Currency War: Definition, How It Works, Effects, and Example

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What Is a Currency War?

A currency war is an escalation of currency devaluation policies among two or more nations, each of which is trying to stimulate its own economy. Currency prices fluctuate constantly in the foreign exchange market. However, a currency war is marked by a number of nations simultaneously engaged in policy decisions aimed at devaluing their own currencies.

Nations devalue their currencies primarily to make their own exports more attractive on the world market.

Key Takeaways

  • A currency war is a tit-for-tat policy of official currency devaluation aimed at improving each nation’s foreign trade competitiveness at the expense of other nations.
  • A currency devaluation is a deliberate move to reduce the purchasing power of a nation’s own currency.
  • Countries may pursue such a strategy to gain a competitive edge in global trade and reduce their sovereign debt burden.
  • Devaluation can have unintended consequences that are self-defeating. The worst of these is inflation. The nation’s consumers bear the burden of higher prices on imports.

Understanding Currency Wars

In a currency war, sometimes referred to as competitive devaluation, nations devalue their currencies in order to make their own exports more attractive in markets abroad. By effectively lowering the cost of their exports, the country’s products become more appealing to overseas buyers.

At the same time, the devaluation makes imports more expensive to the nation’s own consumers, forcing them to choose home-grown substitutes.

This combination of export-led growth and increased domestic demand usually contributes to higher employment but faster economic growth.

It may also lower a nation’s productivity. The nation’s businesses may rely on imported equipment and machinery to expand their production. If their own currency is devalued, those imports may become prohibitively expensive.

Economists view currency wars as harmful to the global economy because these back-and-forth actions by nations seeking a competitive advantage could have unforeseen adverse consequences, such as increased protectionism and trade barriers.

Some monetary policy decisions may have the effect of currency devaluation. Reducing interest rates and quantitative easing (QE), are both examples.

Are We in a Currency War Now?

In the current era of floating exchange rates, currency values are determined primarily by market forces. However, currency depreciation can be engineered by a nation’s central bank through economic policies that have the effect of reducing the currency’s value.

Reducing interest rates is one tactic. Another is quantitative easing (QE), in which a central bank buys large quantities of bonds or other assets in the markets.

These actions are not as overt as currency devaluation but the effects may be the same.

The combination of private and public strategies introduces more complexities than the currency wars of decades ago when fixed exchange rates were prevalent and a nation could devalue its currency by the simple act of lowering the “peg” to which its currency was fixed.

Currency War or ‘Competitive Devaluation’?

“Currency war” is not a term that is loosely bandied about in the genteel world of economics and central banking, which is why former Brazilian Finance Minister Guido Mantega stirred up a hornet’s nest in September 2010 when he warned that an international currency war had broken out.

In more recent times, nations that adopt a strategy of currency devaluation have underplayed their activities, referring to it more mildly as “competitive devaluation.”

A currency war is sometimes referred to by the less-threatening term “competitive devaluation.”

In 2019, the central banks of the U.S., the Bank of England, and the European Union were engaged in a “covert currency war,” according to a report in CNBC. With interest rates at rock bottom, currency devaluation was one of the only weapons the central banks had left to stimulate their economies.

In the same year, after the Trump administration imposed tariffs on Chinese goods, China retaliated with tariffs of its own as well as devaluing its currency against its dollar peg. That could have escalated a trade war into a currency war.

Why Depreciate a Currency?

It may seem counter-intuitive, but a strong currency is not necessarily in a nation’s best interests.

A weak domestic currency makes a nation’s exports more competitive in global markets while simultaneously making imports more expensive. Higher export volumes spur economic growth, while pricey imports have a similar effect because consumers opt for local alternatives to imported products.

This improvement in the terms of trade generally translates into a lower current account deficit (or a greater current account surplus), higher employment, and faster growth in gross domestic product (GDP).

The stimulative monetary policies that usually result in a weak currency also have a positive impact on the nation’s capital and housing markets, which in turn boosts domestic consumption through the wealth effect.

Beggar Thy Neighbor

Since it is not too 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 soon follow suit, followed by nation C, and so on. This is the essence of competitive devaluation.

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

The U.S. Dollar’s Surge

When Brazilian minister Mantega warned back in September 2010 about a currency war, he was referring to the growing turmoil in foreign exchange markets, sparked by new strategies adopted by several nations. The U.S. Federal Reserve’s quantitative easing program was weakening the dollar, China was continuing to suppress the value of the yuan, and a number of Asian central banks had intervened to prevent their currencies from appreciating.

Ironically, the U.S. dollar continued to appreciate against almost all major currencies from then until early 2020, with the trade-weighted dollar Index trading at its highest levels in more than a decade.

Then, in early 2020, the coronavirus pandemic struck. The U.S. dollar fell from its heady heights and remained lower. That was just one side effect of the coronavirus pandemic and the Fed’s actions to increase the money supply in response to it.

The U.S. Strong Dollar Policy

The U.S. has generally pursued a “strong dollar” policy for many years with varying degrees of success. The U.S. economy withstood the effects of a stronger dollar without too many problems, although one notable issue is the damage that a strong dollar causes to the earnings of American expatriate workers.

However, the U.S. situation is unique. It is the world’s largest economy and the U.S. dollar is the global reserve currency. The strong dollar increases the attractiveness of the U.S. as a destination for foreign direct investment (FDI) and foreign portfolio investment (FPI).

Not surprisingly, the U.S. is a premier destination in both categories. The U.S. is also less reliant on exports than most other nations for economic growth because of its giant consumer market, by far the biggest in the world.

The Pre-COVID-19 Situation

The dollar surged in the years before the COVID-19 pandemic primarily because the U.S. was the first major nation to unwind its monetary stimulus program, after being the first one out of the gate to introduce QE.

The long lead-time enabled the U.S. economy to respond positively to the Federal Reserve’s successive rounds of QE programs.

Other global powerhouses like Japan and the European Union were relatively late to the QE party. Canada, Australia, and India, which had raised interest rates soon after the end of the Great Recession of 2007-09, had to subsequently ease its monetary policy because growth momentum slowed.

Policy Divergence 

While the U.S. implemented its strong dollar policy, the rest of the world largely pursued easier monetary policies. This divergence in monetary policy is the major reason why the dollar continued to appreciate across the board.

The situation was exacerbated by a number of factors:

  • Economic growth in most regions was below historical norms; many experts attributed this sub-par growth to fallout from the Great Recession.
  • Most nations exhausted all other options to stimulate growth, with interest rates at historic lows. With no further rate cuts possible and fiscal stimulus not a controversial option, currency depreciation was the only tool remaining to boost economic growth.
  • Sovereign bond yields for short-term to medium-term maturities had turned negative for a number of nations. In this extremely low-yield environment, U.S. Treasuries attracted a great deal of interest, leading to more dollar demand.

Negative Effects of a Currency War

Currency depreciation is not a panacea for all economic problems. Brazil is a case in point. The country’s attempts to stave off its economic problems by devaluing the Brazilian real created hyperinflation and destroyed the nation’s domestic economy.

So what are the negative effects of a currency war? Currency devaluation may lower productivity in the long term since imports of capital equipment and machinery become too expensive for local businesses. If currency depreciation is not accompanied by genuine structural reforms, productivity will eventually suffer.

Among the hazards:

  • The degree of currency depreciation may be greater than what is desired, which may cause rising inflation and capital outflows.
  • Devaluation may lead to demands for greater protectionism and the erection of trade barriers, which would impede global trade.
  • Devaluation can increase the currency’s volatility in the markets, which in turn leads to higher hedging costs for companies and even a decline in foreign investment.

The Bottom Line

It does not appear that the world is currently in the grips of a currency war. Recent rounds of easy money policies by numerous countries represent efforts to combat the challenges of a low-growth, deflationary environment, rather than an attempt to steal a march on the competition through overt or surreptitious currency depreciation.

What Harm Can a Currency War Do?

A currency devaluation, deliberate or not, can damage a nation’s economy by causing inflation. If its imports rise in price. If it cannot replace those imports with locally sourced products, the country’s consumers simply get stuck with the bill for higher-priced products.

A currency devaluation becomes a currency war when other countries respond with their own devaluations, or with protectionist policies that have a similar effect on prices. By forcing up prices on imports, each participating country may be worsening their trade imbalances instead of improving them.

Does Chinese Currency Affect Trade Wars?

It may be the reverse: a trade war damages the currency of the country it targets.

The United States has an enormous trade gap with China. That is, the U.S. imports more than $271 billion worth of goods from China and exports nearly $72 billion, as of June 2022.

In 2020, then-President Donald Trump tried to correct that imbalance by imposing a raft of tariffs on Chinese goods entering the U.S. This protectionist policy was aimed at increasing the prices of Chinese goods and therefore making them less attractive to U.S. buyers.

One effect was an apparent shift in U.S. manufacturing orders from China to other Asian nations such as Vietnam. Another effect was a weakening of the Chinese currency, the renminbi. Less demand for Chinese products led to less demand for the Chinese currency.

What Do Countries Try to Achieve in a Currency War?

A country devalues its currency in order to decrease its trade deficit. The goods it exports become cheaper, so sales rise. The goods it imports become more expensive, so their sales decline in favor of domestic products. The end result is a better trade balance.

The problem is, other nations may respond by devaluing their own currencies or imposing tariffs and other barriers to trade. The advantage is lost.

Is India in a Currency War?

The U.S. Treasury Department placed India on its watchlist of currency manipulators in April 2021. It cited India’s outsized purchase of U.S. dollars as a possible attempt at currency manipulation.

India’s rupee hit a record low of 1 U.S. dollar to 76.68 Indian rupees in April 2020, at the start of the global economic crisis caused by the COVID-19 pandemic.

The rupee has had a tumultuous history since its introduction in 1947 when the nation achieved its independence. The nation moved from a dollar peg to a floating currency in 1991 and, at the same time, devalued the currency to about 1 U.S. dollar to 25 rupees.

The rupee’s value remained relatively high through the first years of its remarkable economic growth but faltered during the economic crisis of 2008-2009.

As of Feb. 5, 2022, it remained relatively low at 1 U.S. dollar to 74.64 rupees.