Understanding The Economics Behind Currency Wars

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A number of underlying forces drive currency moves.

The U.S. government has accused China of gaining an unfair economic advantage by forcing the yuan lower. In the U.K., the drop in the sterling over the past month is also viewed by many as an economic headwind.

The main beneficiaries of a weaker currency are exporters and holders of foreign-currency denominated assets, Capital Economics economist Neil Shearing said in a recent note.

The drop in the exchange rate raises the local currency value of exports, meaning the revenues of exporters increase, he said. 

“This increase in profits should in turn encourage exporters to sell more overseas, meaning that over time output expands,” Shearing said.

“Similarly, holders of foreign currency-denominated assets see the local currency value of these assets — and the income that flows from them 3 increase. This in turn boosts their spending power.” 

Winners And Losers?

Currency devaluations create winners and losers. The macroeconomic consequences of a weaker currency depend on how these winners and losers aggregate.

The main losers from a weaker exchange rate are importers and holders of foreign-currency liabilities, Shearing said. 

“For importers, the local currency costs of foreign purchases increases. This tends to feed through to higher inflation, which in turn squeezes real income and thus spending.” 

How do the different narratives playing out around China and the U.K. fit into this?

“Strange though it might sound, from the narrow perspective of the currency, there are similarities between the situations facing both countries,” the economist said. 

The trade dispute between China and the U.S. is souring, and the U.K. risk of a “no deal” Brexit is becoming more likely.

Both of these cases cause a weaker exchange rate that acts as a safety valve, and that should be viewed as a good thing, Shearing said. 

FXTM senior research analyst Lukman Otunuga said the numerous twists and turns of the Sino-American trade dispute have left most investors uncertain about what will occur next.

“Concerns over a trade war morphing into a currency war are rising, after the yuan blasted through the key psychological seven level for the first time since May 2008 on Monday, Aug. 5,” he said. 

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