Currency Wars Heating Up

Battle lines are forming ahead of a looming currency war that threatens to pit the developed nations against the emerging economies of Asia and South America. Over the coming months, we can expect a “race to the bottom” as countries maneuver themselves into an exchange rate advantage with their trading partners.

Currency devaluation as a policy weapon is nothing new. Exporting nations in particular have relied on it for years and one need only look to China to find a textbook example of how manipulating currencies can give exporters a decided advantage. In the matter of just a few decades, China has transitioned itself from a backwards, feudal-based system to the world’s third largest economy, and if you believe the hype, our best hope for leading the global recovery.

Of course, there are two sides to every story, and while China’s story is one of incredible success, there is no question that much of this success has come on the backs of its trading partners, and the United States in particular.

This is because China continues to follow a policy that “pegs” the yuan closely to the US dollar. It does this by maintaining complete control over the exchange rate it pays for US dollars earned through the sale of exports, and exporters are required to convert all foreign currencies to the yuan. This is also how China has amassed considerable US holdings within its $2.5 trillion total foreign reserves.

By pegging the yuan in this manner, the Bank of China can prevent the yuan from appreciating against the dollar and this is an important consideration as the US accounts for nearly 20 percent of China’s global sales. In 2009, China’s exports to the US were just under $300 billion and if the yuan were allowed to appreciate significantly against the dollar, exports would increase in cost and China would lose much of its competitive edge.

China’s artificial exchange rate presents a daunting challenge for American manufacturers competing for the consumer dollar. President Obama obliquely referred to the trade deficit with China in last January’s State of the Union address when he suggested that reducing the deficit by half would result in new jobs for Americans.

Of course, the trade gap will not decline by 50% on its own. The only way this goal can be reached within the four-year time frame set out by the President, is for the US dollar to depreciate against the currencies of the major exporting nations. Given the existence of the yuan peg however, and the fact that China represents such a large part of the trade gap, it seems that simply devaluing the dollar will not achieve the intended result. But Congress has a plan.

This plan includes a recently approved a bill that if passed into law, will enable US legislators to levy tariffs on goods imported from countries found to be engaging in unfair trade practices. The premise is simple – if we can’t compete on an exchange rate basis, then we’ll price them out of the market. This is no doubt aimed directly at China and is just the latest skirmish in what could easily become a much wider battle.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.