Global Effects of Currency Wars on Currency Exchange Rates

Some countries intentionally lower their currency exchange rates to boost exports and stimulate domestic economy.

Competitive devaluation is a term describing a fierce competition among two or more countries that intentionally try to reduce the exchange rates and currency value of their home currency to support local manufacturers and boost exports. The word “Currency war” was coined by journalists covering the world financial markets, and is widely used as a more popular substitute to competitive devaluation.

The currency war was invented in modern times, when the first of such event occurred in 1930s. Prior to that time, countries and governments preferred to maintain high levels of exchange rates and currency value of their home currencies. However, the globalization of the world economy changed the rules of the game. Usually, competitive devaluation is pursued by governments that wish to establish export led economy. In such a scenario, the advantages of lower exchange rates and currency value are obvious – lower cost of goods manufactured and exported resulting in higher demand for domestically manufactured goods due to their lower price on foreign markets. This process has positive impact on the economy by improving unemployment figures and boost GDP growth.

The other side of the coin is that a competitive devaluation jeopardizes foreign debt servicing when it is denominated in a foreign currency. Moreover, a currency war could lead to higher inflation and diminishing living standard in the country because people experience reduced purchasing power of their national currency both when purchasing imported goods and travelling abroad.

There are several methods to force a competitive devaluation and reduce currency rates of a country’s national legal tender. Quantitative easing is practiced by central banks when they fear a potential or actual recession and increase the money supply domestically. This practice involves printing of new money that is intended to support the local economy, which was a major tool to avoid deepening financial crisis in the United States, the UK and the euro-zone in 2007 and later.

As a rule, large scale currency wars occur only during times of global recession when a critical mass of large economies decide to devalue their currencies simultaneously. Recently, many world economists and politicians warned that a new currency war is at the door and the world community should act to avoid a large scale competitive devaluation. China is the usual suspect of implementing policy of competitive devaluation because its economy is heavily dependent of exports, while Beijing refuses to let its national currency float free.

Many leading economic powers like the US benefit from current lower currency exchange rates and currency value of their home currencies due to higher demand for domestically produced good abroad in times of crisis. Germany is one of the few leading world economies that could benefit from a currency appreciation of the Euro because the country runs a large current account surplus. In contrast, most euro-zone economies like Britain would benefit from depreciation of the Euro.

The currency war is a relatively new phenomenon and is still subject to extensive theoretical studying, while all the pros and cons of implementing such a policy are yet to be revealed.