What is... | October 27, 2010

What is currency war?

It is not a battle with guns but attempts to keep currencies weak can have unintended consequences, and there can be potential for a “currency war” when countries come out of recession.


Despite the name, a “currency war” has little to do with guns and physical fighting. Instead, the weapon is nations’ currencies or, more precisely, the relative strength of their currencies.

Everybody needs good neighbours
A currency war typically involves countries trying to depreciate their currencies with a view to stimulating their economies. A weaker currency can expand exports, for example. But because not all currencies can be weak at the same time, doing this can cause problems. At the extreme, they can result in “competitive devaluations”, a race to the bottom. Just 29% of respondents to an eZonomics poll said they knew what a currency war was.

Japan, China and Brazil have all intervened in currency markets
In the month of October 2010, FT Alphaville listed 25 instances of official intervention and “de facto intervention” in currency markets in a single week – which is historically high. It said actions varied, from Japan selling its own currency to stop it rising, while Brazil and Thailand increased taxes on offshore money flowing into investments in their currencies. Meanwhile, China continued to manage the exchange rate for its currency against the US dollar, keeping it within narrow boundaries.

History offers lessons for the fight
This situation was not exactly a full-blown currency war. However, International Monetary Fund (IMF) managing director Dominique Strauss-Kahn warned countries against using currencies as a “policy weapon” in an interview with the Financial Times, also carried on CNN. Investment magazine Barron’s wrote that Brazil Finance Minister Guido Mantega was “saying out loud what policy makers were saying in private” when he spoke out about the issue of an international currency war. Brazil's curreny, the real, had been at a 10-month high against the US dollar, reducing the country's competitiveness.

History offers lessons for dealing with exchange rate tensions. Negotiations about currency tensions resulted in the Plaza Accord of 1985, which co-ordinated actions between countries with the aim of weakening the US dollar, and the Louvre Accord of 1987, an attempt to stabilise the US dollar.

How currency tensions can hit home
Currency tensions may involve high-level strategy but this does not mean that individuals are exempt from feeling the effects. In the extreme, exports and imports can be severely curbed. This can threaten supplies to businesses as countries fight back with taxes and other policy measures.

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