CURRENCY WAR: What does it mean?

A currency war is something that happens silently, but for real. It happens at the monetary level when a country devalues ​​its currency and has the same response from another government.

The central banks (guardians of price stability) have at their disposal a series of tools to fulfill their objective: to maintain inflation levels. For this purpose, other intentions can be camouflaged: gain competitiveness in the international market.

The problem is that the market is not infinite and the share that these countries can gain through monetary policies is being taken away from others; This is when the currency war begins.

In this article I explain everything related to how a currency war develops, what is its purpose, what countries (governments and central banks) do to counterattack and what effects all this has on the economy and the market . Prepared? Let’s go!

⚔️ What is a currency war?

A currency war is the competition between economies of different countries to lower the exchange rate of their respective currencies (yes, wars are also fought in the economic field).

You heard right, lower the price of their currencies. But why would they want to do this?

When the currency is devalued, price falls in the Forex market. Its change is lower compared to the rest of the other currencies. This situation has consequences for the country’s foreign trade: exports are cheaper and imports more expensive.

? I give you an example

If a country begins to devalue its currency, its price falls in the market. So, assuming that previously the exchange rate against the United States dollar (USD) was 1 unit (one unit of the currency of the country in our example equals one US dollar), now one unit equals 0 .80 USD (we must think that the currencies trade in pairs, if the currency of the country in our example depreciates, the value of the dollar increases with respect to it).

If before, a company in the United States placed an order with any factory in this country for the value of 100,000 currency units and had to pay 100,000 USD, after the devaluation it costs 80,000 United States dollars.

The manufacturer’s price is the same, but the effect of the exchange rate causes exports to be cheaper. The opposite happens with imports.

Thus, national companies have more sales potential. They sell more abroad and, since imports are more expensive, internal trade is also encouraged. Employment goes up, income goes up… But, be careful, inflation too.

This type of maneuver may not sit well with other countries, since it works against them. Then they too can take actions to devalue their currency and enter a spiral of competition, which is known as “competitive devaluation” or “currency warfare”.

Before continuing, you have to be clear that the exchange rate is a variable that can be intervened. The monetary authorities of a country can decide. At this point, it is convenient to know well the difference between “devaluation” and “depreciation”.

?‍♂️ What is depreciation and devaluation?

We refer to a depreciation when a currency loses value as a result of market forces. Currencies trade in pairs, one against the other, in the Forex market (Foreign Exchange). We call the exchange rate the price of one currency in relation to another.

In this case there is no government decision, a currency depreciates when it loses relative value against another, based on existing supply and demand. The opposite is called, as you already know, appreciation.

On the other hand, we talk about devaluation (or revaluation, in the opposite case) when the loss of value of a certain currency is set by its government or competent monetary authority (the central bank of the country).

Therefore, in a currency war, devaluations are carried out, with the aim of benefiting the economy itself to the detriment of that of other countries against which it is competing.

But, how can they devalue a currency if it is listed on the Forex market and it is the market itself that assigns its price?

✔️ How is a competitive devaluation carried out?

In the end, it is the Forex market that assigns exchange rates. However, a market is based on the decisions of millions of buyers and sellers.

If a government decides to carry out a devaluation, it must get a great deal on your coinwith the objective that the demand is not enough and its price falls in the Forex market.

What instrument does a government (or a central bank) have to devalue its currency in the foreign exchange market?

Well, it does not have one, but several mechanisms. The most common are the following:

▶️ Market interventions

Indeed, the central bank can intervene directly in the Forex market, selling your currency and buying others.

However, central banks also intervene in other markets, they can buy assets from other countries (issued in other currencies) to appreciate their currency (that of that country). As a consequence of the appreciation of another currency, yours loses value. They do this because it’s less direct, more camouflaged.

▶️ Increase your money supply

This is a maneuver that has been carried out in recent years, both by the Federal Reserve and by the European Central Bank. It basically consists of “print more money”.

When there are more units of a currency, logically, there is more money supply and the currency is worth less.

▶️ Cut interest rates

The interest rate is one of the biggest weapons of central banks. By lowering the interest rate of a currency it loses its attractiveness for investors; their deposits in that currency yield less and they will look for another more profitable alternative.

The effect is the same: currency sales (of your assets in that currency) and a reduction in the exchange rate.

▶️ Administrative devaluation

This situation occurs when a monetary authority sets the exchange rate that one currency should have in relation to another.

You can set a minimum or maximum rate, but in any case, it is a different free market exchange rate.

? Reflections on these monetary policy instruments

You have to keep in mind that, to a greater or lesser extent, all monetary authorities have control over their currency and their exchange rate. Monetary policy instruments are not primarily intended to create a currency war, but to maintain price stability and encourage economic activity.

Currencies such as the Swiss franc (CHF) and the Japanese yen (JPY) are heavily controlled by their central bank.

The problem comes when you enter into competition. In fact, the concept “currency war” was recently coined (in 2010) by the Minister of Finance of Brazil, Guido Mantega, to denounce precisely how central banks were doing misuse of monetary policy and thus cause damage to the Brazilian economy. However, this type of conflict is old: it has occurred several times throughout history.

? What impact does a competitive devaluation have on the economy?

Once you have seen the weapons that countries have to wage a currency war, you will wonder what their effects are on the economy. The conflict not only affects the belligerent countries, it also leaves collateral damage because the world economy is affected.

A devaluation, by itself, is neither a good nor a bad decision; everything depends on the macroeconomic panorama that the country has.

One of the clearest examples that history leaves us is found after the 1929 crash. In the 1930s, the United States was mired in an economic depression and devaluations were a critical factor in achieving recovery. However, these monetary, trade and other policies negatively affected the world economy.

Barry Eichengreen, professor of economics and political science at the University of California, exposes (and demonstrates) that after successive cross-competitive devaluations, no one gains market share, everyone loses.

The point is that a devaluation has consequences for the country’s economy and international trade, both positive and negative.

? positive consequences

One of the main reasons why a monetary authority decides to provoke a devaluation is to be more competitive in export prices, as we have been dealing with above. Their products are cheaper compared to other countries. In addition, imports become more expensive and local companies also see an increase in the internal market. In short, the market share is increased and more income is obtained.

You should also know that there are nations that devalue their currency (mainly through the system of printing more money). to finance their public spending. As money loses value, debts also have less value in real terms.

Finally, when a devaluation occurs, inflation is created (it is not that prices rise, it is that money is worth less). Therefore, it can be a measure for combat low inflationary levels or the risk of deflation.

The clearest example can be found in Europe after the 2008 crisis. The policy of the European Central Bank is to increase inflation to its target levels (close to 2%). To achieve this, it has cut interest rates to 0% and continuously injects liquidity into the economy through asset purchases. All this causes the euro to lose value in the Forex market.

? Negative consequences

Not everything is good. A devaluation also has a number of detrimental effects.

The first of them would come from the generated inflation. Something dangerous that, if it gets out of hand, can cause a real disaster in the economy. Savers and investors suffer a loss of purchasing power.

As we have mentioned when talking about the positive consequences of a devaluation, money is worth less and, therefore, the debts that may be owed are also worth less. This can be beneficial for those who have debt. But what about creditors?

Lenders and creditors put themselves in the opposite situation and it is not favorable to them. With which, the credit may be reduced. Without credit, the economy does not grow in the same way (or directly does not have the capacity to grow). Money needs to move smoothly.

Furthermore, if the country in question is dependent on oil or some raw material you have to import, a weaker currency will not benefit you Not at all.

As can be seen, a devaluation can have negative effects, not only for other countries, but also internally. In the face of a series of competitive devaluations, there may be victims.

? conclusion

In summary, a currency war is the use of the monetary policy tools that governments and central banks have to compete with each other, causing damage to another economy. It enters into a situation of competition and devaluations of their respective currencies follow one another.

Currency devaluations are a weapon available to the monetary authorities of different countries. It is clear that a given government is trying to carry out a competitive devaluation in order to improve its economy. However, by gaining competitiveness, the market share is being “stolen” from other countries. To what extent could it be considered foul play? Protectionist economic policies gain relevance in times of crisis.

When these maneuvers are carried out and action is taken by other countries, we enter into a currency war.

For example, the policies of liquidity injections in the economy to combat inflation in Europe could be seen by the United States as a maneuver to manipulate the euro, taking actions in this regard (in fact, there are accusations by Donald Trump).

Delicate but important topic all this to know how the market moves.

Doubts? Comments? What do you think of all this?

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