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 nation's central bank uses expansionary monetary policy to deliberately lower the value of its money. The strategy is also called competitive devaluation. In a currency war, countries compete by devaluing their currency. Instead of making their exports better, they make them cheaper. Businesses can export more and the country benefits from stronger economic growth. But currency devaluation also makes imports more expensive. That hurts consumers and adds to inflation.
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.
Most countries are on a flexible exchange rate. They must increase the money supply to lower the currency's value. A central bank has many tools to increase the money supply by expanding credit. It can lower interest rates. It can also just add credit to a nation's bank reserves. 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. Usually, it does it for political reasons, not to engage in a currency war.
United States Currency War
The United States allows its currency, the dollar, to devalue. It uses expansionary fiscal and monetary policy. Federal deficit spending increases the debt. That exerts downward pressure on the dollar by making it less attractive to hold. The Federal Reserve kept the fed funds rate near zero between 2008 - 2015. That increased credit and the money supply. When supply outweighs demand, the value of the dollar drops.
These aren't normal times. Since the financial crisis, the dollar has retained its value despite expansionary policies. That's because it is 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 dollar 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. A high yen value makes those exports cost more in the United States and other countries. It reduces demand and slows Japan's economic growth.
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 of 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. 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.
Forex traders created the opposite problem for Japan 10 years ago, creating 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.
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 .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 drive the currencies higher of Brazil and other emerging market countries. It raises the prices of commodities. Oil, copper, and iron are these countries' primary exports. That makes emerging market countries less competitive and slows their economies.
In fact, India's former central bank governor, Raghuram Rajan, criticized the United States and others involved in currency wars. 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
One of the world's richest men is Mexican telecom titan Carlos Slim. He said that the 2010 currency wars between the United States and China resulted in higher food prices.
As the value of the dollar declines relative to other currencies, the prices of imports will rise. We have already seen an increase in food and oil prices. It also lowers the price of U.S. exports, which helps economic growth. It also makes the U.S. stock market a good deal.
China's Treasury 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.