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What Is a Currency War?

How a cheaper dollar helps economic growth

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China keeps the value of its currency, the yuan, lower than the dollar to increase its exports.

Photo: Doug Armand/Getty Images
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Currency wars can lower the value of all currencies.

Photo: Getty Images
dollars being printed

Printing money is one way to lower the value of a country's currency.

Photo: Getty Images

Definition: Currency wars is a term coined in 2010 by Brazil's Finance Minister Guido Mantega to describe the competition between the United States and China to have the lowest value for their currencies. Low currency values aid exports by making them cheaper in comparison to other currencies.

The U.S. allows its currency, the dollar, to devalue by expansionary fiscal and monetary policy. It's doing this through increased spending, thereby increasing the debt, and by keeping the Fed funds rate at virtually zero, increasing credit and the money supply.

China keeps its currency low by pegging it to the dollar, along with a basket of other currencies. It keeps the peg by buying U.S. Treasuries, which limits the supply of dollars, thereby strengthening it. This keeps the yuan low by comparison.

Japan stepped onto the battlefield in September 2010. That's when Japan's government sold holdings of its own currency, the yen, for the first time in six years. The exchange rate value of the yen rose to its highest level since 1995. This threatens the Japanese economy, which relies heavily on exports. A high yen value makes those exports cost more in the U.S. and other countries, reducing demand and slowing Japan's economic growth.

Japan's yen value had been rising because foreign governments have been loading up on the relatively safe currency.  They were moving out of the euro and the dollar due to fears of further depreciation from the Greek debt crisis and the U.S. debt.

Most analysts agreed that the yen would continue rising, despite the government's program. That's because foreign exchange (forex) traders, not supply and demand, have more influence on the value of the yen, dollar or euro. Japan can flood the market with yen all it wants, but if forex traders can make a profit from a rising yen, they will keep bidding it up.

Forex traders created the opposite problem for Japan 10 years ago, creating the yen carry trade. They borrowed the yen at a 0% interest rate, and invested in dollars or other currencies with a higher interest rate. The yen carry trade disappeared when the Federal Reserve dropped the Fed funds rate to zero.

The European Union entered the currency wars in 2013, to boost its exports and fight deflation. The European Central Bank (ECB) lowered its rate to .25% on November 7, 2013. This drove the euro to dollar conversion rate to $1.3366.

Brazil and other emerging market countries are concerned because the currency wars are driving their currencies higher, by comparison. This raises the prices of commodities, such as oil, copper and iron, which are their primary exports. This makes emerging market countries less competitive, and slows their economic growth. 

In fact, India's new central bank governor, Raghuram Rajan, criticized the U.S. and others involved in currency wars that they are exporting their inflation to the emerging market economies. Rajan has had to raise India's prime rate to combat its inflation, risking slower economic growth. For more, see What You Need to Know About the Emerging Market Crisis

How It Affects You

One of the world's richest men, Mexican telecom titan Carlos Slim, said that the currency wars between the U.S. and China will result in higher food prices.

As the value of the dollar declines relative to other currencies, the prices of imports will rise. We have already seen an increase in food and oil prices. On the other hand, it is lowering the price of U.S. exports, which should help economic growth. It also makes the U.S. stock market a good deal, which is one reason the Dow has broken above 11,000 lately. And, as long as China keeps buying Treasuries to keep the yuan low, mortgage interest rates will stay low.  (For an explanation of this, see Relationship Between Treasury Notes and Mortgage Interest Rates)

What should you do? Buy local. This does two good things. First, it keeps your prices the same, since the products are produced and sold in the dollar. Second, it creates more jobs - something we do need right now. Article updated May 21, 2014

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