Currency war | Commercial awareness on The Gateway

Currency war

Will Hodges asks if we're on the verge of a global currency conflict

They say Japan is at it. The US and China are thought to have been going at it for months. The European Central Bank (ECB) is rumoured to be thinking about it. If the financial media are to be believed, a currency war is on the verge of breaking out on a global scale.

With much of the global economy still struggling to find a path back to growth, there is speculation that many countries are deliberately devaluing their currencies in order to boost their export competitiveness. This competitive devaluation between countries is also known as currency war.

Waging war

The strongest evidence that a currency war is being waged is in Japan. Newly elected prime minister Shinzo Abe recently announced his determination to force down Japan's currency, the yen, to boost exports. The yen has dropped sharply against other major global currencies in recent months, falling by 20 per cent against the US dollar and 30 per cent against the euro since October 2012.

The speed of its drop in value has fuelled speculation that Japan is going back on recent pledges made by the G20 group of countries not to make deliberate attempts to manipulate their currency. The concern is that currency manipulation by Japan may give the green light to other states to follow suit.

China, the world's largest exporter of goods, has more reason than most to follow a currency devaluation strategy. The country's rapid economic growth since the 1990s has been based on its ability to undercut other producers through the comparatively low cost of its products. But a jump in the cost of labour and fuel has started to weigh on the country's export-led growth model, forcing the government to look at new ways to boost competitiveness.

China's central bank deputy governor Yi Gang is quoted as saying: "China is prepared. In terms of both monetary policies and other mechanisms, China will take into full account the quantitative easing policies implemented by central banks of foreign countries."

China's threat to break the G20 agreement is being echoed in Europe, where there are rumours that the European Central Bank (ECB) will soon have to resort to reducing the value of the euro in order to help battered southern European economies export their way out of their current predicament. But speaking in March, ECB president Mario Draghi downplayed suggestions that the bank was considering such a move.

What are the advantages of currency devaluation?

The main benefit of currency devaluation is that it makes exports cheaper, and therefore more popular. This is because as the value of a currency falls, the relative cost of goods produced by that country also falls, which boosts demand from overseas. Meanwhile, the relative cost of imported goods rises, which boosts domestic demand for local products.

Together, these factors tend to reduce unemployment because manufacturing activity rises, creating jobs. A devaluation strategy was pursued by many states during the Great Depression of the 1930s as governments battled to contain high levels of unemployment.

What are the disadvantages of currency devaluation?

Currency devaluation can also produce negative economic effects. Devaluation increases the cost of importing goods, which hits countries that have relatively few natural resources such as Japan especially hard. Higher import costs are then passed on to ordinary people, leading to lower levels of disposable income and reduced consumer spending. In addition, a fall in the value of a country's currency will make it more expensive to borrow money on international markets and increase the cost of interest payments.

The outbreak of a currency war is also likely to have negative consequences for the global economy. When too many countries devalue their currencies at one time, it risks causing havoc on foreign exchange markets. With the World Trade Organisation (WTO) having downgraded its 2013 forecast for global trade growth to just 2.5 per cent, the world economy can ill afford a further shock to its stability.

How is it done?

The most direct form of currency devaluation is what China and, more recently, Japan have been accused of employing, which is to manipulate international exchange markets in their favour. Central banks may choose to sell large amounts of their country's own currency to buy foreign currency, typically US dollars, in the form of cash or government bonds. This causes the value of the local currency to depreciate as a greater supply comes on to the market, while the quantity of the foreign currency in circulation is reduced, causing it to increase in value as demand is higher.

Over the past few months a different, indirect form of currency depreciation has been achieved in the UK and US as a side-effect of their governments' quantitative easing programmes. Central banks in both countries have been buying up government bonds in an attempt to inject more capital into their economies. The increase in the supply of money has had a downward effect on the value of both the pound and the dollar.

A war of attrition

At a recent G20 meeting it was agreed that indirect currency depreciation through quantitative easing would be allowed, within reason, as the objective is to boost domestic growth rather than manipulate money markets. But this is a risky policy, as countries may be allowed to get away with currency manipulation under the pretext of economic expansion. The significant fall in the value of the yen over recent months suggests that at least one country is pursuing this strategy, while American accusations that China has been following such a line stretch back several years.

With no government willing to be outwardly seen to be breaking the G20 agreement, it's difficult to prove that any country is engaging in underhand tactics to boost exports. It appears that tales of currency wars will remain in the financial press, at least for now.

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