Why Global Currency Wars Aren’t as Dangerous as They Sound
By Kimberly Amadeo
A currency war is when a country’s central bank uses expansionary monetary policies to deliberately lower the value of its national currency. This strategy is also called competitive devaluation.
In 2010, Brazil’s Finance Minister Guido Mantega coined the phrase “currency war.” He was describing the competition between China, Japan, and the United States where each seemed to want the lowest currency value. His country’s currency was suffering from a record-high monetary value, which was hurting its economic growth.
Countries engage in currency wars to gain a comparative advantage in international trade. When they devalue their currencies, they make their exports less expensive in foreign markets. Businesses export more, become more profitable, and create new jobs. As a result, the country benefits from stronger economic growth.
Currency wars also encourage investment in the nation’s assets. The stock market becomes less expensive for foreign investors. Foreign direct investment increases as the country’s businesses become relatively cheaper. Foreign companies may also buy up natural resources.
How It Works
Exchange rates determine the value of a currency when exchanged between countries. A country in a currency war deliberately lowers its currency value. Countries with fixed exchange rates typically just make an announcement. Other countries fix their rates to the U.S. dollar because it’s the global reserve currency.
However, most countries are on a flexible exchange rate. They must increase the money supply to lower their currency’s value. When supply is more than demand, the value of the currency drops.
A central bank has many tools to increase the money supply by expanding credit. It does this by lowering interest rates for intra-bank loans, which affect loans to consumers. Central banks can also add credit to the reserves of the nation’s banks. This is the concept behind open market operations and quantitative easing.
A country’s government can also influence the currency’s value with expansionary fiscal policy. It does this by spending more or cutting taxes. However, expansionary fiscal policies are mostly used for political reasons, not to engage in a currency war.
The U.S.’ Currency War
The United States doesn’t deliberately force its currency, the dollar, to devalue. Its use of expansionary fiscal and monetary policy has the same effect.
For example, federal deficit spending increases the debt. That exerts downward pressure on the dollar by making it less attractive to hold. Between 2008 and 2014, the Federal Reserve kept the federal fund rate near zero, which increased credit and the money supply. It also created downward pressure on the dollar.
But the dollar has retained its value despite these expansionary policies. It has a unique role as the world’s reserve currency. Investors tend to buy it during uncertain economic times as a safe haven. As an example, the drastic oil price drop between 2014 and 2016 caused a mini-recession. Investors flocked to the dollar, which caused the dollar value to increase by 25%.
China’s Currency War
China manages the value of its currency, the yuan. The People’s Bank of China loosely pegged it to the dollar, along with a basket of other currencies. It kept the yuan within a 2% trading range of around 6.25 yuan per dollar.
On August 11, 2015, the Bank startled foreign exchange markets by allowing the yuan to fall to 6.3845 yuan per dollar. On January 6, 2016, it further relaxed its control of the yuan as part of China’s economic reform.
The uncertainty over the yuan’s future helped send the Dow Jones Industrial Average down 400 points. By the end of that week, the yuan had fallen to 6.5853. The Dow dropped more than 1,000 points.
In 2017, the yuan had fallen to a nine-year low. But China wasn’t in a currency war with the United States. Instead, it was trying to compensate for the rising dollar. The yuan, pegged to the dollar, rose 25% when the dollar did between 2014 and 2016.
China’s exports were becoming more expensive than those from countries not tied to the dollar. It had to lower its exchange rate to remain competitive. By the end of the year, as the value of the dollar fell, China allowed the yuan to rise.
Japan’s Currency War
Japan stepped onto the currency battlefield in September 2010. That’s when Japan’s government sold holdings of its currency, the yen, for the first time in six years. The exchange rate value of the yen rose to its highest level since 1995. That threatened the Japanese economy, which relies heavily on exports.
Japan’s yen value had been rising because foreign governments were loading up on the relatively safe currency. They moved out of the euro in anticipation of further depreciation from the Greek debt crisis. There was underlying concern about unsustainable U.S. debt, so governments moved away from the dollar at the time.
Most analysts agreed that the yen would continue rising, despite the government’s program. This was due to foreign exchange (forex) trading, not supply and demand.
Forex trading has more influence on the value of the yen, dollar, or euro than traditional market forces. Japan can flood the market with yen attempting to devalue the currency—but if forex traders can make a profit from yen, they will keep bidding on it, keeping the value of the currency up.
Before the financial crisis of 2008, forex traders created the opposite problem when they created the yen carry trade. They borrowed yen at a 0% interest rate, then purchased U.S. Treasury bonds with the borrowed currency, which had a higher interest rate.
The yen carries trade disappeared when the Federal Reserve dropped the federal funds rate (the interest rate banks charge each other for overnight loans) to zero.
The European Union entered the currency wars in 2013. It wanted to boost its exports and fight deflation. The European Central Bank lowered its rate to 0.25% on November 7, 2013.
This action drove the euro to dollar conversion rate to $1.3366. By 2015, the euro could only buy $1.05. Many investors wondered whether the euro would survive as a currency.
In 2016, the euro weakened as a consequence of Brexit, where the residents of the United Kingdom voted to exit the European Union. However, when the dollar weakened in 2017 the euro rallied.
Impact on Other Countries
These wars increased the currency values of Brazil and other emerging market countries. As a result, world commodity prices rose. Oil, copper, and iron are the primary exports of some of these countries—when prices rise for these commodities, demand begins to fall, causing economic slowdowns for the exporting countries.
India’s former central bank governor, Raghuram Rajan, criticized the United States and others involved in currency wars. He claimed that this exports inflation to the emerging market economies. Rajan had to raise India’s prime rate (the rate for borrowers with very high credit ratings) to combat the inflation of its currency, risking a reduction in economic growth.
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 value low. This affects U.S. mortgage rates by keeping them down, making home loans more affordable. This is because Treasury notes directly impact mortgage interest rates. If demand for Treasurys is high, their yield is low—this causes banks to lower their mortgage rates.
Financial institutions so this because Treasurys and mortgage products compete for similar investors. Banks have to lower mortgage rates whenever Treasury yields decline or risk losing investors.
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.
It’s unlikely the next currency war would create a crisis worse than that in 2008. Alarmists point to several indications that one is imminent. But a dollar decline is not a collapse. The dollar could collapse only if there were a viable alternative to its role as the world’s reserve currency.
Currency wars have led to capital controls in China, but that’s because it’s a command economy. It’s unlikely to happen in a free market economy like the United States or the EU. Capitalists wouldn’t stand for it.
Alarmists also point to the bailouts that occurred in Greece and Ireland. These bailouts had nothing to do with the EU’s currency wars. Instead, the Eurozone debt crisis was caused by overzealous lenders who were caught by the 2008 crisis.