Former Brazilian Finance Minister Guido Mantega is generally credited with coining the phrase “currency war” in 2010, though the idea of one goes back much further than that.
“We’re in the midst of an international currency war,” Mantega said in a speech to Brazilian industrial leaders in September of that year. He was reacting to moves by Japan, China and other countries to lower the value of their currencies at the expense of his own country.
“The advanced countries are seeking to devalue their currencies,” Mantega added, also mentioning the U.S. and Europe. “This threatens us because it takes away our competitiveness.”1)
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.2)
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-neighbor’ interest rate policies tend to encourage a domino effect: The fall of one currency leads to the irritating rise of another, and so on.”3)
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 spiraled into trade wars that made the Depression even worse.4)
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.5)
RACE TO THE BOTTOM
“A currency war is really a race to the bottom, whereby 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 are anti-growth and deflationary.”6)
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.7)
“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.”8)
HOW COUNTRIES WEAKEN THEIR CURRENCIES
Countries can devalue their currencies in several ways.
Countries with fixed exchange rates merely announce the new value of their currency. The value of most countries’ currencies, however, varies according to supply and demand in the forex markets. In order to lower the value, they can sell their own currencies, increase the money supply and lower interest rates.
During the financial crisis, for example, the U.S. Federal Reserve not only lowered short-term interest rates but also purchased trillions of dollars of government securities. This boosted bond prices and in turn lowered bond yields, making them less attractive to investors.
It also had the effect of reducing the attractiveness of holding dollars. Nevertheless, the value of the dollar eventually rose during this time because the U.S. was viewed as a safe haven during difficult economic times.
Countries also often find themselves in a currency war, or are accused of fighting one, even if that’s not the intention.
For example, in August 2015 and January 2016, China “startled foreign exchange markets” by allowing the value of the yuan, which had been loosely pegged to the dollar, to fall in response to the rising USD in order to make Chinese goods more attractive to American consumers.9)
IMF RULES ON 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.”10)
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.”11)
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.
A currency war refers to the simultaneous devaluation or depreciation of currencies by multiple countries.
If one country decides to lower the value of its currency in order to make its goods and services cheaper in foreign markets as a way of boosting economic growth, other countries may feel obligated to do the same in order to protect their own currencies and economies or to retaliate.
This could set off a full-scale escalation of “competitive devaluations” that exacerbate into trade wars.