What Is A Currency War And How Does It Work?

how does currency hedging work

A currency war refers to a situation where a number of nations seek to deliberately depreciate the value of their domestic currencies in order to stimulate their economies. Although currency depreciation or devaluation is a common occurrence in the foreign exchange market, the hallmark of a currency war is the significant number of nations that may be simultaneously engaged in attempts to devalue their currency at the same time.

Are We in a Currency War?

A currency war is also known by the less threatening term "competitive devaluation ." In the current era of floating exchange rates. where currency values are determined by market forces, currency depreciation is usually engineered by a nation's central bank through economic policies that may force the currency lower, such as reducing interest rates or increasingly, "quantitative easing (QE) ." This introduces more complexities than the currency wars of decades ago, when fixed exchange rates were more prevalent and a nation could devalue its currency by the simple expedient of lowering the "peg " to which its currency was fixed.

"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 such a hornet's nest in September 2010 when he warned that an international currency war had broken out. But with more than 20 countries having reduced interest rates or implemented measures to ease monetary policy from January to April 2015, the trillion-dollar question is – are we already in the midst of 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, and simultaneously makes imports more expensive. Higher export volumes spur economic growth, while pricey imports also 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 GDP growth. 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.

This phenomenon is also known as "beggar thy neighbor ," which far from being the Shakespearean drama that it sounds like, actually refers to the fact that a nation which follows a policy of competitive devaluation is vigorously pursuing its own self interests to the exclusion of everything else.

US Dollar Surging

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 the US Federal Reserve's quantitative easing program that was weakening the dollar, China's continued suppression of the yuan, and interventions by a number of Asian central banks to prevent their currencies from appreciating.

Ironically, the US dollar has appreciated against almost all major currencies since the beginning of 2011, with the trade-weighted Dollar Index presently trading at its highest level in more than a decade. Every major currency has declined against the dollar over the past year (as of April 17, 2015), with the euro, the Scandinavian currencies, the Russian ruble, and Brazilian real down more than 20% over this period.

The US Strong Dollar Policy

The US economy has withstood the effects of the stronger dollar without too many problems thus far, although one notable issue is the substantial number of American multinationals that have cautioned about the negative impact of the strong dollar on their earnings.

The US has generally pursued a "strong dollar " policy with varying degrees of success over the years. However, the US situation is unique since it is the world's largest economy and the US dollar is the global reserve currency. The strong dollar increases

the attractiveness of the US as a destination for foreign direct investment (FDI) and foreign portfolio investment (FPI). Not surprisingly, the US is often a premier destination in both categories. The US is also less reliant on exports than most other nations for economic growth, because of its giant consumer market that is by far the biggest in the world.

Present Situation

The dollar is surging primarily because the US is about the only major nation that is poised to unwind its monetary stimulus program, after being the first one out of the gate to introduce QE. This lead-time has enabled the US economy to respond in a positive manner to the Federal Reserve's successive rounds of QE programs. In its recent World Economic Outlook update, the International Monetary Fund projected that the US economy would grow by 3.1% in 2015 and 2016, the fastest growth rate of the G-7 nations.

Contrast this with the situation in other global powerhouses like Japan and the European Union, which have been relatively late to the QE party. Countries like Canada, Australia, and India, which had raised interest rates within a couple of years after the end of the Great Recession of 2007-09, have had to subsequently ease monetary policy because growth momentum has slowed.

Policy Divergence

So on the one hand, we have the US, which could well hike its benchmark federal funds rate in 2015, the first increase since 2006. On the other hand, there is the rest of the world, which is largely pursuing easier monetary policies. This divergence in monetary policy is the major reason why the dollar is appreciating across the board.

The situation is exacerbated by a number of factors:

  • Economic growth in most regions has been below historical norms in recent years; many experts attribute this sub-par growth to the fallout of the Great Recession.
  • Most nations have exhausted all options to stimulate growth, given that interest rates in numerous countries are already either near zero or at historic lows. With no further rate cuts possible and fiscal stimulus not an option (as fiscal deficits have come under intense scrutiny in recent years), currency depreciation is the only tool remaining to boost economic growth.
  • Sovereign bond yields for short-term to medium-term maturities have turned negative for a number of nations. In this extremely low-yield environment, US Treasuries – which yielded 1.86% for 10-year maturities and 2.52% for 30 years as of April 17, 2015 – are attracting a great deal of interest, leading to more dollar demand.

Negative Effects of a Currency War

Currency depreciation is not the panacea for all economic problems. Brazil is a case in point. The Brazilian real has plunged 48% since 2011, but the steep currency devaluation has been unable to offset other problems such as plunging crude oil and commodity prices, and a widening corruption scandal. As a result, the Brazilian economy is forecast by the IMF to contract 1% in 2015, after barely growing in 2014.

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.
  • The degree of currency depreciation may be greater than what is desired, which may eventually cause rising inflation and capital outflows.
  • A currency war may lead to greater protectionism and the erecting of trade barriers, which would impede global trade.
  • Competitive devaluation may cause an increase in currency volatility, which in turn would lead to higher hedging costs for companies and possibly deter foreign investment.

The Bottom Line

Despite some evidence that may suggest the contrary, it does not appear that the world is currently in the grip of a currency war. Recent rounds of easy money policies by numerous countries around the world represent efforts to combat the challenges of a low-growth, deflationary environment, rather than an attempt to steal a march on the competition through surreptitious currency depreciation.

Disclosure: The author did not hold positions in any of the securities mentioned in this article at the time of publication.

Source: www.investopedia.com

Category: Forex

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