Currency Wars – Race to the Bottom

The modern day warfare has shifted from the traditional battle field to the corporate boardrooms. The decisions on who survives and who does not are taken by those who strolls the corridors of power. The battle is gauged, not by the number of soldiers felled but by the points the currency has fallen. Today, the currency symbol and not the armoury is the sign of strength. The war is definitely on, but there will not be a single drop of blood; red will only be the spilt ink.

This is the new world order; this is the new way of life.

Various estimates are that the Yuan is currently 25-40% undervalued against the dollar.

“Currency War” was the term coined by the Brazilian Finance Minister Guido Mantega. It is an economic warfare where countries competing against each other try to achieve a relatively low exchange rate for their home currency so as to protect their domestic economy to preserve jobs and growth at home. It is better known as ?Competitive Devaluation‘. It started as a duel between China and the US, but has now developed into an all-out currency war.

Current Scenario

China pegged its currency Yuan to the US dollar in 2007 and stuck with it throughout the crisis. China constantly buys billions of dollars-worth of US  assets, which increases the supply of Yuan relative to dollars in currency markets. This makes Chinese exports artificially cheaper, while making foreign goods artificially expensive to the Chinese.

Various estimates are that the Yuan is currently 25-40% undervalued against the dollar. China is adopting export-led growth (exports make nearly 25% of its GDP) since long and has posted a trade surplus of $13.91 billion in December. Hence, China has resisted pressure from IMF and other advanced countries to allow for a sharp appreciation of its currency citing it could cut down China‘s growth rate to half. China said in June‘10 that it would allow its currency to rise gradually, but so far, it’s risen less than 3% (Figure 1), indicating China is more interested in cosmetic changes than real appreciation.

Figure 1: Change in price of Yuan
Figure 2: Exchange rate

US economy posted an enormous budget deficit to the tune of $1.3 trillion in 2010. Federal Reserve has reduced the dollar‘s exchange rate by providing nearly free credit to banks at only 0.25% interest. This ?quantitative easing” aims at inhibiting U.S. real estate, stocks and bonds from dwindling further in price. Low U.S. interest rates and easy credit motivate investors to lend overseas or buy foreign assets yielding more than 1%. This dollar outflow coerces other countries to defend their currencies from being appreciated. (Figure 2)

In 1985, Japan bowed down to US pressure and agreed to increase its exchange rate against the dollar as per the Plaza Accord. Within one year, the value of the yen had increased by some 60 percent. In an effort to stall the appreciating, Yen Bank of Japan (BoJ) lowered interest rates to nearly zero but Japan has still not recovered from the prolonged crisis that followed.
China recently invested heavily in Japanese government bonds forcing Japan to publicly intervene in the foreign exchange market. Japan lowered its benchmark interest rate to ?virtually zero? and its bold 12 billion dollar move to push down the value of the yen proved ineffective.


Foreign institutional investors bought Indian stocks and bonds worth $221.43 billion in 2010 causing the rupee to appreciate over 6% since September. RBI has not intervened in the exchange rate and is looking at this as a two pronged strategy. Firstly, an appreciated rupee will reduce the imported goods prices, thereby curbing inflation. Secondly, RBI is permitting capital inflows to fund the current account deficit which has reached 3.5% of the GDP in 2010-11 fiscal. In the last quarter, the current account deficit was $13.7 billion while capital account surplus was $17.5 billion.

Figure 3: Loss in Competitiveness

But, RBI may soon decide to intervene in the currency markets because the ?hot money” that came to India in 2010-11 is already starting to reverse its direction. Consequently, the Sensex has already shed more than 3000 points since the beginning of 2011 causing a loss of more than Rs. 11 lakh crores.

Other Countries

In October 2010, to disallow huge inflow of foreign capital, Brazil increased the Tobin tax on foreign capital from 2% to 6%. Some other countries in Latin American and Asia have initiated programs to buy dollars to check currency gains and loss in competitiveness (Figure 3).

The threat in all this is obvious: everyone may start intervening in currency markets, erecting tariff walls, passing anti-dumping legislation and quotas to protect powerful domestic lobbies. This could lead to deflationary spiral, the kind of protectionism that was one cause of the Great Depression.

Figure 4: Trade Imbalance

How severe is Currency War?
Currency war is severe because of its size. Some $3.2 trillion worth of currencies are traded each day. To put that number in perspective, the entire world stock market is about $36 trillion in market capitalization. The currency markets trade this amount every week and a half. Contrasting from trade, it is a ?zero-sum? game. If one country‘s currency rises, another country‘s currency must fall. Hence, there are winners and losers and no economy wants to be on the losing side with a “winning” strong currency.

US want to levy taxes on imported Chinese goods. In other words, it wants to put a 40% tariff on a Chinese good that is enjoying 40% subsidy on account of undervalued Yuan. Today, the United States spends approximately $3.90 on Chinese goods for every $1 that the Chinese spend on goods from the United States. Figure 5 shows how much leverage China has over the US.

Moreover China has almost a complete monopoly on rare earth elements. If China totally cut off the supply of rare earth elements, US would have no hybrid car batteries, flat screen televisions, cell phones or iPods. (Figure 6)

Figure 5: Unequal Competition

Hence, both the U.S. and China have abundant reasons to avoid a serious breakdown in relations. Nations should focus on more coordination rather than adopting ‘beggar thy neighbor‘ policy.

Short term solution

Appreciating the currency is in the interest of the Chinese government because they need to build their domestic consumption market and not be long-term dependent on the whims and fancies of the American consumers. The undervalued Yuan has also created inflationary burdens in China (Figure 7).

US should also control the printing of the dollar to fund the government debt.

Figure 6: Inflation in China

Alternatively, US and Japan can stop China from carrying on its intervention policy without violating any international agreement. They only require enforcing the principle of reciprocity. If the Chinese want to buy more US Treasury bills and Japanese bonds, they can do only if they permit foreigners to buy domestic Chinese debt. The Chinese Central Bank would no longer be able to intervene in the exchange market and face problem of reinvesting the flow of T-bills coming due.

Long term Solution

We are beginning to see the dollar as something like a beached whale, basically in trouble. All this friction among nations marks the end of the process by which the US Dollar has been the undisputed world reserve currency. The world is changing and the institutions that surround the world will have to change with it; one of the institutions being the dollar itself.

The last two years have seen mounting concerns around the validity of US dollar as the dominant currency. This has originated from a horde of reasons, chief amongst them being the weak fundamentals of the United States as highlighted by its huge federal debt that reached 93% of the GDP in the fiscal year 2010, mounting unemployment (9.8% in November 2010) and enormous budget deficit of the order of $1.3 trillion in 2010.

The strongest contender to replace dollar is Special Drawing Rights (SDR) of the International Monetary Fund (IMF). The nominal value of an SDR is formulated from a basket of currencies – precisely, a fixed aggregate of Japanese Yen, US Dollars, British Pounds and Euros. The share each of these four currencies contributes to the nominal value of a SDR is reevaluated every five years. After the onset of the global economic crisis in 2008, the BRIC countries – Brazil, Russia, India and China – led largely by Russia and China, have called for abandoning the dollar and moving into a global currency scheme. There have also been dialogues to expand SDR‘s reference basket to embrace all major international currencies which will be a better representative of the forthcoming multi-polar world.

Globalist organizations such as the IMF believe that devising a true global currency would assist world trade; it would make currency wars unlikely, it would soothe the global economy and it would make the rest of the world less dependent on what is going on in the United States.


So far world finance leaders have failed to find an appropriate solution to the on-going currency tussle and the dialogue has remained at the diplomatic level only. The finance leaders should put the interests of the global economy ahead of their national economies during negotiations. Otherwise, global tensions will further rise over currency rates as emerging markets try to repel off a torrent of investment funds pursuing higher returns, and countries struggle to keep the prices of their exports competitive, leading to a virtual trade war.