Currency wars are nothing new – but who will be the casualty of the next?

Wars frequently take place over years, with shifts in theatres, strategy, and tactics.

The current currency wars began in 2009. Badly affected by the sub-prime crisis, the US cut interest rates dramatically and subsequently launched 3 waves of QE. Between March 2009 and August 2011, the US dollar fell by around 16 per cent on a trade weighted basis against major currencies. With its banks exposed to the 2008 financial crisis, the UK adopted similar policies resulting in a sharp fall in the Pound Sterling.

There were counter-attacks commencing late 2011/early 2012. The European debt crisis forced the European Central Bank (“ECB”) to cut rates and then launch its own version of QE. Between 2011 and 2012, the Euro fell by over 25 per cent against the US dollar. As part of Prime Minister Shinzo Abe’s economic program, the Bank of Japan (“BoJ”) expanded its QE programs, weakening the Yen, which fell by over 30 per cent between 2012 and 2015.

There were side skirmishes. After 2014, falling oil prices and diplomatic conflict with the West over the Ukraine and resulting sanctions caused a sharp fall in the Rouble. Since 2011, the Indian Rupee has lost half its value. Falling commodity prices weakened the Canadian, Australian and New Zealand dollars, Brazilian Real and South African Rand.

The battles themselves have been inconclusive. The US recovery was assisted by the weaker dollar which increased exports. But investment in the shale oil boom, growth in emerging markets, budget deficits and also prompt action to deal with banking problems were crucial. In Europe and Japan, fiscal stimulus, demand from emerging markets and a lower commodity, especially oil, prices were arguably as important as the fall in the Euro and Yen in stabilising economic activity.

The complex impact of devaluations can be seen from the case of the UK. The sharp drop in the pound after 2007 was expected to increase exports. In the early 1990s, it stimulated activity pulling the country out recession. The lower pound, this time, improved the balance of trade but not sufficiently to offset declining domestic demand and the higher cost of imports. The muted effect was driven by the lack of external demand from major trading markets such as the US and Europe, the changed structure of UK industry with its focus on services rather than raw materials, advanced machinery, automobiles and luxury goods demanded by emerging markets, and the decline in North Sea oil and gas production.

The divergence in economic cycles between various major economies caused a change in fortunes. Between August 2011 and July 2014, the US dollar rose by 11 per cent on a trade weighted basis. By January 2016, it had risen a further 25 per cent because of a strengthening US economy, anticipation of higher interest rates and the deliberate weakening of the Euro and Yen.

The rise slowed the US economy. It created pressure on emerging market borrowers with substantial US dollar debt not covered by cash flows or assets in the currency. The stronger dollar placed pressure on already weak commodity prices and resulted in a revaluation of the Yuan which is linked to the American currency.

At the March 2016 G20 Shanghai Summit, the leading economies recognised the stresses. There are suggestions that there was agreement to lower the value of the dollar. Between January and July 2016, the US dollar declined by around 5 per cent. But the accord, if there was one, unravelled quickly. At the G7 Finance Minister’s Meeting in May 2016, Japan clashed with the US on the issue of currency valuation. The dollar’s fall reversed, exposing problems for the US and global economy.

The war is entering a more dangerous phase. Gold, which now functions as a de facto currency, has risen in value anticipating the currency crisis which appears increasingly unavoidable.

Japan and Europe are likely to further ease monetary policy weakening their currencies to address the lack of growth and low inflation. For Europe, the immediate effect of the Brexit decision and the depreciation of the pound is an additional consideration. China needs to devalue to help manage a slowing economy, property bubble, industrial overcapacity, fragile banking system and export-dependent, debt-based economic model.

Policy makers risk losing control. A falling Yen or Euro could force China to retaliate by devaluing the Yuan significantly. Other countries, especially in Asia where currencies are directly or indirectly pegged to the dollar, are likely to be forced to take measures to counter the effects of the stronger US dollar and a loss of competitiveness against the Euro, Yen or Yuan.

The currency wars will spill over into interest rate markets. Central banks globally will be forced into accommodative monetary policies to avoid large capital inflows seeking higher returns pushing up the currency. Sharp falls in interest rates anticipates this trajectory.

Low rates will increase risk in already over-valued asset markets. They will be reinforced by deflationary pressures as countries, such as China, with excess production capacity undercut competitors. Political responses, such as a declaration by the US of Europe, Japan and China as currency manipulators or reporting countries to the WTO for violation of dumping rules, will add a geo-political dimension.

In foreign exchange wars as in military versions, there are no winners. A weaker dollar means that the rest of the world loses. Japan and the Euro zone benefit from a stronger dollar but the US loses. At the same time if the Euro and Yen weaken, then as the dollar rises China loses because the Yuan appreciates. If a country lowers rates to weaken their currency to improve export competitiveness, there is a risk of capital flight, which may weaken the domestic economy. If a country takes no action and their currency appreciates due to aggressive measures from competing nations, then exports suffer as competitors gain market share. It will end, as it does always, in stalemate with major casualties on all sides.