International trade has created a high degree of interdependence among the nations of the world. One of the important factors which govern economic activity between two countries is the exchange rate between their currencies. Exchange rate fluctuations can have profound effects on economies. Controlling the value of a nation’s currency is a top-tier objective of its government’s economic policy. Historically some countries have taken extreme measures including ‘currency wars’ to achieve economic gains. Let’s take a look at what currency wars are and how they work.

Normal devaluation

A slight occasional devaluation of a currency can benefit a country. Devaluation occurs when the exchange rate of a currency declines. This is measured against the US Dollar, or any of the other major currencies. Devaluation means that a buyer can purchase more goods for the same amount of foreign currency. This stimulates demand for exports. For the same reason imports become more expensive and their demand falls. These two effects collectively stimulate local industry, lead to the creation of additional jobs and contribute to GDP growth. The exact opposite happens to a country when the exchange value of its currency rises. Having a strong currency with a stable exchange rate is generally considered a sign of stability and pride. Stable currency rates are linked to predictability in the economic climate and steady growth rates.

Competitive devaluation

Small exchange rate fluctuations are normal. They can occur in fractions of a percent several times each day. These fluctuations are governed by market forces such as supply, demand, speculation, world events and the like. Quick and considerable devaluation of currency is usually involuntary. It can be associated with disasters, instability, and a less than competent government. Such devaluations have historically been observed only during times of war, natural catastrophes, and widespread economic depression.

A currency war starts when a country deliberately adopts policies to competitively devalue its currency against another. This is done through direct government intervention. A nation which does this is seen as pursuing a policy of unilateral and short term gain by transferring unemployment overseas. This causes huge problems both in the long and short term as other countries take retaliatory measures.

How it’s done

Causing a devaluation of a currency against another is fairly simple. Buying a large amount of US Dollars by selling one’s own currency would devalue it quickly. Speculation influences exchange rates. Merely a discussion about projected devaluation by a country’s central bank can cause actual devaluation of its currency in international markets. Governments can print more money. They can manipulate bank interest rates. There are many other economic tools which governments can use to cause competitive devaluation.

Another economic policy that countries sometimes employ is protectionism. Under this policy countries raise import prices and decrease export prices through duties and tariffs. They do so to protect local industry and shift unemployment abroad. However, protectionism is easy to spot and quickly backfires in the form of a trade war. Competitive devaluation can be done more gradually and subtly, and is more difficult to spot.

Demerits

The negative effects of competitive devaluation are many. It makes foreign travel more expensive. It can cripple businesses dependent on imports. It discourages foreign investment. It can lead to runaway inflation. It can significantly reduce the purchasing power and standard of living of ordinary citizens. The trading partners can retaliate with their own competitive devaluations. This can result in a sharp decrease in overall international trade, causing a spiraling effect which hurts everyone. This is exactly what happened during the great depression of the 1930s. Many countries attempted to competitively devalue their currencies simultaneously. This exacerbated the economic slowdown and everyone suffered from the negative effects. Currency wars can severely strain international relations. This became evident from the vocal accusations and an eventual rift which emerged in US-China relations. These events occurred immediately following China’s competitive devaluation policies during the years preceding 2009.

Currency wars and remittances

One of worst affected stakeholder groups caught in the crossfire of currency wars is migrants. Exchange rates have a significant impact for those who work overseas and regularly send money online to support their families. Dealing with the twin uncertainties of exchange rate fluctuations and declining purchasing power back home is a great stress for overseas workers. All countries must actively avoid policies that lead to currency wars. They must do so in the interest of long term economic growth and toward promoting better international relations.