Currency Wars and How They Work

Currency Wars and How They Work

Why Global Currency Wars Aren't as Dangerous as They Sound

By Kimberly Amadeo    Updated on July 19, 2022  Reviewed by Robert C. Kelly

A currency war is when a country's central bank uses expansionary monetary policies to deliberately lower the value of its national currency. This strategy is also called competitive devaluation.

In 2010, Brazil's Finance Minister Guido Mantega coined the phrase "currency war." He was describing the competition between China, Japan, and the United States where each seemed to want the lowest currency value. His country's currency was suffering from a record-high monetary value, which was hurting its economic growth.

Purpose

Countries engage in currency wars to gain a comparative advantage in international trade. When they devalue their currencies, they make their exports less expensive in foreign markets. Businesses export more, become more profitable, and create new jobs. As a result, the country benefits from stronger economic growth.

Currency wars also encourage investment in the nation's assets. The stock market becomes less expensive for foreign investors. Foreign direct investment increases as the country's businesses become relatively cheaper. Foreign companies may also buy up natural resources.

How It Works

Exchange rates determine the value of a currency when exchanged between countries. A country in a currency war deliberately lowers its currency value. Countries with fixed exchange rates typically just make an announcement. Other countries fix their rates to the U.S. dollar because it's the global reserve currency.

However, most countries are on a flexible exchange rate. They must increase the money supply to lower their currency's value. When supply is more than demand, the value of the currency drops.

A central bank has many tools to increase the money supply by expanding credit. It does this by lowering interest rates for intra-bank loans, which affect loans to consumers. Central banks can also add credit to the reserves of the nation's banks. This is the concept behind open market operations and quantitative easing.

A country's government can also influence the currency's value with expansionary fiscal policy. It does this by spending more or cutting taxes. However, expansionary fiscal policies are mostly used for political reasons, not to engage in a currency war.

The U.S.' Currency War

The United States doesn't deliberately force its currency, the dollar, to devalue. Its use of expansionary fiscal and monetary policy has the same effect.

For example, federal deficit spending increases the debt. That exerts downward pressure on the dollar by making it less attractive to hold. Between 2008 and 2014, the Federal Reserve kept the federal fund rate near zero, which increased credit and the money supply. It also created downward pressure on the dollar.

But the dollar has retained its value despite these expansionary policies. It has a unique role as the world's reserve currency. Investors tend to buy it during uncertain economic times as a safe haven. As an example, the drastic oil price drop between 2014 and 2016 caused a mini-recession. Investors flocked to the dollar, which caused the dollar value to increase by 25%.

China's Currency War

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