One of the events that have occurred throughout this financial crisis is the recognition that global coordination and cooperation is needed to ensure economic prosperity. It wasn't too long ago that leaders from around the globe met and agreed joint initiatives to improve financial stability. One of their pledges included not resorting to protectionism (i.e. maintaining free trade between countries).
Today's picture is very different. Pick up the news and you'll probably hear about various countries intervening in their currency markets to improve their own economies, at the expense of others. Japan has been directly intervening to weaken the yen, as they fear the strong currency is hurting their exports. They have also maintained a low interest rate combined with quantitative easing. The US has been doing much of the same. Though not directly intervening, they have been able to weaken their currency with low interest rates and money printing.
In scale and size, none compare to the biggest currency manipulator of all: China. The Chinese have pegged their currency at an artificially low level to the US dollar. They do this by printing their own currency and using it to buy dollars. It is QE (quantitative easing) on a much bigger scale. The fact that the dollar has weakened in the last few months means that China's currency too has weakened against everyone else's. As a consequence, they have built up a large trade surplus and the US has a large trade deficit. It is one of the biggest economic imbalances the global economy has ever seen, and one that will eventually have to be corrected.
Currency manipulation is a form of protectionism. When a country artificially weakens their currency, they make their exports cheaper and their imports more expensive. So it is like a subsidy for exports and a tax on imports. More and more it is the case that countries are acting in this way to help their own economies at the expense of others. Of course when everyone starts to do this, no one's exports increase, and the result is a net decrease in world trade. The sense of cooperation that existed a year ago seems long gone.
So if all countries print more and more money to weaken their currencies, what will be the outcome? For one, exchange rates will become more volatile. This will have a negative effect on international trade, and hurt economic growth. Second, inflation will be higher and more unpredictable. This again, is bad for consumers, bad for businesses, and bad for the economy as a whole.
In the 1930s, after a financial crisis the global economy went into recession. To protect their own industries, countries began engaging in protectionism, mostly by putting up tariffs on imports. We all know what happened next. The recession turned into a depression, and it remains the biggest economic catastrophe in modern history. Let us hope that governments do not make the same mistake today. Economic prospects will be much better for everyone without any kind of currency war.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!
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