A little more than a year ago, in September 2010, Guido Mantega – the Brazilian Finance Minister – made headlines when he warned against the dangers of a global currency war. Nine months later, in July 2011, he boldly stated to the Financial Times that the currency wars were “absolutely not over“.
On the 3rd of October, the US senate with an overwhelming majority approved a bill that would punish any country that keeps its currency ‘artificially low’.
What is a currency war? How does it influence the average trader?
In its simplest form a currency war, often also referred to as ‘competitive devaluation’, is when countries compete against each other to try to maintain the most competitive currency exchange rate.
There are mainly two reasons for this: in the first place, a relatively low value for a country’s currency means that such a country’s exports would be priced more competitively. Secondly, it will make imports more expensive, forcing consumers to switch to local products – thereby stimulating the local economy.
The downside for the local economy and consumers is that basic necessities that have to be imported might become increasingly expensive. An example is that of oil: a country without its own oil will find that fuel prices rise dramatically if the local currency is allowed to devalue significantly.
If we look at Fig. 10.24(a), we see that the Chinese Yuan has devalued quite significantly against the US dollar during the past couple of months. This means Chinese imports are now even cheaper than a few months ago – and the US will find it harder to sell ‘overpriced’ US products in the Chinese market.
Looking at Fig. 10.19(a), however, we see that the US Dollar has appreciated not just against the Yuan, but also against a basket of other currencies forming part of the US Dollar Index. Whether China is in fact therefore ‘artificially’ keeping its currency value low remains a matter for debate.
The country has already warned against “waves of trade protectionism that would favour nobody”, if the US should go ahead with its plans to punish China for its competitive exchange rate.
What does that mean for the ordinary trader? If one country could manage to consistently devalue its currency against that of another, it would create a wonderful opportunity for traders to exploit: go long on the currency that appreciates in value or short on the one that is dropping in value.
The problem comes when a full-scale ‘war’ breaks out and the countries involved use their central banks to interfere in the currency markets. This often causes huge instability in the markets: one day currency A would be ‘ahead’ in the devaluation game and the next day the situation would be reversed.
Such a market is very difficult to trade. To make things even worse, the instability could cause investors to lose faith in the currencies involved in the ‘currency war’ and switch to more stable investments – such as gold. The recent surge in the price of gold is a point in case: investors (and traders) switched to gold in large numbers because it was seen as a more reliable investment vehicle than any of the major currencies.
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