“What is a currency war?”

A currency war is a condition whereby a number of countries aim to intentionally gain trade advantage over other countries by allowing the exchange rates of their currencies to fall in relation to other currencies. The strategy they use is a phenomenon more commonly known as currency/competitive depreciation/devaluation.

‘Currency wars’ is a term coined in 2010 by Brazil’s former Finance Minister, Guido Mantega, when he warned that an international currency war had broken out between the leading countries (the United States and China) to see who had the lowest currency value. It was followed by involving countries such as Japan, Columbia, and Israel (later that year in September), South Korea, Brazil and even from Chile – a country that is known for avoiding government intervention in favour of free market policies (in January 2011), and subsequently, the European Union -when the European Central Bank (ECB) lowered its rate to 0.25% in November 2013, which drove the euro to dollar conversion rate to $1.3366.

In order to grasp why they do it, one has to first understand how they do it:

Exchange rates determine the value of a country’s currency against another’s. Countries with fixed exchange rates (whose national government authorities intervene in the foreign exchange market) simply set the rate by making an announcement. Most countries fix them to the U.S. dollar because it’s the global reserve currency.

However, most countries in this era use a floating exchange rate, whereby the rates are generally determined by market forces (i.e. demand and supply). Now, countries in a currency war could deliberately lower that value via the central bank by imposing an expansionary monetary policy, in which they increase the money supply. A central bank has various approaches to increase the money supply; by printing more money (an indirect method of quantitative easing) or by expanding credit. The other side of such monetary policies would be to lower interest rates.

Besides adopting such policies, a country’s government could also impose an expansionary fiscal policy. This policy influence the currency’s value by increasing government spending or by reducing tax rates, leading a to higher disposable income and possible higher propensity to consume goods. The goods acquired will consist of imported goods and when these goods are purchased, the country’s currency is sold to the market, leading to an increase in supply of the country’s currency and a reduction in value of the country’s currency.

“What’s the rationale behind this?”
“Don’t countries prefer stronger currencies?”

Contrary to popular beliefs, a strong currency is not undoubtedly in a country’s best interests because in the event of a global economic slowdown, demand would be low and when countries strive to overcome this, sensibly, devaluation becomes an attractive option to boost domestic demand and this move is said to stimulate their economies.

Here’s why; for example, a devaluation of the Malaysian Ringgit (MYR) means the exchange rate of the currency falls, making exports relatively cheaper and hence, more competitive in other countries; also imports into the country become more expensive. This gives rise to an increase in demand for domestic goods by domestic consumers as they will favour domestic goods as opposed to imports, thus spurring economic growth. Following the devaluation, this should achieve the goal of increasing the domestic demand.

“What are the drawbacks of such a strategy?”

Generally, a devaluation could contribute to inflationary pressures due to rising demand for exports and higher import prices. There is likely to be an increase in Aggregate Demand (AD) which sometimes can be seen to mimic inflation. In theory, AD is equal to C+I+G+(X-M), if export volumes (X) increase and the quantity of imports (M) fall, a higher net exports (X-M) value could be obtained. If consumption (C) also increases, this may amplify the effect. If the economy is close to full capacity, this will lead to a higher AD, causing inflation. Nonetheless, one must be aware that the overall impact depends on the state of the economy (whether it is in recession) and other factors affecting inflation (whether other AD components are low enough to cancel the effect of a rise in C and (X-M)).

“How does this impact the rest of the world?”

In the end, I believe that these wars tend to drive currencies of other emerging market countries higher. It raises the prices of commodities such as crude oil, copper, iron, coffee and other agricultural goods, which are these countries’ primary exports. With that being said, this makes emerging market countries less competitive and slugs their economies and ultimately, if and when all countries adopt a similar strategy to devalue their currency, it can lead to a general decline in international trade, harming all countries and no one emerges as ‘winners of the war’.

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Report: Where Do You Stand on Currency Wars.

Infographic: Where Do You Stand on Currency Wars

 

References

Economicshelp.org. (2017). Competitive Devaluation and Currency Wars | Economics Help. [online] Available at: http://www.economicshelp.org/blog/6736/economics/competitive-devaluation-and-currency-wars/ [Accessed 27 Jan. 2017].

Elvis Picardo, C. (2017). What Is A Currency War And How Does It Work?. [online] Investopedia. Available at: http://www.investopedia.com/articles/forex/042015/what-currency-war-how-does-it-work.asp [Accessed 27 Jan. 2017].

The Balance. (2017). Thank the Global Currency War for Lower Prices. [online] Available at: https://www.thebalance.com/what-is-a-currency-war-3306262 [Accessed 27 Jan. 2017].

Das, S. (2017). Why currency wars will cause the world more financial pain. [online] MarketWatch. Available at: http://www.marketwatch.com/story/why-ongoing-currency-wars-will-cause-the-world-more-economic-pain-2016-07-27 [Accessed 27 Jan. 2017].

Anon, (2017). [online] Available at: 1. http://dollarcollapse.com/the-economy/a-currency-war-battle-that-europe-and-japan-cant-afford-to-lose/ [Accessed 27 Jan. 2017].