exports as a result of devaluation amongst the continent’s competitors could be devastating. In many ways the strong German economy is holding up Europe at the moment – but Germany is particularly reliant on exports. The worst case scenario could see Europe’s stronger northern economies no longer able to bail out its struggling southern states like Greece, which is currently surviving on handouts.
Alternatively, there is another worst case scenario involving Europe – the loss of confidence in the Euro, perhaps caused by some unseen event connected to the sovereign debt crisis, leading to massive and sudden devaluation.
But the country which arguable has the most to lose is the United States of America. The US dollar’s status as the global reserve currency makes it difficult for the country to pursue devaluation policies. What’s more if traders are worried about the future of other currencies, they are more likely to buy the dollar, causing appreciation rather than devaluation. This could lead to America’s exports taking a big hit, while at the same time the country would be flooded by cheaper imports from other countries.