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Currency war

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Currency war involves nations competing against each other on the foreign exchange markets to achieve a relatively low exchange rate, in order to boost their exports.

Currency war, also known as Competitive devaluation, is a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their home currency, so as to help their domestic industry.

Competitive devaluation has been rare through most of history as even at times when a system of fixed exchanges rates has not been in place, countries have generally preferred to maintain a high value for their currency or have been content to allow its value to be set by the markets. A widely recognised episode of currency war occurred in the 1930s. According to Brazil's finance minister and to several financial journalists, global currency war has again erupted in 2010, though this has been disputed by other commentators.

The currency war of the 1930s is generally considered to have been an adverse situation for all concerned, with all participants suffering as unpredictable changes in exchange rates reduced international trade. The 2010 outbreak of competitive devaluation is being pursued by different mechanism than was the case in the 1930s and opinion among economists is divided as to whether it will have a net negative effect on the global economy.

Reasons for intentional devaluation

During most historical periods its rare for governments to intentionaly devalue their currencies. For a country with low levels of unemployment, its more common to consider a strong currency desirable. A high exchange rate means a nation's citizens will enjoy more purchasing power, both when they buy foreign goods and when they travel abroad. It helps keep inflation down. A strong currency has often been considered a mark of prestige.

However when a country is suffering from high unemployment or wishes to pursue a policy of export led growth, a lower exchange rate can be viewed as a potential solution. A lower value for the home currency will raise the price for imports while reducing the price for exports. This encourages more production to occur domestically, which raises employment and GDP. Devaluation can be especially attractive as a solution to unemployment when other options like increased public spending are ruled out due to high public debt and also when a country has a balance of payments imbalance which a devaluation would help correct. A reason for preferring devaluation common among emerging economies is that maintaining a relatively low exchange rate helps them build up their foreign exchange reserves, which can protect them against future financial crises.

Mechanism for devaluation

The options a country has to effect a devaluation vary depending on the nation in question and the arrangement of the International monetary system that prevails at the time they wish to devalue. During the 1930s, countries had relatively more direct control over their exchange rates through the actions of their central banks. Following the collapse of the Bretton Woods system in the early 1970s, markets have substantially increased in influence so unless a nation has very strong capital controls their exchange rate is essentially set by the markets. However a nations central bank can still intervene in the markets to effect a devaluation – if it sells its own currency to buy other currencies [1] then this will cause the value of its own currency to fall. Less directly, if a central bank indulges in quantitative easing as had became common in 2009 and 2010, this tends to lead to a fall in the value of its currency even if the bank doesn't directly buy any foreign assets. A third method is for authorities simply to talk down the value of their currency, by hinting at future action that will discourage speculators from betting on a future rise, though this method sometimes has little discernable effect. A fourth method to effect a devaluation is for a central bank to lower its base rate of interest, however this only has limited effect and since the end of WWII most central banks have set their base rate according to the needs of their domestic economy. [2]

Quantitative easing

Quantitative easing (QE)is a practice when a central bank trys to mitigate a potential or actual recession by creating money and injecting it into the domestic economy. There is typically a promise to destroy the newly created money once the economy improves, so as to avoid inflation. QE was widely used as a response to the financial crises that began in 2007, especially by the US , Japan, the UK and to a lesser extent the Euro zone.[3] Theoretically money could be shared out among the entire population, though in practice the new money is often used just to buy assets from financial institutions such as banks, the idea being that the extra money will then flow from them to other areas of the economy where they are needed, boosting spending and investment. QE acts to devalue a nations currency in two indirect ways. Firstly it encourages speculators to bet that the currency will decline in value. Secondly, the large increase in the domestic money supply will lower domestic interest rates, often they will become much lower than interest rates in countries not practicing QE. This creates the conditions for a carry trade, where market participants will have an earner by borrowing in the currency of the country practicing QE, and then lend within a country with a high rate of interest. Beacause they are effectively selling the currency being used for QE on the international markets, this pushes down the currencies value. By October 2010 expectations in the markets are high that the US, UK and Japan will soon embark on another round of QE, with the prospects for the Eurozone to join them less certain.[4]

International conditions required for currency war

For a widespread currency war to occur a large proportion of significant economies must wish to devalue their currencies at once. This has so far only happened during a global economic downturn.

An individual currency devaluation has to involve a corresponding rise in value for at least one other currency. The corresponding rise will generally be spread across all other currencies [5] and so unless the devaluing country has a huge economy and is substantially devaluing, the offsetting rise for any individual currency will tend to be small. In normal times other countries are often content to accept a small rise in the value of their own country or at worst be indifferent to it. However if much of the world is suffering from a recession, low growth or are pursuing strategies which depends on a favourable balance of payments, nations can begin competing with each other to devalue.

History of currency war

Up to 1930

For centuries, governments have slowly devalued their currencies by reducing the percentage of gold in the coins, substituting it for less precious metals in order to finance wars or pay debts. Until the 18th century, the proportion of the world's trade that occurred between nations was very low, so exchanges rates were not generally a matter of great concern. Substantial devaluations occured during the Napoleonic wars but these are not generally considered to have been done for the purposes of economic competition. Until the late 20th century money generally had intrinsic value, often either being convertable in gold or even actually made of gold or other precious metals, and so it made little sense for nations to try to reduce the purchasing power of their currency. Instead, when nations wished to compete economically they practiced mercantilism – this still involved competing to boost exports while limiting imports, but not by means of devaluation. A favoured method was to protect home industries using current account controls such as tariffs. From the 19th century , and especially in Great Britain which for much of the period was the world's largest economy, mercantilism became increasingly discredited by the rival theory of free trade, which held that the best way to encourage prosperity would be to allow trade to occur free of government imposed controls. The intrinsic value of money remained and became increasingly formalised with a gold standard being widely adopted between about 1870–1914, so there was little incentive for devaluation. Following the end of WWI, many countries other than the US experienced recession and few immediately returned to the gold standard, meaning some of the conditions for a currency war were in place. However currency war did not occur as Great Britain was trying to raise the value of its currency back to its prewar levels.[6] By the mid 1920s many former members of the gold standard had rejoined, and while the standard didn't work as successfully at it had pre war, there was no widespread competitive devaluation.[7]

Currency wars during the Great depression

During the Great Depression of the 1930s, most countries abandoned the gold standard, resulting in currencies that no longer had intrinsic value. With widespread high unemployment, devaluations became common. Effectively, nations were competing to export unemployment, a policy that has frequently been described as beggar thy neighbour. [8] However, because the effects of a devaluation would soon be counteracted by a corresponding devaluation by trading partners, few nations would gain an enduring advantage. On the other hand, the fluctuations in exchange rates were often harmful for international traders, and global trade declined sharply as a result, hurting all economies. The currency war of the 1930s is generally considered to have began in 1931 when Great Britain took the pound off the gold standard and to have ended with the Tripartite monetary agreement of 1936.[7] [9]

Bretton Woods era

From the end of WWII until about 1971, the Bretton Woods system of semi- fixed exchanged rates meant that competitive devaluation was not an option, which was one of the design objectives of the systems architects. Additionally, global growth was generally very high in this period, so there was little incentive for the major economies to want to devalue even if it had been possible.[7]

1973 to 2000

While some of the conditions to allow a currency war were in place at various points throughout this period, countries generally had contrasting priorities and at no point were there enough countries simultaneously wanting to devalue to for a currency war to break out.[10] On several occasions countries were desperately attempting not to devalue but to maintain the value of their currency, striving not against other countries but against the markets who wanted them to devalue. Examples include Great Britain during Black Wednesday and various tiger economies during the Asian crises of 1997. During the mid 1980s the US wanted to devalue significantly, but they were able to secure the cooperation of other major economies with the Plaza accord agreement. As free market influences approached their zenith during the 1990s advanced economies and increasingly transition and even emerging economies moved to the view that it was best to leave the running of their economies to the markets and not to intervene even to correct a substantial current account deficit.[7]

2000 to 2008

The 1997 Asian crisis saw several Asian economies running critically low on foreign reserves, leaving them forced to accept harsh terms from the IMF and often causing them to accept low prices for the forced sale of their assets. This shattered faith in free market thinking among developing and emerging economies, and from about 2000 they generally began intervening to keep the value of their currencies low. This enabled them to adopt export led growth strategies while at the same time building up foreign reserves so they would be better protected against further crises. No currency war resulted because on the whole advanced economies accepted this strategy – in the short term it had some benefits for their citizens in that they were able to buy more cheap goods and thus enjoyed a higher material standard of living. The current account defecit of the US grew substantially but the dominant opinion expressed by free market economists and policy makers like Fed Chairman Alan Greenspan and US Treasury secretary Paul O'Neill was that the defecit was not a major concern. [11] Economists such as Michael P. Dooley, Peter M. Garber, and David Folkerts-Landau have described this new economic relationship between emerging economies and the US as Bretton Woods II.[12][13]

Currency war in 2010

By 2009 some of the conditions required for a currency war had returned, with a severe economic downturn seeing global trade in that year decline by 12% . There was a widespread desire among countries to lower their exchange rates, with both advanced and emerging economies effectively competing to devalue.

On 27 September 2010 Brazils finance minister Guido Mantega said that an "international currency war" is underway. Numerous financial journalists have agreed with this view referring to recent interventions by various countries seeking to devalue their exchange rate such as China, Japan and Switzerland.[14][15][16][17] [18]

Other analysts have said fears of a currency war are exaggerated. In September senior policy makers such as IMF managing director Dominique Strauss-Kahn and US treasury secretary Tim Geithner were reported as saying the risk of a genuine currency war breaking out is low, though by early October Mr Strauss-Kahn was warning that risk of a currency war is real. Industry insider Daniel Tenengauzer, head of emerging-market currency and rates strategy at Merrill Lynch has suggested talk of a currency war can be viewed as "political posturing", noting that emerging economies were intervening on a wider scale back in 2009. [19] [20] [21]

In early October just prior to the 2010 annual IMF and World Bank meeting, the Institute of International Finance has called for leading countries to agree on a currency pact to aid the rebalancing of the world economy and to advert the threat of a currency war.[22] [23] Leading financial journalist Martin Wolf has suggested there may be advantages in western economies taking a more confrontational approach against China, which in recent years has been by far the biggest practitioner of competitive devaluation. Though he suggests that rather than using protectionist measures that may spark a trade war, a better tactic would be to use targetted capital controls against China to prevent them buying foreign in order to further devalue the yuan [24], as previously suggested by Centre for European Policy Studies director Daniel Gros. [25] [26]

Chinease premier Wen Jiabao has stated that reforms to rebalance the Chinease economy away from its current dependency on exports are well underway and that the yuan is being allowed to gradually appreaciate. He warned that if China is forced to revalue its currency too fast that would lead to social unrest in China, bankruptcy for export dependent companies and "disaster for the world". [27]

Global perspectives

USA and UK

The USA and to a lesser extent the UK share a position where they have independent currencies in addition to twin deficits - both large current account deficits and large fiscal deficits. Though austerity programmes can address their ficical deficits, the effect of these can only be to move debt from the public to private sector, unless the countries begin earning more than they spend – in other words their overall debt can only be paid off by going into current account surplus.[28] Lowering their exchange rates is considered by some commentators as an important part of their approach to achieve lower current account surpluses. The UK and USA have not directly intervened to devalue their currencies, however their QE programmes have exerted downwards exchange rate preasure. As of October 2010 analysts widely expect that the UK and US will employ additional QE.[4]

China

China has a large current account surplus and huge foreign reserves; in part due to her continued intervention on the markets to keep her currency at a relatively low value compared to the dollar. For much of 2009 and 2010 China has been under pressure from the US to allow her currency to appreciate. In some ways China is well positioned to transition towards growth led by domestic demand, which would allow her to appreciate her currency and reduce her current account surplus while still maintaining high GDP growth and decreasing unemployment. !!IMF However her economy has long been geared towards export led growth, and hence a substantial appreciation could cause a sharp rise in unemployment. The detailed thinking of Chinese policy makers on this issue has not been made public. Leading economic commentators such as Martin Wolf have speculated that China is wary of complying with pressure to allow a substantial currency appreciation as she considers the long period of stagnation Japan experienced after the Plazza accord as in part resulting from Japan allowing a substantial appreciation of her currency against the dollar.[14]

Japan

Japan also has a large current account surplus and in 2009 and 2010 she did allow her currency to appreciate. However in Septermber 2010 Japan intervened to effect a devaluation!! Japan has a number of challenges that limit her ability to allow a devaluation, including an aging population, high public debt (though not net debt as she has high private savings) and vulnerability to deflation. Her September devaluation did not draw widespread international condemnation.[14]

Eurozone

The Eurozone is a special case where some members, principally Germany, enjoy a large current account surplus and so could accept or even benefit from a currency appreciation. Other countries though such as Greece , Spain, Portugal and Ireland have twin deficits and so to a large extent would benefit from a depreciation. While the ECB did practice some QE in 2009, this was to a much lower extent than the USA or UK. The value of the Euro has been effectively left to float, and in fact early in 2010 central authorities intervened to defend the Euro’s value against the market. Following the generally positive results from bank stress testing that were released in summer, market participants have stopped speculating against the Euro, and the currency has tended to rise as a result of other countries practing competitive devalution.

Brazil

Brazil is a large economy which has largely allowed their currency to float freely, with the exception of some low level interventions to counter large capital inflows resulting from major stock sales. As a result, since early 2009 her currency has risen substantially against the dollar, with Goldman Sachs saying the real is the most over valued currency in the world. [15]

Comparison with the 1931-36 currency war

Both periods of competitive devaluation occurred during global economic downturns. An important difference with the 2010 period is that international traders are much better able to hedge their exposures to exchange rate changes due to more sophisticated financial markets. A second difference is that during the later period devaluations have invariably been effected by nations expanding their money supplies – either by creating money to buy foreign currency in the case of direct interventions, or by creating money to inject into their domestic economies in the case of QE programmes. So while there has been no collaborative intent, some economists such as Barry Eichengreen have suggestd the net effect will be similar to semi – coordinated monetary expansion which will help the global economy.[16]

Other uses

The term "currency war" is sometimes used with meanings that are not related to competitive devaluation.

In the 2007 Book Currency wars by Chinese economist Song Hongbing, the term is used in a somewhat opposite sense, to refer to an alleged practice where unscrupulous bankers lend to emerging economies and then speculate against the emerging nation's currency, trying to force it down in value against the wishes of the nations governments. However by 2010 Honbing had also used the term currency war to mean competitive devaluation.

In the 2008 book Currency Wars by John Cooley the term refers to the efforts of a nation's monetary authorities to protect its currency from forgers, whether they are simple criminals or agents of foreign governments trying to devalue a currency and cause excess inflation against the home government's wishes.

The term is also sometimes used to refer to the competition between Japan and China for their currencies to be used as the preferred tender in parts of Asia in the years leading up to Second Sino-Japanese War [29]

Notes and references

  1. ^ In practice this chiefly means purchasing assets such as government bonds that are denominated in other currencies
  2. ^ Wilmott, Paul (2007). "chp 1". Paul Wilmott Introduces Quantitative Finance. Wiley. ISBN 0470319585.
  3. ^ To practice QE on a wide scale it helps to have a reserve currency, as do the US, Japan, UK & Eurozone, otherwise there is a risk of market speculators triggering runaway devaluation to a far greater extent than would be helpful to the country.
  4. ^ a b Gavyn Davies (2010-10-04). "The global implications of QE2". The Financial Times. Retrieved 2010-10-04.
  5. ^ Though not necessarily evenly: in the late 20th and early 21st century countries would often devalue specifically against the dollar, so while the devalueing currency would lower its exchange rate against all currencies, a corresponding rise against the global average might be confined to only the dollar and any currencies currently governed by a dollar peg. As a furhter complication the dollar is often effected by such huge daily flows on the forex that the rise caused by a small devaluation may be offset by other transactions.
  6. ^ This was against the interests of British workers and industrialists who preferred devaluation, but was in the interests of the financial sector, with government being also influenced by a moral argument that they had the duty to restore the value of the pound as many other countries had used it as a reserve currency and trusted GB to maintain its value.
  7. ^ a b c d Eirc Helleiner , Louis W Pauly ; et al. (2005). John Ravenhill (ed.). Global Political Economy. pp. 7–22, 177–204. {{cite book}}: Explicit use of et al. in: |author= (help); Text "publisher Oxford University Press" ignored (help)
  8. ^ Dietmar Rothermund (1996). The Global impact of the Great Depression 1929-1939. Routledge. p. 6-7. ISBN 0415118190.
  9. ^ Robert A. Mundell and Armand Clesse (2000). The Euro as a stabilizer in the international economic. Springer. p. 284. ISBN 0792377559.
  10. ^ Though a few commentators have asserted the Nixon shock was in part an act of currency war.
  11. ^ Carmen Reinhart and Kenneth Rogoff (2010). This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press. pp. 208–212. ISBN 0199265844.
  12. ^ Michael P. Dooley, David Folkerts-Landau, Peter Garber (September 2003). "An Essay on the Revived Bretton Woods System". National Bureau of Economic Research.{{cite web}}: CS1 maint: multiple names: authors list (link)
  13. ^ Michael P. Dooley, David Folkerts-Landau, Peter Garber (February 2009). "Bretton Woods II Still Defines the International Monetary System". National Bureau of Economic Research.{{cite web}}: CS1 maint: multiple names: authors list (link)
  14. ^ a b c Martin Wolf (2010-09-29). "Currencies clash in new age of beggar-my-neighbour". The Financial Times. Retrieved 2010-09-29.
  15. ^ a b Jonathan Wheatley in São Paulo and Peter Garnham in London (2010-09-27). "Brazil in 'currency war' alert". The Financial Times. Retrieved 2010-09-29.
  16. ^ a b Alan Beattie (2010-09-27). "Hostilities escalate to hidden currency war". The Financial Times. Retrieved 2010-09-29.
  17. ^ Ambrose Evans-Pritchard (2010-09-29). "Capital controls eyed as global currency wars escalate". The Daily Telegraph. Retrieved 2010-09-29. {{cite web}}: Italic or bold markup not allowed in: |publisher= (help)
  18. ^ West inflates EM 'super bubble'. The Financial Times. 2010-09-29. Retrieved 2010-09-29.
  19. ^ Emily Kaiser and Lesley Wroughton (2010-10-04). "Currency war fears tinge IMF meetings". Reuters. Retrieved 2010-10-04.
  20. ^ Tenengauzer Dismisses Currency War Threats as Posturing. Bloomberg L.P. 2010-09-28. Retrieved 2010-10-04.
  21. ^ Alan Beattie in (2010-10-05). "IMF chief warns on exchange rate wars". The Financial Times. Retrieved 2010-09-06.
  22. ^ Alan Beattie and Tom Braithwaite (2010-10-04). "Call for new  global currencies deal". The Financial Times. Retrieved 2010-10-04.
  23. ^ Richard Blackden (2010-10-04). "World's powers must head off threat of currency war". The Daily Telegraph. Retrieved 2010-10-06. {{cite web}}: Italic or bold markup not allowed in: |publisher= (help)
  24. ^ Unless China lifts their existing capital controlss to allow foreigners to make reciprocal purchases of Chinease assets
  25. ^ Martin Wolf (2010-10-05). "How to fight the currency wars with stubborn China". The Financial Times. Retrieved 2010-10-06.
  26. ^ Daniel Gros (2010-09-23). "How to Level the Capital Playing Field in the Game with China". CEPS. Retrieved 2010-10-06.
  27. ^ Alan Beattie in Washington, Joshua Chaffin in Brussels and Kevin Brown in Singapore (2010-10-06). "Wen warns against renminbi pressure". The Financial Times. Retrieved 2010-10-06.
  28. ^ Though if high growth or inflation was an option that would reduce the burden of the debt.
  29. ^ Shigru Akita and Nicholas J. White (2009). The International Order of Asia in the 1930s and 1950s. Ashgate. p. 284. ISBN 0754653412.
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