The ongoing US-China trade war has been filling the news headlines, with the world’s two largest economies locked in a struggle to impose ever-greater tariffs on each other’s goods in order to gain trade dominance. And now there is a new dimension: a currency war. But what is a currency war, and how does it work?
Also known as competitive devaluation, a currency war occurs when countries deliberately attempt to depreciate the value of their own currencies. On face value this seems a strange thing to do: why would a country devalue its own currency? The reason is that currency devaluation can stimulate a country’s own economy. By causing the exchange rate of its own currency to fall against other currencies, a country can boost its trading position. As the exchange rate of its currency falls, a country’s exports become more competitive overseas, while imports become more expensive. The currency devaluation therefore has a double benefit for the domestic economy.
So, illogical as it may seem, a strong currency is not necessarily an advantage for a country. Higher export volumes, due to competitive pricing, will stimulate economic growth and because imports have become more expensive, consumers are more likely to favour locally-produced goods. This change in the terms of trade usually means a lower current account deficit, which is a measure of a country’s trade balance, since the value of imported goods and services exceeds the value of exported products.
Currency devaluation is a common feature in the foreign exchange market. Devaluation occurs when the exchange rate of one currency drops against the value of other currencies, and fluctuations are simply the natural outcome of the floating exchange rate system. The relative value of one currency against another is determined by a wide number of factors, such as economic performance and outlook, interest rates, and inflation.
As these factors are constantly changing, currency values will fluctuate from one moment to the next. For the typical consumer, the exchange rate will only have a bearing when international transactions are involved – remittances being a prime example. Most countries let market forces influence exchange rates, and finance ministers from the Group of 20 countries have repeatedly urged policy makers not to manipulate exchange rates. However, countries are increasingly looking at currency manipulation as an economic weapon.
The term ‘currency war’ was coined in 2010 by Guido Mantega, the Brazilian minister for finance, but competitive devaluation is nothing new and has been practised for decades. Due to the China-US trade conflict it has been increasingly frowned on as an aggressive economic act, with policy makers deliberately driving down exchange rates, or fixing them too low, to secure an advantage. It’s a situation that can spiral when nations retaliate in a tit-for-tat competition, as we are now witnessing with the US-China trade war developing into a currency fight.
So how does a country weaken its currency? Put simply, it happens when a central bank decides to make its currency less valuable as part of its monetary policy. Let’s take the recent example of China. Every morning the bank announces its desired foreign exchange rate for the yuan, and allows it to rise and fall through the day according to market forces. For the last 11 years, the bank has kept the yuan below a 7-to-1 ratio against the dollar. In August 2019, it set the yuan’s exchange rate below the 7 benchmark for the first time in in 11 years. This was a response to new tariffs imposed by the United States on Chinese imports.
Because China pegs its currency to the dollar, all it has to do to devalue the yuan is adjust the peg. However, because most major world economies are free floating and not pegged to a currency, it is more complex to devalue their currencies. There are a number of ways a central bank can devalue a free-floating currency, such as quantitative easing (increasing the supply of the currency) and lowering interest rates.
The economic effect of a currency devaluation can be significant. When China devalued the yuan in 2015 it was felt worldwide. Most currencies were also impacted, notably the Indian rupee, Singapore dollar, Korean won, Malaysian ringgit, and the Indonesian rupiah. Once again, following the recent devaluation, currencies in Asia are feeling the effects.
In a new report, the Institute of International Finance concludes is that if the yuan depreciates further, the currencies of emerging-market nations will suffer. For example, the Indian rupee fell by 3.65% against the dollar during August, the biggest monthly decline in six years. It was also heavily affected in 2015, when the rupee plunged to a two-year low against the dollar and remained low for the remainder of the year. This led to a surge in remittances because the weakened rupee made exchange rates more attractive.
While the economic effect of devaluing a currency may improve a country’s trading position, there are also downsides. In making exports more competitive, and imports more expensive, devaluation can both decrease purchasing power and lead to inflation. In the long run, currency devaluation may lower productivity because imports that are needed to support local businesses may become too expensive.
When considering the impact on exchange rates due to devaluation, remittances are of course part of the complex web of cause and effect, profit and loss. In a war, real or economic, there are always winners and losers. With currencies, volatility will create opportunities for any transaction that involves pairs. As one currency rises, another must fall – to someone’s advantage or disadvantage.