UK Markets closed

The great currency war of 2013 explained

Kathleen Brooks, Director of Research UK

Combat has been joined, with the world’s economic superpowers locking horns on the international markets. But what exactly is a currency war? Could one wrong move by the Japanese say, or the Europeans, cause the US or Brazil to mobilise their armies?

Maybe not, but a currency war does have lasting repercussions for the losers and rich spoils for the winner – and the latest G20 meeting in Moscow did nothing to reduce hostilities meaning it’s likely to continue for the foreseeable future. This is why.

As governments and central banks change policies, traders jump to sell or buy their currencies. That could mean the pound soars against the dollar or crashes against the euro. And this matters.

A strong pound means less inflation in Britain as foreign goods become cheaper, but hurts exports and jobs as British-made goods cost more overseas and it’s expensive for international companies to operate in the UK.

On the other hand, a plunging pound might push up the price of petrol and food, but it means it’s cheap for other countries to open plants in Britain and helps boost any British company trading abroad.

Right now – with growth almost non-existent in the developed world – the objective seems to be to drop your country’s currency to the lowest level you can and so “win” business from abroad and return to growth, inflation being seen as collateral damage.

Who started it?

The “cause” of the current war has been the recent drop in currencies like the yen, leading to corresponding increases in currencies like the euro.

To currency traders the “currency war” has another name - trending markets – and is to be encouraged. If you had jumped on the long USDJPY trade in November you would have locked in nearly 20% profit, if you had jumped on EURJPY back in July when European Central Bank (ECB) chief Mario Draghi said the ECB would do “whatever it takes” to save the euro, you would have made 35% - some nice juicy profits.

Put simply, that means in a little over three months it’s become 20% cheaper to do business in Japan than the US and in half a year working in Europe has become a third more expensive than in Japan.

And the ECB doesn’t like it. Its central bankers have one of the hardest jobs in central banking: They need to decide on policy that works for 17 individual nations at the same time. Due to this, currency market volatility makes their job harder, they would much rather that markets were not trending and instead moved slowly and steadily – otherwise known as range trading, often the scourge of the trader.

So maybe the real war is actually between the market and the central banks?

After all, the market is the one actually selling the yen and making it drop. Japan might be pursuing an ultra-loose monetary policy, however, its economy is extremely weak, at the end of 2012 it registered its third consecutive quarter of negative growth, and it is mired in deflation.

So keeping rates at zero and pumping money into the economy through quantitative easing seems a perfectly logical policy decision, even if it does weaken the yen. But that doesn’t mean it’s not a headache for everyone else.

The winner?

The massive fall in the value of the yen means you could argue that Japan is the clear winner in this war. However, it’s worth keeping in mind little old Blighty.

The pound is the second worst performer in the G10 so far this year, yet the UK has not been mentioned at all in relation to currency manipulation even though the Bank of England actually owns more of its government debt as a percentage of GDP than the Bank of Japan does.

So maybe the UK is the real winner of this war, as it hasn’t even had to deal with the diplomatic consequences of having a weak currency.

And the losers

Unless there is a serious shift in market sentiment, fast-growing and transitioning emerging market currencies with a strong export or commodities bases are likely to be the losers in the currency war.

That would mean the developing economies that have been seen as so cheap to operate in for so long are rapidly becoming more expensive as their currencies soar as ours plummet.

The Brazilian real and the South Korean won are most at risk, in our view. At least for now.

Because the currency war is alive and well and expect the losers to launch a counter-attack at any stage.

More from