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Currency Wars: what are they and why do they matter?
The UK, US and Japan are trying to drive down the value of their currencies. What's going on?
by Gavin Lumsden on Feb 08, 2013 at 15:11
I visit the Imperial War Museum to talk about 'currency wars' and why countries like the UK, US and Japan are competing with each other to weaken their currencies.
This is the latest video in The Lolly Investor Programme series aimed at explaining the basics of investing to ordinary people.
Can't watch the video right now? You can read my script instead.
Hello, our political and economic debates are often framed in terms of struggle and of war.
In recent years we’ve had the war on terror and then the war on the economy as we strived to get over the 2008 financial crisis.
I’ve come to the Imperial War Museum in south London because right now the hot topic in financial circles is the currency war being waged by the big guns of the global economy.
In the currency war countries like the UK, US, Japan and to a certain extent the eurozone are engaged in a competition to drive down the value of their currencies.
Sounds crazy doesn’t it?
In investing, we’re trying to grow and increase the value of our money. Why on earth then would countries want to devalue the notes in their citizens’ wallets?
Because by lowering their currencies countries hope to boost their exports because it becomes cheaper for people in another currency to buy their goods and services.
Countries like the UK also want to reduce their dependency on financial services and expand the role that manufacturing plays in the economy.
An export drive led by a weak pound is a key part of this strategy.
So how do countries achieve a weaker currency?
It’s simple, they print more of it!
Yes, the currency wars we’re talking about are a result of the controversial quantitative easing policies of the Bank of England and the US Federal Reserve.
When I looked at QE before I explained how these central banks created huge sums of new money in order to lower long-term interest rates. They did this by using the new money to buy their governments’ bonds.
A side effect of all this new money and the ultra-low interest rates it caused meant the pound and the dollar were a bit less attractive for overseas investors to hold. The currencies fell, exports rose, the central bankers patted themselves on the back.
A weak currency can lead to higher inflation, however. The flipside of making exports cheaper is that imported goods become more expensive. Unless you stop imports altogether the risk is inflation will rise.
After the financial crisis the Bank of England was worried about deflation and an economic slump. It wanted a bit more inflation to get the economy going so didn’t mind taking that risk.
Nowadays, we’re getting a bit more concerned about where inflation may be heading.
The other trouble with currency wars is the idea can catch on.
The term currency war was first used when the US launched its QE programme in 2009. Recently it’s been revived because the new government in Japan has signalled it wants to get far more aggressive with its QE policies.
Japan has suffered from deflation, that’s falling prices, and an overvalued currency, the yen, for many years. This has made its exports expensive and hit the profits of its big firms.
Prime minister Abe is doing something about it, pressuring the Bank of Japan to adopt similar policies to the UK and US.
The result has been impressive. The yen has slumped and share prices on the Tokyo stock exchange have soared.
The problem is where will it end?
A series of tit-for-tat moves by countries weakening their currencies could lead to governments taking steps to restrict imports from those countries.
A new era of protectionism would reduce world trade and damage the global economy. The stakes are high.
The currency war also produces some bizarre results.
The euro – which we were worried could break up a year ago, causing financial mayhem – has recently risen on currency markets – because its QE policies are weaker than those of the UK, US and Japan.
Countries like Germany, France and Spain are worried that the strength of the euro will make it difficult for the eurozone to climb out of recession.
Meanwhile, the US dollar doesn’t always do as badly as you might think, given it has an enormous QE money printing policy and has a huge budget deficit as a result of years of over spending to sort out.
Because the US is the world’s biggest economy, the dollar is the world’s reserve currency. People will want to do business in dollars regardless of whether or not they think the US is on the skids.
Where does this leave investors? Nowhere much.
Currency movements can be frustrating if you’re investing overseas. For example, if the pound is weak against the currency of the country you’re investing in, it will reduce some of your returns.
That said, the opposite can happen just as easily.
That’s why currency markets are often described as a zero sum game because the rises and falls of currencies against each other tend to even out over time.
Some investment funds offer share classes that hedge out or remove the currency risk. However, they can be expensive and do not have a long track record.
We just have to hope governments don’t get too carried away with their currency wars.
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