Currency Wars and How They Work With Examples

Why Global Currency Wars Aren't as Dangerous as They Sound 

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.

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.

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 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'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 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 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.