“The supreme art of war is to subdue the enemy without fighting.” ~ Sun Tzu, Chinese Strategist
What are Currency Wars?
A currency war is a situation wherein many nations deliberately devalue their domestic currencies to stimulate their economies. Currency devaluation is a common occurrence within the forex market. A currency war takes place when many governments are simultaneously engaged in attempts to devalue their currency at the same time.
A devaluation means that more domestic currency is needed to purchase imports, and exporters get more local currency when converting the export proceeds.
In other words, imports become expensive; importers lose money while exporters earn.
Let’s understand it through an example
● Suppose India is exporting mangoes to the USA, and the cost/unit of mangoes in India is ₹ 70 and assume that India devalued INR from ₹ 70 = $ 1 to ₹ 140 = $ 1. Now let’s analyse what will happen.
Before rupee devaluation: Americans will get only one mango for 1 $
After rupee devaluation: Americans will get two mangoes for 1 $
Hence, this move is supposed to discourage imports and encourage exports, thus reducing trade deficits.
It can seem counter-intuitive, but a strong currency isn’t necessarily in the country’s best interest. The stimulative monetary policies resulting in a weak currency also can positively impact the country’s economy, as observed in China.
How is China managing it?
The Chinese government limits its currency movement against the U.S. dollar, and hence Yuan isn’t freely traded. The People’s Bank of China is not self-reliant, and it faces claims of intervention when big moves occur in its value.
The U.S. labels China as a “Currency Manipulator” and the accusation is; Chinese government devalues its currency to make its exports more attractive and gain competitiveness artificially. The exchange went up from 6 Yuan/USD to 7 Yuan/USD in August 2019, a devaluation of 16.3 percent.
The U.S. said that China has been using illegitimate means by using shell companies to release a large amount of Yuan through purchasing dollars; this artificially leads to the shortage of dollars and excess of Yuan. Thus, the Chinese currency depreciates.
Since 2014, the Yuan has depreciated frequently. In 2015, the People’s Bank of China pushed its currency to its lowest rate against the U.S. dollar in 3 years to ease growth. The People’s Bank of China said the move intended to support market reforms. The last time Yuan traded at the 7-level against the USD was during the global financial crisis of 2008.
Being an export-driven economy, China has taken all possible advantages of currency manipulation. The 2019 devaluation case was in retaliation to the trade war started by then-president of the US, Donald Trump. China was able to cover up the maximum losses that it faced due to the trade war.
But every coin has two faces...
Negative Effects of a Currency War
Currency depreciation is not a cure for all economic problems and has its disadvantages, primarily:
- Adverse Impact on Local Business
Currency devaluation may lower productivity in the long term since imports of capital equipment and machinery become too expensive for local businesses; if genuine structural reforms do not accompany currency depreciation, productivity will eventually suffer.
- Leads to Rise in Inflation
The degree of currency depreciation may be more than desired, which may eventually cause rising inflation and capital outflows.
- Currency Volatility
Currency volatility essentially means unpredictable movement of exchange rates in the global foreign exchange market., Competitive devaluation may cause an increase, which would lead to higher hedging costs for companies and possibly deter foreign investment.
Brazil may be a case in point. The Brazilian currency has plunged 48% since 2011. Still, the steep currency devaluation has been unable to offset other problems like falling petroleum and commodity prices and a widening corruption scandal. As a result, the Brazilian economy contracted by 3.5% in 2015, after barely growing in 2014.
Why Currency Manipulation is so controversial?
By China or any other country, currency manipulation is seen to defy global trading rules by gaining unfair competitive advantages. Laurence Howard in the Emory Law Review said currency manipulation has “serious effects on the global market.” “Around the globe, currency manipulation is possibly responsible for millions of jobs lost in the United States and a smaller but still significant number of jobs lost in Europe,” Mr. Howard wrote.
Are we in a Currency War right now?
Currency war is also known as “competitive devaluation.” In the present era of floating exchange rates, market forces determine currency values; a nation’s central bank mainly engineers currency depreciation. It created more complexities than the currency wars of decades ago when fixed exchange rates were more prevalent.
“Currency war” is not a term loosely mentioned in the 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.
Even in August 2019, it was speculated that the US-China trade war could turn into a potential currency war; but as the world went into a series of lockdowns because of coronavirus, trade-war took a back seat. Ex-President of the US, Donald Trump, was now active in criticising China for the pandemic.
Due to many reasons, Trump failed to win the elections again, and Joe Biden emerged as the new president of the U.S. The future of a potential currency war is now uncertain, and it’s only dependent on how the two largest economies, namely the U.S. and China, get along with each other.
Conclusion
While currency devaluation seems to be a financial angel, the strategy needs to be well implemented to benefit the nation’s economy. Currency devaluation fundamentally helps prosperous export economies and won’t work in the economies where exporting power is less.
In the age where all power of financial control lies with the government, a parallel financial system is being created, and to counter that; China is buckling itself up again. Stay tuned for an insightful blog on that.
Do you consider currency devaluation as an ethical practice or not? Let us know in the comments.
- Blog Credits: Shashank Gupta, Sarthak Gupta, Saurav Motiramani
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