What is a Currency War and How Does it Work?

currencyCurrency values have been thrust into the headlines this month as countries begin discussing their monetary policies for the coming year. Specifically, a theme of inflation-heavy policies that will both stimulate the economy and depreciate a local currency is emerging. While this is a normal course of action for governments to pursue during a financial recovery, the interesting part to notice is how it is that multiple countries are not just devaluing their currencies to attract investors, but they are also going to be doing so competitively, creating a situation known as a ‘currency war’.

A currency war occurs when various governments use monetary policies to reduce the value of their currencies in order to attract investors and importers to start doing more business there. The policies are very aggressive in the way they stimulate a local economy, which encourages investors. Firstly, the government is able to make it cheaper for companies and individual to finance their purchases (and therefore improve their ability to purchase goods), while money can also be strategically injected into the economy, so as to support strategic industries.

The purpose of the policy-line is to then use this kind of monetary policy to encourage investors to buy into the local economy to benefit from the artificially increased demand, and in hopes that foreign importers will see the value in purchasing through the now cheaper currency (again, supporting investors using the local currency). That being said, such a strategy exists entirely to take over exporting business from other countries. This creates a competitive situation where the competing exports will want to also devalue their currencies to maintain their exporting revenues. The end result can be similar to the kind of price war that consumers see at gas stations.

Importing goods is an extremely price-sensitive endeavor. The sheer scale of purchasing goods from abroad means that tiny savings on the purchasing price are enough to make a major impact on the bottom line. This means that a currency prices matter enough to importers that they will consider changing suppliers in order to obtain a more favorable purchasing price as a result of a devalued currency. In order to stay competitive, exporters need to make sure that their currencies are competitively cheap.

If multiple countries then take on a monetary policy to devalue their currency at competitive rates, the end result is then a situation where exporting countries will repeatedly undercut each other’s currency value in terms of their values against the goods that competitively export. While doing so will maintain their ability to sell to importing countries, they will be doing so at a smaller and smaller margin, to the point at which the country is essentially devaluing itself into a state of working poverty.

Given that competitive currency devaluation has come up as a major theme for the coming year, we’re going to be digging into the specific of how it works, how investors can keep track of it, and most importantly, how personal savers can better understand the implications of a currency war on their portfolio.

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