What is a Currency War

Currency wars can lead to investment inflation, and a kind of translucent wealth that is only made visible by the illusion of value. In other words, currency wars can stimulate economic activity, and investment value, if only in the short-term, and at a cost that can impact the overall wealth of consumers. To illustrate further, currency wars are contests to outbid international competitors to improve sales of a nations products and services.  Just like storefront price wars, countries in price wars attempt to keep the valuation of their currency below their competitor in order to boost economic activity.

China, Japan and the United States are all believed to be showing signs of a currency showdown as 2011 approaches. Currency showdowns, price war and competitive devaluation essentially refer to the same thing. The tools of currency wars are quantitative easing and money supply; both make it easier for banks to borrow and lend money by either increasing money supply or decreasing the cost of borrowing money. Currency wars occur when economies are seeking to either maximize growth or supplement weak growth. The affect on financial markets is increased liquidity by investment banks that may see leverage opportunities amidst lower market prices.

In October 2010, the Bank of Japan, a central bank that carries out monetary policy, advanced its quantitative easing plan by reducing its interbank lending rate to zero percent, a move similar to that of the U.S. Federal Reserve Bank. Between December 2008 and October 2010, the Federal Funds Rate was held at a quarter percent. The one month London Interbank Offered Rate (LIBOR) is similar to the Fed Funds Rate and has also been quite low for almost as long i.e. below .53 percent since January, 2009.

When interest rates decline, it can also affect currency valuation in the foreign exchange market. For example, the price of the United States Dollar rose against the Japanese Yen may rise when the Bank of Japan lowered its interest rate to zero. This, at least temporarily, made it more expensive to purchase U.S. goods and services but made U.S. consumers a little wealthier in terms of international spending power.

The problem with currency war is the financial and economic damage that has an increased risk of being created by excess liquidity. For example, if U.S. monetary policy produces too much money, the cost of living can actually rise for Americans during a time where wage pressure is high. This can make it more difficult to save and invest in the long-term. Large amounts of currency liquidity can also reduce businesses spending power when the majority of their profits are earned domestically. Another possible fiscal bi-product of this lower spending power, is further erosion competitive positioning of U.S. corporations, share prices and the industrial sectors they compete in.

In addition to potentially negative affects of price wars on investments via a decline in competitive positioning and market share of domestic companies, quantitative easing can reduce confidence in the national currency. When international confidence in a currency wanes, economic power declines because things like Foreign Direct Investment (FDI) and financing of government debt instruments such as U.S. Treasury Notes declines. For the U.S. the possibility of not remaining the international reserve currency can also increase leading to dampening of economic control prospects both nationally and internationally.

In the United States, liquidity measures are the remedy for an economy that needs growth stimulus; exports also help. In China, a low Yuan-Renminbi has helped its exports and it has been reluctant to increase the value of its currency to maintain growth encouraged by these exports. For the U.S. this means the risk of being priced out of export markets increases thereby indirectly jeopardizing its workforce through lower product and service demand.

The affects of currency wars can be felt by individuals, investors, businesses and economies world wide depending on the size and scale of the currency showdown. If national trade and account deficit values do not decline despite quantitative easing measures it either means a nation is spending more than it earns despite an increase in earnings, or that earnings have declined further in proportion to spending. This is a sign a currency war is not achieving its desired affect. The second fiscal quarter of 2010 yielded a U.S. Account Deficit of $123.3 billion according to the Bureau of Economic Analysis (BEA). Currency wars can also under price valuable goods and services thereby undermining the very economies they attempt to leverage.
Sources: (Date of record, October 20, 2010)

1. http://bit.ly/aOhawU (Bureau of economic analysis)
2. http://bit.ly/9IGV1u (Federal Reserve Bank)
3. http://yhoo.it/afbBGh (Yahoo Finance)
4. http://bit.ly/d356KF (WSJ Prime Rate)