CURRENCY WAR

A currency war is when a country's central bank uses expansionary

monetary policy to deliberately lower the value of its national money.
The strategy is also called competitive devaluation.

In 2010, Brazil's Finance Minister Guido Mantega coined the phrase

currency wars. He was describing the competition between China,
Japan, and the United States to have the lowest currency value. His
country's currency was suffering from a record-high value, hurting its
economic growth.
 PURPOSE

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 profitable, and create new jobs. As a result, the
country benefits from stronger economic growth. To summarise, the
decline in the value of currency makes exports more competitive and
imports more expensive.

Currency wars also encourage investment in the nation's assets.

The stock market becomes less expensive to 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 one country's currency versus

another's. A country in a currency war deliberately lowers that value.
Countries with fixed exchange rates just make an announcement. Most
countries fix their rates to the U.S. dollar because it's the global reserve
currency.

But most countries are on a flexible exchange rate. They must increase
the money supply to lower the 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. It can also add credit to the reserves of
the nation's banks. That's called open market operations or 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. But most of the time, it does it for political reasons, not to engage
in a currency war.
 DEVALUATION VS INFLATION
It is very common to mix up these terms as they are both very complex
and seem similar, but they are not.

Inflation happens when a price is higher than most prices. A very good
example would be living in a city will be much costlier than the country
side as prices of groceries, services and etc. are generally pricier. If you
compare the price of an apple bought in a city for 2 dollars and an apple
bought in a village for 1 dollar, it is safe to say that the price of a city-
bought apple is inflated compared to the village-bought apple.

Devaluation on the other hand, is much more about the worth and value
of a currency. Devaluation means losing value. For example- An apple
from our grandparents or ancestors day could well be worth around 50
cents. Compare with an apple today which cost 2 dollars, it is fair to say
prices way back then was cheap, only because back then, money has
so much value that you just need 50 cents for an apple. Now with money
losing its value, you’ll end up paying more for an apple.
 Weak Currencies Can Boost Exports
The term "currency war" is somewhat ironic, in that countries engaged in
one seek to weaken the value of their currencies.

However, in an actual war, the goal is to strengthen oneself as much as

possible against the enemy. That's because a strong currency is not
always in a country's best interest, while a weak one can provide
benefits, at least in the short term.

From time to time, counties try to lower the value of their currencies in
order to make the goods and services they produce cheaper in world
markets, thus hoping to boost their own economic growth at the expense
of other countries. They do this through a variety of fiscal, monetary and
exchange rate policies.

At the time of Mantega's speech, many countries had taken steps that
had the effect of cheapening their own currencies. The "war" appears to
have started in China, which was trying to hold down the value of the
renminbi in order to make Chinese goods cheaper in foreign markets.
In response, central banks in Japan, South Korea, Taiwan and other
Asian countries took steps to lower the value of their own currencies,
including selling their currencies in the foreign exchange markets to
drive down the price, at the same time buying up other countries'
currencies in order to raise their prices.

They also announced expansionary monetary policies that had the effect
of lowering their own interest rates, thus making their government
securities – and thus their currencies – less attractive to investors.

A good example of the latter policy occurred in the U.S. and Europe,
where in response to the global financial crisis the Federal Reserve and
the European Central Bank cut interest rates to zero and below.

The goal of those policies was to stimulate their economies, not to

necessarily weaken their currencies, but governments in other countries,
such as Brazil, didn't always see it that way because they were
sometimes hurt by those policies.
 Domino Effect of Currency Wars
Mantega's use of the term "war" was an apt one, as the actions taken by
the countries cited above "end up weakening currencies," according to
Fortune. "More important, such 'beggar-thy-neighbour' interest rate
policies tend to encourage a domino effect: The fall of one currency
leads to the irritating rise of another, and so on."

But that was not the first time a currency war was fought, if 2010 meets
that description. Fortune reported that there was "an official currency
war" during the Great Depression, which then spiralled into trade wars
that made the Depression even worse.

Currency devaluations can indeed spiral out of control and cause

unintended negative consequences.

While currency depreciations make a country's exports cheaper in

foreign markets, they conversely make imports more expensive at home.
That discourages consumers from buying foreign-made goods and
services, which could hurt domestic economic growth. Higher prices also
could lead to higher inflation.
 Negative Effects of Currency Wars
Currency wars are anti-growth and deflationary.

A currency war is termed as “a race to the bottom”. “In this, one country
after another devalues their currency to gain an export price advantage,
creating too much supply and not enough demand, which elevates the
risks of even more anti-growth protectionist measures," said Joe
Quinlan, an investment strategist at U.S. Trust.

Currency wars also go by the more euphemistic term "competitive

devaluation." However, devaluations can quickly escalate into wars
involving multiple countries, as each tries to defend itself by lowering the
value of its currency to stay competitive while retaliating against other
countries.

According to Foreign Policy magazine, the big issue is that currencies

"don't rise or fall in a vacuum" when they're part of a connected global
economy.
When many countries devalue their currencies at the same time in an
effort to make their exports more competitive, it forces other countries —
Brazil for instance — to join in to prevent their currencies from rising.

So, while devaluing currency makes exports more competitive, it makes

imports more expensive, decreasing citizens' purchasing power. It can
also increase inflation. Currency wars tend to dampen international
trade.
 Early Currency Wars
The term currency war was coined in 2010 by the Brazilian Minister for
Finance, Guido Mantega, but the process of competitive devaluation has
been going on since WWI, when countries first departed from the gold
standard (a system in which the country's paper money was tied to their
reserves of gold) and became able to manipulate the value of currency
through monetary policy.
In the 1920s, Germany, France, and Belgium depreciated their
currencies in order to get back on the gold standard after abandoning it
during WWI. Britain did the opposite, instead raising the value of its
currency; this prevented widespread currency war. In the late 1920s,
however, Britain, France and the U.S. engaged in a cycle of competitive
devaluation that discouraged global trade and ultimately may have
contributed to the Great Depression. In 1936, the three countries agreed
to stabilize their currencies, ending the currency war.
 The Dollar System
In 1944, many nations got together and agreed to a mostly-fixed
exchange rate tied to gold through the U.S. Dollar. This kept currencies
mostly stable for nearly three decades before Nixon took the U.S. off the
gold standard again in 1971. Currencies were more volatile, but currency
war didn't break out because countries typically had different priorities
and rarely engaged in competitive devaluation all at once.

In 1997, several Asian economies collapsed, triggering the Asian Crisis.

After the crisis, their faith in free-exchange was shaken; many countries
began intervening to keep the value of their currencies low relative to the
dollar. China, for example, has bought more than a trillion U.S. dollars to
keep the dollar strong and the Yuan relatively weak.
 What limits the Currency Devaluations
What is IMF?

The International Monetary Fund (IMF) is an organization of 189

countries, working to foster global monetary cooperation, secure
financial stability, facilitate international trade, promote high employment
and sustainable economic growth, and reduce poverty around the world.
Created in 1945, the IMF is governed by and accountable to the 189
countries that make up its near-global membership.

The IMF's primary purpose is to ensure the stability of the international

monetary system—the system of exchange rates and international
payments that enables countries (and their citizens) to transact with
each other. The Fund's mandate was updated in 2012 to include all
macroeconomic and financial sector issues that bear on global stability.
What are the rules on the currency devaluations?

While countries surely engage in "competitive devaluation," if not outright

currency wars, they're not supposed to.

Members of the International Monetary Fund—to which 189 of the

world's 195 countries belong—are required under Article IV to "avoid
manipulating exchange rates or the international monetary system in
order to prevent effective balance of payments adjustment or to gain an
unfair competitive advantage over other members."

They also agree to "undertake to collaborate with the Fund and other
members to assure orderly exchange arrangements and to promote a
stable system of exchange rates."

However, that's not easy to enforce. As we've seen, it's not always
possible to tell the difference between launching a currency war and
taking legitimate steps to bolster one's economy.
 United States Currency War
The United States doesn't deliberately force its currency, the dollar, to
devalue. But 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 fed funds
rate near zero. That increased credit and the money supply. That also
put 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 buy it
during uncertain economic times as a safe haven. As a result, the dollar
strengthened 25 percent between 2014 and 2016. Since then, it has
begun to decline again.
 China 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 percent trading range of
around 6.25 Yuan per dollar. The exchange rate tells you $1 will
purchase 6.25 Yuan.

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
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
percent 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 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. They left
the dollar because they were concerned about the unsustainable U.S.
debt.

Most analysts agreed that the yen would continue rising, despite the
government's program. That's because of forex trading, not supply and
demand. It has more influence on the value of the yen, dollar, or euro
than traditional market forces. Japan can flood the market with yen all it
wants. But if forex traders can make a profit from a rising yen, they will
keep bidding it up.

Before the financial crisis, forex traders created the opposite problem
when they created the yen carry trade. They borrowed the yen at a 0
percent interest rate. They invested in the U.S. dollar which had a higher
interest rate. The yen carry trade disappeared when the Federal
Reserve dropped the fed funds rate to zero.
 European Union
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 percent on November 7, 2013. That drove the euro to
dollar conversion rate to $1.3366. By 2015, the euro could only buy
$1.05. But that was also partly a result of the Greek debt crisis. Many
investors wondered whether the euro would even survive as a currency.
In 2016, the euro weakened as a consequence of Brexit. But when the
dollar weakened in 2017, the euro rallied.
 Impact on Other Countries
These wars increased the currencies of Brazil and other emerging
market countries. As a result, it raised the prices of commodities. Oil,
copper, and iron are these countries' primary exports. Currency wars
among the major powers make emerging market countries less
competitive and slow their economies.

In fact, India's former central bank governor, Raghuram Rajan, criticized

the United States and others involved in currency wars. He said they
export their inflation to the emerging market economies. Rajan had to
raise India's prime rate to combat its inflation, risking slower economic
growth.
 How It Affects an Individual
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 Treasurys is
high, their yield is low. Since Treasurys 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 pummelled 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.
 The Next Currency War
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 reserved 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. But they 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. In addition, Greece did not practice good fiscal
management.