Are we in the middle of a global currency war?

Chinese Yuan US dollar

Briefing: Many countries are weakening their currencies to boost exports, but China is main problem

BY Tim Edwards LAST UPDATED AT 16:34 ON Wed 6 Oct 2010

Governments around the world have been intervening to reduce the value of their currencies in a bid to boost exports and spark economic recovery. Last week, Brazil's finance minister Guido Mantega responded by saying: "We're in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness."

By far the biggest offender, to Western eyes, is China, whose booming economy is based on exports. The Communist Party is accused of keeping the country’s currency, the yuan, artificially low in order to keep its exports competitive.

Finance ministers of the G7 nations will meet tomorrow, with currency manipulation now at the top of their agenda. The Institute of International Finance, a banking lobby group sent a letter to the International Monetary Fund, which meets after the G7 gathering, saying: "Urgent action is needed to arrest the disturbing trend towards unilateral moves on macroeconomic, trade and currency issues."

Why does everybody want to export?Countries emerging from the worst downturn since the Great Depression are looking for ways to spark sustained economic growth. The concept of an export-led recovery is particularly attractive since it reduces unemployment in the exporting country.

What have exports got to do with exchange rates?One way for a country to encourage exports is to reduce the value of its currency – often by reducing interest rates. This makes the goods cheaper, and therefore more attractive, in foreign markets. Reducing interest rates also makes consumers spend more money domestically, boosting the economy, as there is no incentive to put money into savings accounts.

The problem is that a weak currency makes foreign goods expensive to the country's consumers, shrinking the export market for foreign countries.

Foreign investors also prefer to buy the currencies of stable countries with higher interest rates, like Brazil, making those currencies stronger. Mantega says Brazil is one of many developing countries whose exports are being eroded by the actions of developed countries reducing their interest rates.

It is impossible for every country to export its way out of recession – but that won’t stop every country trying.

Are many countries manipulating their currencies?Yes. Earlier this week, Japan pegged its interest rate back to 0 per cent from 0.1 per cent and is considering $59.7bn in 'quantitative easing' – effectively printing money - in a bid to combat a strengthening a yen which was playing havoc with the exporting powerhouse.

Brazil, whose finance minister sounded the "international currency war" alarm, has doubled a tax on foreign investors buying bonds in an attempt to weaken the real, which is rallying on high interest rates and a commodity boom.

South Korea, Switzerland and Taiwan have all intervened recently to weaken their currencies. Meanwhile, the Bank of England and the United Stated Federal Reserve are considering new rounds of quantitative easing and China has been keeping the yuan artificially low relative to the US dollar for years.

How should currency exchange rates behave?The currencies of countries with large trade deficits, such as the US and UK, should fall in value, boosting demand for their exports. Currencies belonging to exporters such as China, Japan and Australia ought to appreciate, allowing them to buy foreign goods more cheaply. This has already begun to happen in Japan, which explains its return to 0 per cent interest rates, and Australia.  

What is actually happening?China is pursuing policies that keep the yuan artificially low and boost the US dollar, such as buying dollar assets. Meanwhile, despite a weak dollar, US exports are failing to take off in China because consumers there, saddled with a weak yuan, can't afford them. This is not just a problem for the US, but for any country hoping to sell goods to China.

And China is not the only culprit, it is just the largest.

So is there a currency war?Not quite, but the US Congress has drawn up battle lines by voting to impose trade sanctions on countries, such as China, which they believe are manipulating their currencies to boost their economies. Tim Murphy, a Democratic congressman sponsoring the bill, said the weakness of China's currency had cost 500,000 US jobs. Unilateral action risks an all-out trade war, which would also lead to the loss of US jobs related to Chinese exports, but there are some who say the US can't actually lose a trade war, since their trade deficit is already so horrific.

What does China say?China denies purposefully keeping the yuan low, but refuses to allow it to appreciate in any case, saying a low yuan is needed to help pull millions of peasants out of poverty. President Wen Jiabao said after meeting EU leaders that he wanted countries to make an orderly exit from fiscal stimuli (of the kind that keep rich countries’ currencies low) and "keep the exchange rates of major reserve currencies relatively stable".

What is the best thing to do?Nothing. This will allow an international rebalancing of currency exchanges to their natural level, with the pound and US dollar relatively weak because of big trade deficits and the yuan and yen relatively strong because of big trade surpluses.

Will the G7 meeting avert a currency war?Probably not. Quite how developed countries will make the case that China should allow its currency to strengthen after Japan's recent tinkering is anybody’s guess. However, since doing nothing is the best course of action, perhaps this is for the best. · 

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