Many countries (particularly advanced economies such as the United States and Europe) are finding economic growth difficult to achieve because of a lack of domestic demand: consumers and businesses are not spending. One way in which governments can try to drive economic growth is by adopting policies that increase their country's exports.

There are various options for doing this, but a favored choice has been to depreciate the local currency, so that a country's goods and services become relatively cheaper on the global stage. A weak currency also increases the cost of imports, thus making domestic producers more competitive in the national economy, again driving growth.

Since mid-2008, a number of the large exporting countries have adopted policies that have resulted in their currencies remaining weak. The Chinese government is following such policies, and the renminbi remains undervalued (although it has been appreciating against major currencies over the last few years). The United States has been very critical of the Chinese government, but its own bursts of quantitative easing (QE), which were undertaken in an effort to underpin the economy, have impacted the U.S. currency, and the Chinese administration in turn argues that the United States is also employing policies to ensure its own currency remains weak (despite its strong dollar policy). Similarly, the United Kingdom has implemented QE to support the economy. Meanwhile, the sovereign debt crisis in Europe and politicians' failure to agree to a long-term solution to the problems of certain member countries has weakened the euro. Japan also recently decided in favor of deliberately weakening the yen.

Currency wars can seriously affect the risks associated with doing cross-border business. Three key risks exist:

Policy uncertainty: As countries attempt to offset weak currencies, governments can implement policies that affect cross-border business. One example is the pegging of the Swiss franc to the euro, which effectively devalued the Swiss franc overnight by 6 percent, leaving traders with an unexpected potential loss.

Currency uncertainty: Although currency volatility can be offset through hedging, this adds further costs to businesses, undermining profits amid already-shrinking margins.

Supply chain disruption: Countries with stronger currencies implement policies to protect their domestic sector. Barriers to trade such as tariffs and import quotas threaten the smooth running of supply chains.

What Usually Happens When Currency Wars Break Out?

The most famous currency wars example is from the 1930s, when countries got into a vicious spiral of currency devaluations in order to try to maintain the competitiveness of their exporters. All that was achieved was that these countries' trading partners sank deeper into the mire of recession, further curtailing trade and leading to more depreciations. Thus, the global economy shrank and global trade and investment was devastated, a situation that only ended after the outbreak of the Second World War. Although we are not predicting that the current situation will lead to such a severe outcome, there are some parallels between the significant problems in each historical case.

As countries rush to protect the competitiveness of their exports, currency wars will prompt a number of problems, such as asset-price volatility (particularly in the currency markets), increased adoption of trade protection policies, and a rise in anti-dumping and countervailing duty disputes. These all raise risks for cross-border trade and investment.

Questions

2. Do you think the policy of keeping currencies weak will continue in the long run?
4. What other alternatives are available for countries?

Answer rating: 100% (QA)

Potential Answers 1 The Policy of Keeping Currencies Weak The policy of deliberately keeping currencies weak to boost exports and drive economic growt... View the full answer