Currency wars explained: a guide to devaluing currencies

We explain what a currency war is, how they work and outline the benefits and drawbacks of devaluing a currency.

Bank notes Source: Bloomberg

What is currency manipulation?

Currency manipulation is when a government or central bank introduces monetary policy or other measures with the intent of weakening its own currency or that of another country.

How currency manipulation can lead to a currency war

A currency war can break out after a country deliberately devalues its own currency and prompts another nation to do the same. This is also known as ‘competitive devaluation’. Countries purposely cause their currencies to depreciate in the hope it can invigorate economic growth and give them an edge over other nations.

Currency wars are all about tit for tat. If a country has devalued their currency, then others can regard it as an act of economic war and respond in kind. A country only devalues its own currency out of self-interest and at the expense of other countries, which in turn do not like to feel as if they are losing out or being taken advantage of by another nation’s monetary policy.

It is important to stress that a country can aim to weaken its own currency without intending to ignite a currency war, but if another country responds by devaluing its own currency then a war can break out nonetheless.

Why do countries manipulate their currency?

There are many benefits to having a strong currency. It can reduce the price of imports and improve the standard of living for citizens, who enjoy greater purchasing power when buying goods from around the world. It can help keep inflation in check and encourage companies to become more competitive and efficient.

But there are also benefits to having a weaker currency:

  1. Makes exports more competitive
  2. Drives demand for domestic goods and services
  3. Improves terms of international trade
  4. Increases foreign investment and tourism
  5. Can make government debt more manageable
  6. Drives inflation higher

Makes exports more competitive

If a country’s currency depreciates in value then this means goods and services produced in that country become more affordable to the rest of the world, which boosts demand for exports. Increasing a country’s exports can help ignite economic growth, improve employment levels and accelerate overall gross domestic product (GDP) growth.

Drives demand for domestic goods and services

A weaker currency does, however, mean that importing goods becomes more expensive. This can deter people from buying foreign goods and services because they have become too expensive, and encourage them instead to purchase domestically-produced alternatives. This can increase consumer spending and demand for home-grown items, helping spur on economic growth (although this comes with its downfalls, as we explore later).

Improves terms of international trade

Boosting exports to other countries while simultaneously discouraging the import of foreign goods and services can have a dramatic effect on a country’s terms of trade. Exporting more and importing less will mean a country’s trade deficit (when it imports more than it exports) will reduce. Similarly, if a country is already in a trade surplus (when it exports more than it imports), then this will grow.

Increases foreign investment and tourism

A weaker currency can enhance the attractiveness of the country to foreigners. Assets, whether that be securities or housing, become cheaper for overseas investors as they can get more for their money. Tourism can also benefit as it becomes more affordable for foreigners to travel and shop in the country.

Can make government debt more manageable

A weaker currency can also make a country’s debt more manageable. This is because devaluing a currency also effectively devalues any outstanding loans denominated in that currency. Lenders tend to lose out when a currency is weakened as the amount they will receive back from the borrower will ultimately be worth less than it was when the loan was issued. But this can be good news for borrowers as it can make repayments more manageable and reduce the overall amount that has to be paid back.

Read more on what government bonds are and how to trade them

Drives inflation higher

Higher inflation can be both good and bad, depending on what an individual country or central bank is trying to do. Although a weaker currency can increase demand for exports, the fact that imports become more expensive and consumer’s purchasing power is weakened means the overall cost of living usually rises – driving inflation higher. Devaluing a currency is often described as a way of ‘importing inflation’.

What are the possible consequences of devaluing a currency?

There is always a risk that the international community will disagree with a country’s plan to devalue their currency, usually because of the effect it will have on everyone else. If one nation decides to devalue their currency and then another country responds by doing the same, and then another, then you have the makings of a full-blown currency war.

It is unsurprising that more countries are considering weaponising their currencies in today’s world where protectionism is rising, borders are being erected, globalisation is being slowly eroded, and growth is slowing or stagnating. However, many regard currency wars as counter-intuitive because they fuel a race to the bottom. As we have established, devaluing a currency can spur on inflation and raise the cost of living for citizens. Plus, trying to get one over on your trading partners is hardly a way to improve international trade and relations.

Although some countries may try to raise inflation by devaluing their currency, this can go wrong if the balance isn’t right. If a country depreciates its currency too much or too little, then there is a risk that the desired outcomes won’t be achieved. That could lead to higher-than-expected inflation, greater outflows of capital than anticipated, or cause the currency to depreciate at a faster rate than intended. If a devaluation is not implemented properly then it can be difficult to get a grip on it again and introduce unwanted volatility to exchange rates. This sort of environment can dampen the mood of investors and businesses that prefer to operate in stable and predictable economies.

Read about Goldman Sachs slashing US GDP growth forecasts as China trade war continues

Devaluing a currency certainly has its short-term benefits but few regard it as a long-term, sustainable solution to a country’s economic woes. For example, increasing exports and reducing imports can help deliver short-term economic growth as total demand for a country’s goods will rise, but making foreign goods and services more expensive can stifle productivity and growth over the longer term (no country is completely self-sufficient). Importing machinery, hiring foreign workers, or outsourcing work abroad, for example, will all become more expensive and hamper industry’s ability to grow.

How do countries manipulate currencies and how do currency wars start?

Whoever is in charge of a country’s monetary policy – usually a central bank – is the architect of any plan to devalue a currency.

Some countries, including China, still peg their own currency to another (in this case the yuan to the dollar). If China wants to devalue the yuan, then it simply has to adjust the peg to which the exchange rate is fixed.

However, most major world economies no longer peg their currencies to an asset but instead let them float freely. Devaluing a free-floating currency is much more complex than devaluing a pegged one. There are several ways that a central bank in charge of a free-floating currency can try to depreciate its value:

  1. Quantitative easing (QE)
  2. Lowering interest rates
  3. Intervention buying
  4. Controlling capital flows
  5. Diplomacy and threats

Quantitative easing (QE)

QE is the act of increasing the supply of money. If, for example, the Bank of England (BoE) undertook a QE programme then this would mean it would increase the supply of pounds into the market. As supply outstrips demand, the value of the currency decreases.

Lowering interest rates

If a country cuts interest rates then it makes that nation a less-attractive place to save money, which encourages people and businesses to shift their money to other countries that offer higher interest rates. If large amounts of capital begin to leave the country then the currency of that country will begin to depreciate, while the currencies of the countries receiving the influx of capital will strengthen.

Read more on how to trade interest rates

Intervention buying

Intervention buying is about purchasing assets to support prices. The best example of this is China, which spends large amounts of its foreign currency reserves to purchase US treasuries. By doing this, China provides support to the dollar and, as the yuan is pegged to it, keeps a lid on the value of its own currency. If a country wants to strengthen its own currency, then it would purchase its own currency to raise demand and therefore the value.

Controlling capital flows

A country or central bank may seek to control the flow of capital in and out of the country to adjust the value of their currency. For example, if the UK introduced limits on the amount of foreign exchange that can flow into the country (capital inflow controls) then it could prevent overseas investors from purchasing UK assets. If it restricted UK citizens from acquiring foreign currencies or assets overseas (capital inflow controls), then this would make it harder for UK residents to spend their money overseas. Limiting the flow of capital coming in or going out of the country is a way of adjusting demand for either your own currency or that of other countries.

Diplomacy and threats

A less formal but still highly relevant way of devaluing your currency or starting a currency war is simply stating so. Financial markets, including foreign exchange, are driven by emotions and sentiment. If the leader of a country or central bank openly states that they will take action to strengthen or weaken their currency, then this message will filter through to the markets even if no formal policy is introduced to back it up.

Read on whether Trump’s trade wars are bad for the dollar

Examples of currency wars

Monetary policy changes and it can be difficult to define whether a currency war has broken out. Numerous countries can introduce measures aimed at weakening their own currency without intending to start a currency war. Still, it is widely recognised that there have been three major currency wars so far, even if there have been smaller battles along the way.

Currency war I: the gold standard after WW1

The first currency war started in the 1930s. Before World War I erupted, the value of most major currencies was derived from the price of gold. Countries pegged their currency to the metal, and this was known as the ‘gold standard’. However, countries needed to print more money to fund the staggering costs of the war.

The gold standard provided stability in foreign exchange markets, but it also provided limited flexibility to governments. This prompted countries to abandon the gold standard to help manage the huge financial burden of the war, but once it was over most of them craved the relative stability it brought and tried to return to it.

This was an issue for most countries as the amount of gold available to underpin a currency had barely changed, but countries now had significantly more money in circulation. This meant several countries, including Germany and France, decided to devalue their currencies to readopt the gold standard. The fact others like the UK and the US decided to raise the value of their own currencies by readopting the gold standard at the pre-war rate largely prevented a race to the bottom in terms of a currency war.

However, the widespread support for the gold standard started to dissipate as financial trouble hit Europe. Driven by German hyperinflation, the meltdown started to spread across Europe, enough so that pressure started to be exerted on the pound, forcing the UK to action.

The UK’s response was unexpected. While many expected the country to raise interest rates in response, it decided to abandon the gold standard altogether. This resulted in the pound significantly depreciating against almost every other currency, making British exports much more competitive on the world stage. Other countries saw this as an aggressive act and responded by implementing controls on capital flows and slapping tariffs on imports. The UK’s abandonment of the gold standard inspired numerous other countries to follow suit, but most of Europe continued to use it, causing a division between those that used it and those that didn’t.

The devaluations, tariffs, capital controls and other measures escalated as a result. This gradually hammered the global economy and those that were using the gold standard once again found themselves with little wiggle room with which to respond. For example, as the downturn in global trade started to send the US into the Great Depression, the Federal Reserve’s (Fed's) ability to intervene was limited as it had to have a set amount of gold to back the amount of currency in issue, and getting hold of large amounts of gold so you can print more money is not easy nor cheap. This was exacerbated by the fact people started hoarding gold – depleting the Fed’s gold reserves – as the downturn took hold. The then US president, Franklin D Roosevelt, effectively scrapped the gold standard by forcing everyone to turn in their gold to the Fed in return for dollars, and stopping them from trading their dollars in for gold. This was how the world-renowned Fort Knox gold reserve was borne and why the US became the largest hoarder of gold in the world.

When the downturn started to ease and the Great Depression ended in 1939, countries were once again keen to return to the gold standard but were aware it wasn’t perfect. This resulted in the Bretton Woods Agreement being signed in 1944, which set how much each currency was worth in terms of gold. As the US held most of the world’s gold, more countries started to peg their currencies to the dollar, which itself was still technically underpinned by gold. This gradually saw countries start to peg their currencies to other currencies rather than gold. This is why the dollar remains the world’s official reserve currency today.

Currency war II: abandoning in the gold standard

The Bretton Woods Agreement was successful in preventing another currency war for over 20 years and offered relative stability to currency markets. But this came to an end when the UK, suffering from high inflation, decided to devalue the pound against the dollar in 1967, which opened the doors for others to do the same. The US was suffering from the same inflationary problems as the UK but, whereas the pound and other currencies were now pegged to the dollar, the dollar was still pegged to gold (even if the dollars couldn’t be converted into gold). This meant that if the US wanted to retaliate and devalue the dollar in response then it would have to rebase the value of gold.

Having suffered several recessions, the US decided to formally abandon the gold standard altogether: the value of a dollar would no longer be derived from gold, which meant those currencies pegged to the dollar weren’t either. In 1973, the International Monetary Fund (IMF) brought an end to the Bretton Woods Agreement by introducing free-floating exchange rates that would manage themselves and change daily, which is the system that we know today. This meant the dollar no longer derived its value from a specific asset.

Currency war III: a race to the bottom

The term ‘currency war’ was only coined during the latest one, when Brazil’s finance minister Guido Mantega claimed one had broken out between the US, China and others. He argued that they had sparked a race to devalue their currencies to gain a competitive edge and said this was causing the currencies of Brazil and other emerging economies to rise and hurting economic growth. China, which pegged the yuan to the dollar in 2007, had been spending billions of dollars to keep its own currency weak against that of the US. Japan had done the same by selling yen and buying dollars. Numerous countries, including Switzerland and Israel, also tried to lower the value of their currencies.

This slowly strengthened the dollar, which in the past would have suited the US and its policy to have a strong dollar. However, over time the US now feels other countries, particularly China, have purposely kept the value of their currencies low relative to the dollar in order to secure large trade surpluses and an advantage over US companies.

Will the US and China keep currency war III going?

Some argue that currency war III is still underway, led by growing tensions between the US and China. The US has been gradually shifting away from its strong dollar policy and now, with the US President Donald Trump in the White House, is aiming to weaken the dollar to make US manufacturers and exporters more competitive. As far as the US is concerned: the reason the US has such a large trade deficit with China is because it has purposely kept the value of the yuan low for decades, and for this to change the dollar must weaken and the yuan must strengthen.

The current fears surrounding currency wars have emerged after China refused to intervene to stop the yuan from devaluing further against the dollar. It has traditionally ensured that one dollar would equal no more than six yuan, but recently let that slip to over seven yuan to prompt fears that China is manipulating its currency. That is significant as it comes at a time when trade tensions between the two countries are already high, demonstrating that countries devalue their currencies as part of a wider strategy involving tariffs, capital controls and other trade policies.

Read about the US labelling China a currency manipulator

How to trade currency wars

If history is anything to go by, a currency war has no winners in the long run. But the outbreak of one can provide opportunities for foreign exchange traders. Currency wars introduce volatility. Currencies trade in pairs and if one currency is to fall then another must rise.

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