Are the US and China Losing a Currency War?

For years, the threat of a full-blown currency war has hung over a global economy that has been struggling to generate significant economic growth for more than six years.  Fortunately, such a currency war did not erupt at the time when the global economy was at its weakest, despite the monetary policy decisions in the United States that led to the introduction of quantitative easing (QE) and the subsequent weakening of the US dollar.  Moreover, China’s efforts to keep its currency weak also did not provoke a full-blown currency war, despite widespread criticism of Chinese monetary policy in the US and elsewhere.  Today, it is those two countries that took the steps that could have provoked a currency war, the United States and China, that are facing the fallout of the aggressive monetary policies being carried out by many of the world’s other leading economies as the world stands on the brink of the sort of currency war that it has long feared.

In the wake of the financial crisis in 2008 and 2009, the aggressive monetary policies of the United States and China allowed both countries to improve their export competitiveness, enabling the US to offset its domestic weaknesses and allowing China to remain the world’s dominant exporter.  However, a number of central banks, particularly those with weak domestic markets, have taken major steps in recent years to weaken their own currencies in order to boost export growth and to propel growth on their domestic markets through injections of huge amounts of cash into their economies.  First, Japan’s government and central bank enacted dramatic reforms aimed at weakening the yen, boosting Japan’s export competitiveness and bringing an end to 20 years of deflation.  In recent months, it is the European Central Bank that has enacted similar moves as it combats deflation and weak demand levels at home, as well as a deterioration of the Eurozone’s export competitiveness.  These moves in Japan and the Eurozone were followed by similar moves in many of the countries that have strong economic ties with these two economic powers, leading a host of major currencies downwards in recent months.

As a result of the significant devaluation of currencies such as the euro, the yen, the ruble, the peso and the real, it is the US dollar and the Chinese yuan that find themselves as two of the world’s strongest currencies in term of exchange rates over the past year.  For the United States, this strong dollar threatens to curtail the strong export growth achieved in the US in recent years, particularly at a time when many key export markets remain weak.  Furthermore, an even stronger dollar could introduce the threat of longer-term deflation to the US, particularly if oil prices remain low or fall even further.  As for China, the strong yuan is also harming the country’s export competitiveness, especially when it is factored into the rising labor costs in China.  While this is fueling Chinese investment outside of the country, the strong yuan is unlikely to be tolerated if Chinese economic growth rates fall faster than is anticipated in the coming months.

Given the disparity between the handful of strong currencies at present (US dollar, Chinese yuan, Indian rupee) and the rest of the world’s more important currencies, the threat of a full-blown currency war has risen sharply.  As such, it is China that now holds the key to the decision of whether or not a currency war will erupt.  This is due to the fact that the United States and India have economies that are improving, particularly in terms of rising levels of domestic demand, and this allows them to live with a stronger currency for a prolonged period of time.  In contrast, China’s economy is slowing and domestic demand is not growing as fast as the Chinese government had hoped, and thus any further decline in export growth is likely to force the Chinese government to consider a serious devaluation of the yuan.  If China makes such a move, the pressure on the US and Indian governments will be immense for them to make similar moves, while those economies that have already weakened their currencies will have no incentive to let them rise again.  If such a currency war erupts, the threat to the global economic recovery that is struggling to take hold will be immense and could do major damage to international trade and investment.