Currency Wars Explained

It seems strange to most members of the general public and even some Forex traders, but many countries actually make it point to depress their currencies, intervening in the markets in a way that devalues a currency. During times of recession, currency devaluation often becomes a tool meant to provide a competitive advantage to a country – and help stimulate economic growth. However, when one country starts devaluing its currency, other countries are likely to jump in to nullify the advantage. When this happens, it is said that there is a currency war in progress, as countries strive to keep their own currencies’ value low as compared to other currencies.

Why Is a Weak Currency Desirable?

During times of economic expansion, many countries do, in fact, prefer strong currencies. These strong currencies allow citizens to purchase more, and a strong currency can lead to a higher quality of life. The stronger currency will also help keep inflation in check.

A weak currency, though, has its own benefits – at least countries think so. When your country has a weaker currency, relative to its counterparts, your exports are cheaper, and more attractive. Japan is well-known for its desire to maintain a relatively weak currency. This is because it keeps the price of exports lower so that people in other countries will want to buy them. The same is true of China, a country that prefers a weak yuan relative to the US dollar, since it means that more Americans will buy cheaper Chinese products.

With lower export prices, a country can sell more goods to other countries. This, in turn, can create jobs as the country with the weaker currency must produce more goods in order to meet demand for cheap products. Such a situation can also boost economic growth. Currency devaluation can lead to economic growth, which is why so many countries are interested in a weaker currency during times of recession.

How Can a Country Weaken Its Currency?

One strategy employed by countries to keep their currencies weak is to create a peg. Recently, the Swiss introduced a ceiling rate to the euro, which resembles the peg closely. Concerned at how fast the franc was appreciating relative to the euro, the Swiss decided to peg the franc to the euro, ensuring that that the franc could only gain so much against the euro.

There are other ways for a country to weaken its currency as well:

  • Lower interest rates: The method of choice amongst central banks trying to weaken currencies is to cut interest rates. When a country has a lower interest rate, its currency is less attractive. Saving in the economy is less attractive as well, since the yield is so low. As a result, investors look to higher-yielding assets and the currency can lose value relative to other currencies.
  • Increase the money supply: In some cases, a country might simply create money out of thin air. Increasing the money supply means that there is more of a currency, lowering its value. In basic terms, supply exceeds demand, and that means that the currency value has nowhere to go but down. Increasing the money supply can be done through the purchase of a country’s own assets. In the United States, the Federal Reserve can increase money supply by purchasing US Treasuries, or even purchasing the bonds of private countries. The Fed essentially creates new money for this purpose, and that increases money supply. This tactic is called quantitative easing, while the one-time effort to increase the money supply is called currency intervention.
  • Buying assets from other countries: A country might also buy assets of another country. One of the ways that China has been able to encourage a weaker yuan relative to the US dollar is by purchasing US assets. This means there is greater demand for the dollar, and the dollar value moves higher, helping the yuan remain weak – as planned by the Chinese government.

Of course, these tactics can help depress one currency, but soon other countries are joining in, trying to devalue their own currencies so that they can have the benefits of competitively priced exports and a growing economy.

In some cases, countries actively trying to devalue their currencies are punished by others through increased taxes, and through trade restrictions that make it difficult for the cheaper goods to be purchased in as large numbers.

Problems Arising from Currency Wars

While some argue that a weaker currency can be helpful in times of economic recession, others point out that there are problems with currency wars that can cause even more problems.

One of the biggest issues is that the attempt by several countries to devalue their currencies at one time – and benefit from it – can actually lead to instability. When everyone is trying to gain the upper hand through currency manipulation, it can make the global market economy increasingly unstable. Eventually, it can actually discourage investment and trade, which actually limits growth rather than encouraging it.

Many people, though, think that the biggest risk posed by currency wars is widespread inflation. When the money supply increases, and as currencies are devalued, prices rise. One unit of currency buys much less than it used. Citizen purchasing power decreases. To some extent, inflation is a desirable by-product of economic growth. However, too much inflation stifles growth and wipes out middle class savings. When this happens, it renders the entire system unstable, and can result in an economic crash. Some worry that currency wars, especially in a global economy that has become so integrated, could lead to widespread hyper-inflation, and serious trouble for the entire system. An all-out currency war could lead to a number of problems for the global economy, and result in no one’s economy being sufficiently stimulated.

Allegations of Currency Tampering

Of course, there are always allegations of currency tampering. The US has been accusing the Chinese of artificially depressing the yuan for years. As a result, the US threatens to raise tariffs on Chinese imports to America, and has been trying to apply pressure on China to allow its currency to appreciate (and America’s to depreciated relative to the yuan).

Lately, though, Japan has been one of the most blatant in debasing its currency. Japanese officials have intervened multiple times in 2011 to keep the yen lower, in order to prevent exports from becoming too expensive. Indeed, there is some chatter that Japan could employ some more measures to keep the currency depressed as it works to rebuild the areas devastated by the tsunami back in March.

While the US finger-wags toward China and Japan, it, too, engages in measures meant to keep the dollar weak. However, US tactics are not as blatant as those used by China or Japan. Indeed, efforts at quantitative easing toward the end of 2010 were criticized by eurozone leaders, who were upset about all of the currency debasement. While the European Central Bank has its lending facilities and the ability to engage in currency devaluation, it has thus far used the ability rather sparingly. While the US and Japan persist in keeping interest rates quite low, the ECB raised interest rates in July 2011. With rumors of QE3 in the US beginning again, there is a chance that we could see an all-out currency war sometime soon.

What’s Happening Now?

So far, while there have been some attempts to weaken various currencies, a full-fledged currency war has yet to break out on a large scale. For the most part, isolated attempts at currency devaluation to promote economic stimulus have been seen in different countries (and currency zones). However, to this point such attempts have been relatively small, and have not resulted in a large degree of inflation – yet.