Better understanding the currency war

When several countries deliberately manipulate the value of their currency in order to become more competitive compared to each other, we speak of a currency war. How does this work and what are the consequences of such practices? myLIFE offers simplified answers to the main questions that arise.*

What is a currency war?

A currency war refers to a situation where the authorities of several countries simultaneously seek to stimulate their economy, mainly by weakening the value of their currency. They then practice what is called competitive devaluation.

These successive decreases, often perceived as unfair, create economic and commercial tensions between countries, hence the term “currency war.”

Good to know: in a single monetary zone (such as the euro area), the currency being the same for all member states, they cannot devalue it individually. A currency war then takes place between the concerned monetary zone and the other countries of the world.

Why decrease the value of a currency?

Devaluing a currency can be an instrument of economic policy used to revive the competitiveness of a country or a monetary zone and to reduce its trade deficit.

Weakening the value of a currency makes the products of a state cheaper for foreign buyers, which favours exports and allows it to gain market share internationally. At the same time, imports become more expensive for inhabitants who will then consume more local products and stimulate the national economy.

The ability of authorities to influence the value of a currency depends on the exchange rate regime.

How can authorities influence the value of a currency?

The ability of authorities to influence the value of a currency depends on the exchange rate regime. In a fixed regime, the central bank can intervene directly in the market in order to influence the exchange rate. For example, by selling its own currency and buying foreign currencies, it increases the quantity of money in circulation, which leads to a depreciation.

In a floating exchange rate regime, the value of a currency depends mainly on supply and demand in the foreign exchange market, which in principle limits direct interventions. However, by using monetary policy instruments to maintain financial stability and the proper functioning of the economy, the central bank also indirectly influences exchange rates and, consequently, the value of the currency.

For example:

• • A decrease in key interest rates can make investments less attractive for investors, which will tend to weaken the value of the currency.
  • A massive purchase of public or private bonds (quantitative easing or QE) injects liquidity into the financial system, which reduces long-term interest rates and can contribute to a weakening of the currency.
  • An explicit communication on the implementation of a monetary policy (forward guidance) can encourage investors to anticipate future orientations and impact the value of a currency.

Good to know: we speak of “devaluation” when an authority voluntarily reduces the value of a currency in a fixed exchange rate regime, whereas we speak of “depreciation” when the weakening results from market movements in a floating regime.

Why do we speak of a “war”?

The decrease in the value of a currency of a country or a zone will have repercussions on the economy of other nations. It can be perceived as an economic aggression, since it reduces the competitiveness of other countries and degrades international trade relations.

The affected states may react by weakening in turn the value of their currency in order to avoid an economic disadvantage. They may also, more rarely, adopt defensive measures (customs duties, sanctions) to protect their economy. The term “war” thus underlines the escalation of economic rivalry between countries.

Weakening the currency can bring temporary advantages, but when several states engage in a strategy of competitive decrease, this can lead to a currency war.

What are the positive effects of a decrease in the monetary value of a country?

Decreasing the value of a currency can present several advantages, particularly in times of economic slowdown:

• • Improvement of export competitiveness: national products become less expensive for foreign buyers, which can encourage international sales.
  • Stimulation of production and employment: as imported products cost more, households and businesses will tend to consume more local goods, thus supporting national production and employment.
  • Strengthening of economic growth: the increase in domestic and foreign demand will revive economic activity.
  • Rebalancing of the trade balance**: the increase in exports and the decrease in imports can improve the trade balance in the long term.

Note: these benefits may vary depending on the nature of trade exchanges and the capacity of national production.

Weakening the currency can bring temporary advantages, but when several states engage in a strategy of competitive decrease, this can lead to a currency war.

What are the risks of a currency war?

Once engaged, a currency war can cause global economic and financial disruptions. The main risks are the following:

• • Risk of high inflation: a massive injection of money into the economy can accentuate inflation and lead to a decrease in consumers’ purchasing power.
  • Increase in volatility: the prospect of a decrease in the value of currencies can increase uncertainty in the markets, prompting investors to withdraw their capital and thus reinforcing volatility.
  • Imported inflation: if imported products are more expensive, companies see their costs increase and may pass this rise on to consumer prices.
  • Escalation of trade tensions: successive devaluations deteriorate trade exchanges and lead to economic rivalries between partners.

Note: the extent of the impact of a currency war depends on the dependence of countries on imports or on their level of trade openness.

Devaluation policies can thus impact global economic activity and cause a loss of confidence in governments and the monetary system.

The most well-known historical episode of a currency war dates back to the 1930s.

Have there been significant currency wars in History?

The most well-known historical episode of a currency war dates back to the 1930s. To revive its economy hit by the 1929 crisis, Great Britain suspended in 1931 the convertibility of the pound sterling into gold and devalued its currency. The countries that had remained attached to the gold standard then suffered severe deflation (sharp fall in prices). In reaction, more than twenty of them also devalued their currency in order to preserve their competitiveness. This movement, associated with the rise of protectionism, ultimately worsened the global crisis.

Subsequently, several periods have been assimilated to currency wars, even if the objective of monetary authorities was to revive the economy and ensure financial stability. Thus, after the financial crisis of 2008, several major central banks (Federal Reserve, Bank of England, Bank of Japan, European Central Bank) carried out quantitative easing policies intended to support their growth. These measures had the side effect of decreasing the value of their currencies. In 2010, the Brazilian Finance Minister then denounced a “currency war,” estimating that these policies weakened his economy by overvaluing his currency. In the same period, the United States accused China of maintaining its currency undervalued to boost its exports. These tensions then continued under the second presidency of Donald Trump who imposed a series of customs duties on Chinese goods, creating a trade war between the United States, China and, to a lesser extent, Europe.

If monetary policy aims to maintain financial stability or to support economic activity, the voluntary weakening of a currency can lead to a succession of competitive devaluations. These strategies then risk fueling trade tensions and, in the long term, destabilizing the global economy. You now know more about the mechanisms and consequences of a currency war. However, be aware that these mechanisms are complex and that certain information has been significantly simplified to facilitate the understanding of this article.

* Content translated from French by the BIL GPT AI tool

** The trade balance corresponds to the difference between the value of exports and imports of goods and services over a given period.