Are we in a currency war?
Since the beginning of 2015, more than 20 central banks around the world have cut benchmark interest rates (loose monetary policy), led by the European Central Bank (ECB) and the Bank of Japan (BOJ). With so many banks taking action, in February 2015, Bank of America ML estimated currency volatility to be at a 20-year high.1
The map above shows the cuts by various banks around the world2 (for map details, scroll to the end of this post). The fall of global currencies has been driven primarily by monetary policies of foreign banks. Meanwhile, the U.S. dollar has climbed the currency charts in the last 12 months as other currencies around the world have fallen. This raises the question: Are we in a currency war – should investors be worried or is this another media-fueled apocalypse du jour?
What is a currency war? The term stems from the perception that currency devaluation is a zero-sum game that represents an economic battle where some countries use different policies such as lowering interest rates to improve their growth, causing other countries with stronger currencies and higher rates to suffer a slowdown in growth. Lower rates cheapen a country’s domestic currency, improving exports, international trade, staffing deflation, employment and economic growth. For example, a cheaper U.S. currency could make Boeing more competitive internationally with France’s Airbus. The problem is that when one country starts to weaken its currency, other countries follow suit, and that could spiral a race to the bottom. If multiple countries try to compete by devaluing their currencies for too long, that could result in protectionism and insulated trade barriers by countries. Such moves may limit the benefits of free trade and reduce global growth.
Are currency wars common? While currency wars are not a daily phenomenon, we have seen a few of them in history. During the Great Depression, many countries devalued their currencies to help their countries grow out of Depression, arguably making the Depression worse. In 1931 alone, 17 countries abandoned the Gold Standard and/or devalued their currencies.3
More recently, in 2010-11, China and U.S. exchanged heated words over the valuation of China’s yuan. In 2013, Japan’s quantitative easing program sparked concerns about currency war breaking out.4 In January 2015, fears of another currency war were ignited once again as the European Central Bank launched its quantitative program and 20 Central Banks around the world lowered their rates.
Can a currency war be good? Some contend that currency devaluation could result in a positive-sum game as devalued currencies may boost domestic demand in countries and thereby help global demand and make everybody better off. Lower rates help consumers spend more in their own country which is good for global demand as consumers buy products which are produced both domestically and globally.
The media use the term “currency war” to boost ratings, as fear generates more readers. The kernel of truth lies not in the words used to describe the action, but in its potential impact on the economy. Historically, devalued currencies have helped increase global growth, employment, global trading and stocks. Devaluing currencies historically has helped in deflationary times by boosting domestic demand and staving off deflation (a bigger economic risk than devaluation).5 However, devaluation could hurt in hyperinflationary times like we had in the 1970s.
In Stop Worrying about ‘Currency Wars’, Bloomberg author Ramesh Ponnuru discusses the benefits of currency devaluation. He references the work done by Scott Summer, an economics professor at Bentley University, who noted that in recent times, monetary easing by a country has tended to boost stocks of other countries. The article also discusses the findings of the International Monetary Fund in 2011, which determined that the “spillover effects” of the U.S.’s Quantitative Easing or low rates program had a positive impact on other countries. Another positive impact of lowering rates is that investors typically invest in countries where rates are higher, thereby raising that country’s asset prices.
Barry Eichengreen, a professor at University of California, has written extensively on the positive impacts of currency devaluation, arguing that “What are now referred to as currency wars were part of the solution, not part of the problem.”6
These views are quite contrary to the generally accepted view that currency devaluation often creates a crisis. Currency is like a commodity whose value over the long term is determined by its supply and demand. In the short term, a strong dollar might hurt U.S. growth and the weaker global currencies might strengthen global growth; but in the long term, their intrinsic value will be determined by their supply and demand.
Conclusion: We do not believe we are experiencing a “currency war.” This is just another apocalypse du jour. Moreover, we believe “war” actually could be good for business! We have been in a period of low rates for a while and deflation has been a threat. We believe various central banks are now trying to fight off deflation with the few remaining tools they have, including quantitative easing. And regardless of what actions central bankers might take, in the end, it is the fundamentals of companies, consumers and the economy that keep companies growing and reward long-term investors. Though currency volatility might indeed be up, we maintain that does not alter these fundamental tenets of investing. This time is not different.
Map & Key
- The Central Bank of the Republic of Uzbekistan cut its benchmark rate by 100 basis points to 9%
- National Bank of Romania cut its key interest rate by 50 basis points to a record low of 2.25%
- The Swiss National Bank cut its target rate by 50 basis points to negative 1.25%.
- The Central Bank of Egypt cut its overnight deposit and lending rates, its two key rates, by 50 basis points to 8.75% and 9.75%
- The Reserve Bank of India cut its benchmark rate by 25 basis points in January, then cut it by another 25 to 7.5% in March.
- The Central Reserve Bank of Peru cut its benchmark rate 25 basis points to 3.5%.
- The Bank of Canada surprised the market by cutting its benchmark rate 25 basis points to 0.75%
- The Central Bank of the Republic of Turkey cut its main interest rate first by 50 basis points, then by another 25 points to 7.5%.
- The European Central Bank expanded its quantitative easing program to include government bonds, announcing that it would buy 1.1 trillion euros (about $1.3 trillion) of government bonds, asset-backed securities and covered bonds in 60 billion-euro increments.
- The State Bank of Pakistan cut its policy rate by 100 basis points to 8.5%.
- The Monetary Authority of Singapore said it would reduce its policy band for the Singapore dollar to slow its appreciation against a basket of currencies.
- Bank of Albania lowered its key interest rate to 2%, a record low.
- The Central Bank of Russia cut its benchmark rate by 200 basis points to 15% after hiking it drastically in December to stem capital outflow as the ruble’s value collapsed.
- The Reserve Bank of Australia cut its benchmark rate 25 basis points to 2.25%.
- Chinese policy makers cut its reserve ratio requirement by 100 basis points in April.
- The Nationalbank, Denmark’s central bank, cut its interest rate on certificates of deposit four times in three weeks. The latest was a 25 basis points reduction to negative 0.75%.
- The Riksbank, Sweden’s central bank, cut its repo rate for the second time this year to negative 0.25%, and announced another 30 billion krona in bond purchases.
- Bank Indonesia lowered its BI rate and its deposit facility rate by 25 basis points to 7.5% and 5.5%.
- Bank of Botswana cut its bank rate by 100 basis points to 6.5%.
- The Bank of Japan voted to continue purchases of Japanese government bonds, exchange-traded funds and real-estate investment trusts.
- Bank of Israel cut its benchmark rate by 15 basis points to 0.10%.
- The National Bank of Poland cut its benchmark rate by 50 basis points to 1.5%
- The Bank of Thailand cut its main policy rate by 25 basis points to 1.75%
- The Bank of Korea lowered its benchmark base rate by 25 basis points to 1.75%.
- The National Bank of Hungary cut its main interest rate to a record-low 1.8%. Central bank policy makers said they may continue to cut rates until they achieve their goals for consumer-price inflation.
2 Graphic source: The Wall Street Journal based on data from Market Watch Research