Unfold the truth of Currency Wars ?

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Unfold the truth of Currency Wars ?

#1 Postby ANKITSHAH » Fri Dec 19, 2014 3:08 pm

It’s something all the nations are accusing others of starting and doing it themselves covertly. They are waging Currency Wars against others. The term “Currency war” was coined by Brazilian finance Minister Guido Mantega in September 2010 in response to United States quantitative easing program. He said that though the policy masked as one, which will ward off deflation and stimulate a depressed economy, was actually a “beggar thy neighbor” policy that seeks to increase domestic economic welfare at the expense of other countries’ welfare. Under these policies country devalues its currency in order to boost its domestic output and employment but, by doing so, shifts the output and employment problem onto other countries, resulting in inflation in other countries, their currency appreciation, their loss of competitiveness in international markets and increasing real asset prices.

But usually it is not a unilateral phenomenon and other countries can also respond by devaluing their own currencies to maintain their competitiveness in foreign markets and home markets. And in the end we may be left with similar competitive advantage as before but with higher rate of inflation.

Currency wars are usually waged by unusually huge expansive monetary policies. It need not to be done necessarily by printing huge amount of money by the central bank but can also be done by lowering domestic interest rates and thus encouraging capital to leave the country in search of higher returns abroad and thus lowering the demand for the domestic currency compared to other countries’ currencies and hence currency devaluation.

Today most of the countries are engaging in some form of currency wars. United States due to quantitative easing program, Japan under Abenomics and many other Asian countries with huge stockpile of foreign exchanges. To push down the exchange value of its currency, a government purchases foreign currency with its own currency. Such behavior results in direct effects on the exchange rate.

But the question here is why do countries devaluate their own currency; the answer, it appears, is to improve their balance of trade. When a currency falls in exchange value, exports become cheaper to foreigners (who then buy more), while imports become more expensive to a nation’s own residents (who then buy less). The net result is an improvement in the balance of trade. The higher trade balance supports more employment and adds to economic growth through expansion of industries that export as well as industries that face less competition from imports. This expansion is matched by economic contraction in its trade partners, who now export less and import more. In other words, currency aggression is roughly a zero-sum game, shifting production (and jobs) from one country to another without changing total employment or output, at least in the short run. With time, the effects on employment in each country usually wear off, as monetary policy in the aggressor countries must tighten to prevent inflation and monetary policy in the non-aggressor countries must loosen to encourage employment in other industries.

Also, there is one important thing to consider here. Usually a country with a trade surplus is supposed to lend to the other countries, countries with trade deficit through increased ownership (by the government or private investors) of foreign financial assets (bonds, bank loans, and stocks). This can been seen in US-China trade relationship, there is huge trade surplus for China and hence China is holding a lot of US assets including US sovereign bonds. Here there is an increase in liability for US as more and more of their assets are being owned by China.

This system of trade surpluses and of course, deficits elsewhere is good as it may be beneficial for all the countries, creating demand in economies operating at less than full capacity and hence creating jobs there and cooling excess demand in overheated economies and hence preventing inflation there. So ideally to achieve economic balance in the long run, the pattern of surpluses and deficits should follow from differences in the returns on investments. Industrialized countries with low returns should thus be lending to developing countries where returns are usually high. So, industrialized countries should run trade surpluses, while developing ones should run deficits.

But this behavior was not observed in the last decade might be due to currency aggression on the part of developing countries fueling growth through exports. The developing countries has been lending to the industrialized countries to sustain more competitive exchange rates and export-led growth, thereby running a huge collective surplus.

As you export more and more, your currency is supposed to get appreciated. But if you engage in currency manipulation, you may prevent the appreciation or rather depreciate your own currency. Many developing countries turned to currency manipulation as a means of resuming growth after the late 90’s financial crises in Latin America and Asia. They built larger stockpiles of foreign exchange reserves to protect themselves from the rising volatility of global financial markets.

Currency wars in the long term when all the other countries also de-valuate their currencies in not good for any of the countries with price levels permanently at the higher levels while everyone being at the similar levels of competitiveness before. But at the same time, it is not possible to expect no country to use it to their advantage as the temptation is simply too much to resist. One of the ways to diffuse currency wars is to use World Trade Organization (WTO) and International Monetary Fund (IMF) more effectively to deter any aggression on currency front. Countries that believe they are harmed by such aggression should be able to file formal complaints with the WTO. Nevertheless currency wars needs to be warded off by terms of multilateral forums in which limits on currency manipulation can be negotiated and some mechanism needs to be developed to enforce it on member countries.

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