CURRENCY WARS

Apurv Chauhan 2010CE10333 Divyam Rastogi 2010CE10313

INTRODUCTION

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 own currency. As the price to buy a particular currency falls so too does the real price of exports from the country. Imports become more expensive. So domestic industry, and thus employment, receives a boost in demand from both domestic and foreign markets.

Brazilian Finance Minister Guido Mantega, who made headlines when he raised the alarm about a Currency War in September 2010.

BEGGAR THY NEIGHBOUR

Competitive devaluation has been rare through most of history as countries have generally preferred to maintain a high value for their currency. Countries have allowed market forces to work or have participated in systems of managed exchanges rates. An important episode of currency war occurred in the 1930s

Reasons for intentional devaluation

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 seen as advantageous. In 1980s the International Monetary Fund (IMF) has proposed devaluation as a potential solution for developing nations that are consistently spending more on imports than they earn on exports

Devaluation, with its adverse consequences, has historically rarely been a preferred strategy It also can add to inflationary pressure.

Effects

A lower value for the home currency will raise the price for imports while making exports cheaper. This tends to encourage more domestic production, which raises employment and Gross Domestic Product (GDP). Devaluation can be seen as an attractive solution to unemployment when other options, like increased public spending, are ruled out due to high public debt, or when a country has a balance of payments deficit balance of payments deficit which a devaluation would help correct.

Effects

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: Selling currency

A state's central bank can intervene in the markets to effect a devaluation if it sells its own currency to buy other currencies then this will cause the value of its own currency to fall a practice common with states that have a managed exchange rate regime.

Mechanism for devaluation: Speculation

Another method is for authorities simply to talk down the value of their currency by hinting at future action to discourage speculators from betting on a future rise, though sometimes this has little discernible effect

Mechanism for devaluation: Lowering rate of interest

Central bank can effect a devaluation by lowering its base rate of interest, however this sometimes has limited effect, and, since the end of World War II, most central banks have set their base rate according to the needs of their domestic economy

Quantitative Easing

Quantitative Easing (QE) is the practice in which a central bank tries to mitigate a potential or actual recession by increasing the money supply for its domestic economy. This can be done by printing money and injecting it into the domestic economy via open market operations. There may be a promise to destroy any newly created money once the economy improves in order to avoid inflation.

How QE works

It can encourage speculators to bet that the currency will decline in value. 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 practising quantitative easing. This creates the conditions for a carry trade, where market participants can engage in a form of arbitrage, borrowing in the currency of the country practising quantitative easing, and lending in a country with a relatively high rate of interest. Because they are effectively selling the currency being used for quantitative easing on the international

In early November 2010 the United States launched QE2, the second round of quantitative easing, which had been expected. The Federal Reserve made an additional $600 billion available for the purchase of financial assets. This prompted widespread criticism from China, Germany, and Brazil that the United States was using QE2 to try to devalue its currency without consideration to the effect the resulting capital inflows might have on emerging economies

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.

Currency War in 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 Beggar they neighbor: 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.

Currency War in the Great Depression

The three principal parties were Great Britain, France, and the United States. For most of the 1920s the three generally had coinciding interests, both the US and France supported Britain's efforts to raise Sterling's value against market forces. Collaboration was aided by strong personal friendships among the nations' central bankers

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 states simultaneously wanting to devalue to for a currency war to break out On several occasions countries were desperately attempting not to cause a devaluation but to prevent one

2000 to 2008

US China conflict and Chimerica By 2005 a chorus of US executives along with trade union and mid-ranking government officials had been speaking out about what they perceived to be unfair trade practices by China.

Competitive devaluation after 2009

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 about 12%. There was a widespread concern among advanced economies concerning the size of their deficits; they increasingly joined emerging economies in viewing export led growth as their ideal strategy. Reuters suggested that both China and the United States were "winning" the currency war, holding down their currencies while pushing up the value of the Euro, the Yen, and the currencies of many emerging economies

Comparison between 1930s and 21st century currency war

Both the 1930s episode and the outbreak of competitive devaluation that began in 2009 occurred during global economic downturns. An important difference with the 2010s period is that international traders are much better able to hedge their exposures to exchange rate volatility due to more sophisticated financial markets.

Comparison between 1930s and 21st century currency war

Another difference is that during the latter period devaluations have invariably been effected by nations expanding their money supplieseither by creating money to buy foreign currency, in the case of direct interventions, or by creating money to inject into their domestic economies, with quantitative easing.

CURRENT SCENARIO

In January 2013, measures announced by Japan which are expected to devalue its currency sparked concern of a possible second 21st century currency war breaking out, this time with the principal source of tension being not China versus the US, but Japan versus the Eurozone. By late February, concerns of a new outbreak of currency war has been partially allayed after statements from the G7 and G20 groups of nations made commitments to avoid competitive devaluation.

Currency war in 2013

Japan's economy minister Akira Amari has said that the Bank of Japan's bond buying programme is intended to combat deflation, and not to weaken the yen. A mid February statement from the G7 affirmed the advanced economies commitment to avoid currency war

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