Yuan Devaluation: Currency Wars Revisited

In 1922, in post-war Germany, a group of people going for dinner would ask to pay for the meal in advance, why? Because just a couple of hours after ordering a few dishes (and beers), when the diners would already be in heavy digestion, the price of the meal would have gone significantly up. I am not saying that the group would have got carried away and asked for more dishes, I am saying that the price for the same amount of food would be literally higher after the meal. This was due to the hyperinflation that the German economy was experiencing. The devaluation of the mark was the beginning of the first currency war in our history. The purpose? To collapse the value of the mark in order to, among other thing, try to get the U.S. and England to alleviate the demands imposed to Germany in the Versailles Treaty.

What is known by “currency war?”
Currency War – A situation in which countries compete against each other devaluating their currencies.

During the period of the classical Gold Standard, between 1870 and 1914, countries could not devaluate their currencies since their values were tied to Gold, and hence to each other. The stability of exchange rates prompted a golden age in which technological improvements in communication and transportation among other sectors raised living standards and productivity. In 1914 WWI began, and apart from the 17 million dead and 20 million wounded, it left a completely devastated economical landscape not only for Germany, but also for all the countries involved. The scenario didn’t allow a reinstatement of the gold standard, at least not the one seeing from 1870 to 1914.

It is important to understand that global trade growth picked up in the second half of the XIX century and up to 1914. This is why currency rates became so important and why the Gold standard was key during 44 years. However, once broken, countries were free to devaluate their currencies, but why would they do so?

Why do currency wars exist?

Let’s use this point to get some macroeconomics concepts clear in our heads. We all know what GDP is, but how do we get to that number? There are three ways:

Production Approach – The GDP is calculated as the gross value of all domestic output for all the economic activities minus the intermediate consumption which are the cost of materials, products, and services used in the production of final goods or services.

Income Approach – Known by another name, GDI, the GDP given by the income approach should match the one given by the Production Approach. In this second way we need to add the following 4 factors:

  1. Retributions to business’ workers
  2. Corporate Profits
  3. Investment income
  4. Unincorporated businesses’ income

To these 4 factors we need to add the indirect taxes minus subsidies, and depreciation.
Expenditure Approach – This is the approach that we are going to use to explain why currency devaluation is a tool to improve GDP growth, at least in theory. In this third approach we add all the uses of goods and services that are final by adding all the final expenditures in the economy. In this approach GDP is known as Y and it is the sum of consumption (C), Investment (I), government spending (G), and net exports à Exports – Imports (X-M)

Y = C + I + G + (X-M)

In an economy where consumption and investment are stagnant and low, and where the government doesn’t have the ability to inject more money, the easiest and fastest way to affect the GDP growth would be to modify the net exports number. Exchange rates have the answer! If the country that is experiencing the above-mentioned situation exports a significant amount of goods and services it could devalue its currency in order to improve its GDP. This devaluation would have an almost immediate effect in the GDP growth rate since the domestic products would be way more attractive in foreign countries and the foreign products would be less attractive in the domestic region.

The exchange rate between the U.S. dollar and the Euro was, one year ago, about 1.40 dollars per euro, and its now about 1.11 dollars per euro. Last summer, a bottle of French wine with a price of 50 euros in France, was sold (just converting with the exchange rate, without adding shipping and other costs) for 70 dollars in any city in the U.S. However, this summer, the same 50 euros bottle can be sold for 55.5 dollars. Just due to the depreciation of the euro vis a vis the dollar a bottle of wine from France is 21% cheaper in the U.S. than a year ago, while the amount of euros received per bottle in France remains the same, 50 euros. So, now, due to the 21% price improvement, Americans will buy more wine and the amount of French wine sold in the U.S. is going to increase. If we add all the other French products that are sold in the U.S. we will get an increase in exports (X) from France to the U.S.

The relation affects the imports as well. A GM or a FORD with a price tag of 50,000 thousand dollars in the U.S. would cost last summer almost 36,000 thousand euros. However, this summer costs 45,000 thousand euros. Due to the big move in the pair EUR/USD French people are going to be more willing to buy a Renault, a Citroën, or even a Volkswagen, since the Euro is also the official currency in Germany, than to buy a GM or a Ford, which cost went up 25%. This means that the import amount (M) will drop. If X increases and M decreases the term (X-M) increases and keeping the rest of the variables constant Y increases.

Exchange rates: As you can see devaluating the currency of a country makes perfect sense in order to pump exports and decrease imports. However, a country cannot expect to perform devaluations and not expect any type of retaliation from other nations. When the other nations understand the game that is being played and want to revert the situation, the currency war is on the way.

Most important episodes in the currency wars

If you want to read an exhaustive summary of the different currency wars that our world has suffered (I highly recommend it) you should read “Currency wars, The Making of the Next Global Crisis.” Many of the facts presented in this post come from this great book by James Rickards.
First episode

Children’s blocks made of cash : Germany’s 1920s hyperinflation left money near-worthless, hours after it had been printed.
Children’s blocks made of cash. Source: nypost.com

The first episode of the currency wars was played by the fantastic 5: Germany, England, France, Japan, and the U.S. The results of WWI, especially for Germany, sparked the initial fire of competitive currency devaluation, however, the lack of a gold standard or any other system that would anchor the value of the different currencies to an asset provided the right scenario for a massive battle.

The first to move was Germany. Crippled from the major economic effort that a war involves, especially when you lose it, Germany was also suffering the cost of the reparations that France and England were imposing. Desperate times call for desperate measures, and it will be hard to argue that any advanced country has been more desperate than Germany in the beginning of the XX century. The Reichsbank, the central bank of Germany at that time, started a crusade to completely destroy the value of the mark through massive money printing. It got to a point that since the central bank was scared to run out of ink, it would only print the bills in one side of the paper. At the beginning, it seemed that Germany was trying to increase exports and encourage tourism, but the levels of hyperinflation reached demonstrated that the real reason for the currency devaluation was to blow up the German economic system to get out of the war reparations demanded by England and France.

The second one to move was France. The British Gold standard Act of 1925 started a new and different gold standard, but France had successfully devaluated the Franc in 1923 while England and the U.S. returned to gold at the pre-war rate in 1925. This gave an interesting advantage to France during a few years. In 1931 England broke with the newly adopted gold standard and devaluated the sterling to match the Franc’s previous devaluation. Only one year later the Lausanne Conference, held in Lausanne (Switzerland), resulted in the suspension of Germany’s reparations payments signed in the Treaty of Versailles. This was a major win for Germany, and maybe the first big win for currency devaluation. In 1933 the U.S. was devaluated against gold and finally France broke with the gold standard in 1936.

As James Rickards explains in his book:

“In round after round of devaluation and default, the major economies of the world raced to the bottom, causing massive trade disruption, lost output and wealth destruction along the way. The volatile and self-defeating nature of the international monetary system during that period makes Currency War I the ultimate cautionary tale for today as the world again confronts the challenge of massive unpayable debt. “

The Bretton Woods Conference, held at the Mount Washington Hotel in Bretton Woods, New Hampshire, and also known as The United Nations Monetary and Financial Conference, was an attempt to learn from past mistakes and set a proper international monetary system. The problem was that due to its political and military power, the U.S. was able to force the other nations to create a system in which the reserve currency would be the U.S. dollar instead of the bancor, as suggested by John M. Keynes. The monetary system created was anchored to gold by the U.S. dollar, which was convertible to gold at $35 per ounce, and the other currencies were pegged to the dollar. The other currencies were required to maintain a determined exchange rate within plus or minus 1% of parity, what is known as a pegged with a band. The Bretton Woods era, from 1944 to 1973 marked the start of the U.S. dollar as the world currency.

The system worked for about 20 years; however, in the 60s England was dealing with lower growth than Germany and France and a rampant unemployment rate. This is why in 1967 the pound experienced the first big currency devaluation since the starting of the Bretton Woods era.

However, the biggest attack to the monetary system came from the other side of the Atlantic. In 1971 Nixon announced its new economic policy in which, among other things, imposed a 10 % tariff on imports, and broke with the gold standard of the time. Nixon’s goal was to devaluate the dollar, but he wanted it fast. This is why he imposed the tariff. A tariff has the same impact as a currency devaluation for imports, so Nixon wanted to force the other nations to let the dollar devaluate and then end the tariff.

After numerous G10 meetings the Smithsonian Agreement was reached. The outcome: The dollar devaluated between 9 and 17% against all the other major currencies of the time. However, the effects were not as expected and the other currencies started to break the Smithsonian Agreement and devaluating their currencies. In 1973 the IMF ended the Bretton Woods system. This officially marked the end of a currency era where gold had a central role in the international monetary system and the beginning of a new one where currencies were allowed to float against each other as Mr. Market pleased.

After a period of high economic growth in the U.S. the dollar gained “too much value” and the U.S. again needed a new attack in order to devaluate its currency and gain ground in the international trade space. This situation was motivated by the fact that during the first half of 1980s (despite of the high economic growth) the unemployment rate was quite high, by historical levels, and Americans were blaming the strong dollar of this situation. They felt that the U.S. could bring unemployment down by encouraging exports and discouraging imports. The dollar was successfully devaluated (the U.S. leveraged its political and military power even more efficiently than during the Nixon years) but “surprise surprise” the unemployment remained high and the growth rate dropped.

As we can see, currency wars do not bring the expected outcomes. However there is one thing that they do bring, high inflation.

Lessons from past currency wars

The problem of competitive devaluation is that no country will benefit from the devaluation since at the end all the currencies remain at a similar level after all the devaluations have taken place. This could result in countries using protectionist measures, such as tariffs or subsidies, in order to promote domestic consumption and exports. This results in a drop in international trade and a loss of output for the entire economy.

The only real way of achieving sustainable GDP growth is by increasing consumption and private investing and ultimately improving technology. However, we will treat this topic more in depth in a different post.

We want to leave this post here for now since there is quite a bit of information to digest. To read the second post in the series – Yuan Devaluation: Currency Wars – part 2. To read the third and last part go to - Yuan Devaluation: Currency Wars – part 3

Source: source: Opseeker – Contributing to financial literacy

Dig deeper

  1. Bretton Woods Monetary conference
  2. abundance-and-happiness.com
  3. Children’s blocks made of cash. Source: nypost.com
  4. Children’s blocks made of cash | many links
  5. History of money; what it is and how it works
  6. My rss thread on China
  7. “It’s Official: China Confirms It Has Begun Liquidating Treasuries, Warns Washington.”
  8. China’s Complexity Problem | Stephen Roach
  9. China on Project Syndicate
  10. Global imbalances and the Chinese economy | Michael Pettis
  11. Are we starting to see why its really the exorbitant “burden” | Michael Pettis


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Mis en ligne le 01/08/2014 pratclif.com