What is a currency war?

A currency war is an escalation of currency depreciation policies between two or more countries attempting to stimulate their economy. Constant fluctuations in currency prices characterize the foreign exchange market. On the other hand, a currency war is defined by several nations simultaneously engaged in policy decisions to devalue their currencies.

Nations devalue their currencies primarily to increase the attractiveness of their exports on the global market. In a currency war, also known as competitive devaluation, governments devalue their money to make their exports more appealing in foreign markets. The country’s products become more attractive to overseas buyers by effectively lowering the cost of their exports.

At the same time, the depreciation makes imports more expensive for domestic consumers, forcing them to opt for home-grown alternatives.

This mix of export-led growth and increased domestic demand typically leads to higher employment but faster economic growth.

Are we in a currency war now?

Market forces primarily determine currency values in the current floating exchange rate era. On the other hand, currency depreciation can be engineered by a country’s central bank through economic policies that reduce the currency’s value.

One strategy is to lower interest rates. Another method is quantitative easing (Q.E.), in which a central bank purchases large quantities of bonds or other marketable assets.

Currency war” is not a term that is thrown around loosely in the sophisticated world of economics and central banking, which is why former Brazilian Finance Minister Guido Mantega sparked outrage in September 2010 when he warned that an international currency war had broken out.

Countries that use a currency devaluation strategy have downplayed their actions, referring to them as “competitive devaluation.”

The central banks of the United States, the United Kingdom, and the European Union were engaged in a “covert currency war” in 2019. With interest rates at all-time lows, currency depreciation was one of the few tools available to central banks to stimulate their economies.

After the Trump administration imposed tariffs on Chinese goods in the same year, China retaliated by imposing tariffs and devaluing its currency against its dollar peg. A trade war could have devolved into a currency war due to this. A weak domestic currency increases a country’s export competitiveness in global markets while making imports more expensive. Higher export volumes stimulate economic growth, while expensive imports have a similar effect because consumers prefer domestic alternatives to imported products.

This improvement in trade terms generally translates into a lower current account deficit (or an enormous current account surplus), higher employment, and faster GDP growth (GDP).

The stimulative monetary policies that usually result in a weak currency also positively impact the country’s capital and housing markets, boosting domestic consumption via the wealth effect. Because it is not difficult to pursue growth through currency depreciation, whether overt or covert, it should come as no surprise that if nation A devalues its currency, nation B will quickly follow, followed by nation C, and so on. It is what competitive devaluation is all about.

The phenomenon is also known as “beggar thy neighbor,” which is not a Shakespearean phrase but a national monetary policy of competitive devaluation pursued at the expense of other countries.

The U.S. Dollar’s surge

When Brazilian Minister Mantega warned of a currency war in September 2010, he referred to the increasing turmoil in foreign exchange markets caused by new strategies adopted by several nations. The Federal Reserve of the United States’ quantitative easing program weakened the dollar. China was still suppressing the yuan’s value, and several Asian central banks had intervened to prevent their currencies from appreciating.

Until early 2020, the U.S. dollar appreciated against almost all major currencies, with the trade-weighted dollar Index trading at its highest levels in more than a decade. For many years, the United States has generally pursued a “strong dollar” policy with varying degrees of success. The effects of a stronger dollar did not cause too many problems for the U.S. economy. However, one significant issue is the damage that a strong dollar causes to the earnings of American expatriate workers.

However, the situation in the United States is unique. It has the world’s largest economy, and the U.S. dollar serves as the world’s reserve currency.

Not surprisingly, the United States is a top destination in both categories. Because of its massive consumer market, which is the largest globally, the United States is also less reliant on exports for economic growth than most other countries.

Policy divergence

While the United States pursued its firm dollar policy, the rest primarily pursued more accommodative monetary policies. This disparity in monetary policy is the primary reason why the dollar has continued to rise across the board.

Several factors aggravated the situation:

Economic growth in most regions was below historical norms, with many experts attributing this to the aftermath of the Great Recession.

With interest rates at historic lows, most countries have exhausted all other options for stimulating growth. With no further rate cuts on the horizon and fiscal stimulus, not a contentious option, currency depreciation was the only tool left to boost economic growth.

Adverse effects of a currency war

Currency depreciation is not a cure-all for all economic ills. Brazil is a prime example. The country’s attempts to solve its financial problems by devaluing the Brazilian actual resulted in hyperinflation and the destruction of the domestic economy.

What are the negative consequences of a currency war? Currency depreciation may reduce productivity in the long run by making imports of capital equipment and machinery prohibitively expensive for local businesses. Productivity will suffer if genuine structural reforms do not accompany currency depreciation.

Among the dangers are:

Currency depreciation may be more significant than desired, resulting in rising inflation and capital outflows.

Depreciation may lead to increased protectionism and the erection of trade barriers, thereby impeding global trade.

Currency depreciation can increase currency volatility in the markets, resulting in higher hedging costs for businesses and even a drop in foreign investment.

Whether intentional or unintentional, currency depreciation can harm a country’s economy by causing inflation. Suppose the cost of its imports rises. If it cannot replace those imports with locally sourced products, the country’s consumers will be forced to foot the bill for higher-priced goods.

When other countries respond to a currency devaluation with their devaluations or protectionist policies that have a similar effect on prices, a currency devaluation becomes a currency war. By forcing up import prices, each participating country may worsen rather than improve their trade imbalances.

To sum up

The world does not appear to be in the grip of a currency war. Recent rounds of easy money policies implemented by many countries intended to combat the challenges of a low-growth, deflationary environment rather than steal a competitive advantage through overt or covert currency depreciation.

A debt crisis in one country, whether in the private or public sector, can and frequently spread economic pain to other countries. It can occur due to a tightening of financial conditions, such as an increase in interest rates, a slowdown in trade and economic growth, or simply a sharp drop in confidence. It is especially true if the affected country is large and intricately linked to the global economy.