(We are real men, we will act like real men) This was the mouthpiece of some major countries' economies officials in the face of the US. When, where and how? Please pay attention to this quite important story I am going to tell briefly.
In the late seventies and early eighties, the inflation rate in the United States rose and reached record levels due to the oil crisis and excessive government spending. The Americans were suffering from a state of unparalleled high prices since the second World War. We are talking about a rise in prices that exceeded 14%. Federal Reserve Chairman Paul Volcker vowed at the time to raise interest rates continuously and densely in order to control the hyperinflation rate.
Thereby, he began raising interest rates in 1980 and 1981 until they reached 20%, which is the highest interest rate ever. The high rise in interest reflected on the strength of the US dollar, which rose against other major currencies at that time by more than 47%. Hence, imbalances began to appear in the global economy. Some other major economies started to suffer from the rise of the dollar compared to their currencies.
That was until those countries agreed with each other to put an end and forced the United States to devalue the daunting dollar raises. This was in addition to the pressures that US President Ronald Reagan was exposed to at the time from American exporters themselves.
In point of fact, on September 22, 1985, at the Plaza Hotel in New York City, the finance ministers and central bank governors of the countries called the G-5, namely West Germany, France, Japan, the United Kingdom and the United States, met and signed the Plaza Agreement, which was named after the hotel in which it took place. They agreed to reduce the value of the US dollar by 40% over two years against the German mark, the French franc, the Japanese yen and the pound sterling through direct intervention in the currency markets.
After the devaluation of the US dollar, the United States wanted to stop the devaluation process in 1987. So; another agreement was signed, the Louvre Agreement to stop the continued decline of the dollar and stabilize the exchange rate. What does that scene remind you of? You are right. It is exactly the same scenario that is happening now.
A significant rise in the inflation rate, as a result of which the US Federal Reserve began raising interest rates at a fast pace and will continue until next year. This led to a significant increase in the value of the US dollar. The only difference is that the United States is not going to interfere and devalue the dollar, and this has pushed several countries towards an inverse currency war.
What is the inverse currency war that flared up? How does the rise of the dollar help the US control inflation? Why did the major economies also decide to revalue their currencies in order to face the growing strength of the dollar? Who will win or lose in this currency war? What is our position here in the Arab World on this issue? This is what we are talking about today.
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It is your subscription that helps us grow up and develop. Now, let us discuss the battle that has begun between the currencies of the major global economies and how it will affect us. We have all seen currency wars in its traditional form wherein countries jockeying for a competitive export edge by driving down their currencies.
We have seen many currency wars and conflicts before, common types of such conflicts is what happened in 2010, when Brazilian Finance Minister at the time, “Guido Mantega” launched a major attack on the powerful rich economies, especially Switzerland and Japan, accusing them of deliberately weakening their currencies to increase their competitiveness abroad and stimulating their economies at the expense of emerging market economies, thereby he considered it a currency war.
A more popular example; We have seen the clash that took place during Donald Trump presidency over China's refusal to allow the yuan to rise in order to ensure that its exports are cheaper all over the world, which contributed to the economic boost in China and of course the widening of the trade deficit gap between the United States and China.
It eventually resulted in a trade war in which the two countries imposed mutual tariffs during the Trump presidency, and China responded by devaluing the yuan again, which made the US Treasury on August 5, 2019 officially designating China a currency manipulator.
In the common form of currency war, countries resort to devaluing their currency against other currencies because this is the way to support their economy. How is that? When its currency depreciates, its exports are cheaper compared to competitors exporting the same goods and services.
This boosts demand from abroad, because their exports are cheaper. At the same time, the depreciation of a country's currency boosts import prices thereby spur domestic consumption of more homegrown products and services. All of this in the end serves local producers and thus increases economic growth and this is the ultimate goal of devaluing the country's currency.
There is another form of that currency war and it is called the reverse currency war. This is a war in which countries resort to the opposite image, which is to make their currency stronger or raise the value of their currency, and the goal here is not to increase economic growth, but to control inflation.
This will be illustrated shortly. The United States started the inverse currency war when it decided to raise interest rates and thus made the US dollar stronger and dominant over the rest of the other major currencies.
The US dollar also rose against the other major currencies by 7% in the past six months. Let's take a look at the performance of the US dollar against other major currencies in the past six months, from December 2021 to June 20, 2022…
- Last December, the euro was equal to 0.88 cents per dollar, but the dollar continued to increase until it reached 0.95 cents per dollar.
- Last December, the Swiss franc was equal to 0.91 Swiss rupee per $1. It continued to increase until it reached 0.96 Swiss rupees per 1 dollar.
- Last December, the British pound was equal to 0.74 penny per $1, But the dollar continued to increase until the pound reached 0.82 penny to one dollar.
- Last December, the Japanese yen was equal to 115 yen per 1 dollar, but the dollar continued to increase until the yen reached 136 yen per dollar.
- Last December, the Chinese yuan was equal to 6.3 yuan per $1, But the dollar continued to increase until the yuan reached 6.7 yuan per dollar.
Countries with big economies often do not express their attempts to boost the value of their currency because this will put them in confrontations with many countries because this is considered currency manipulation. On the contrary, it tries to make it clear that the change in the value of its strong currency is not intentional. This is what the United States is currently doing because many major countries are starting to get upset about the "strong dollar" and are talking about it openly.
So US Treasury Secretary Janet Yellen said in a statement, for calm, on May 18 in Germany that it's understandable that the dollar had risen and has impacts on other countries and that is a concern.
We're committed to a market determined exchange rate, the Federal Reserve itself confirmed more than once that its goal in raising interest rates is to fight inflation, not to support the dollar.
Of course, Yellen's diplomat's talk about the dollar's appreciation, and the Fed's denial that it was deliberately raising the value of the US currency, did not curb some US politicians from celebrating the dollar's gains. For example, the Republican Senator from Pennsylvania Pat Tommy said that the Federal Reserve is supposed to complete its path to combat inflation as the strength of the dollar helps a lot in this task. Here an important question is raised, And that is the next question.
How does the strength of the currency help fight inflation?
A large part of the high rate of inflation in most of the world's economies, including the US economy, is due to external factors. In other words, it is an imported inflation And the reasons are due to:
- To high food prices.
- The rise in oil and gas prices due to the outbreak of the Russian-Ukrainian war.
- The Chinese lock down to control the Corona virus outbreaking again.
- And the current global shortage of semiconductors, in addition to the persistence of some supply chain disruptions and charging problems.
Thus, the goods that are imported are already expensive and this fuels the continuous rise in the rate of inflation.
What can he do to reduce the value of imports?
Raising the value of the currency to reduce the value of imports. A stronger currency means relatively cheaper imports, thus controlling inflation and enhancing people's purchasing power.
This is a simple example in order to illustrate the idea, suppose that the United States imports cars from Europe.
The exchange rate between the dollar and the euro is 0.88 cents per dollar, as it was last December. If someone were to import a car that costs 1,000 euros, for example, the American importer would pay the Europeans $1,136 at that exchange rate for the car that would be sold in the US domestic market. The exchange rate between the dollar and the euro is almost equal.. 1 dollar = approximately 1 euro at the time of writing this article.
The same car that was imported from Europe for 1136 dollars a few months ago, its price is now only 1000 dollars at the current exchange rate after the rise in the value of the dollar, and thus the value of imports decreased, and this reduces the amount of inflation inside the US, even a little.
- But, to what extent will the changing interest rate help curb inflation rates?
- Is it worth raising the value of the currency?
- Or, will currency revaluation cause problems with other countries instead?
Economists can know the effect of a movement in the exchange rate on the rate of inflation through what is called the 'pass-through rate'. Thus, they resort to that rate in order to know how the strength of the currency, which is the US dollar, curbs the rate of inflation. In some previous bouts of dollar strength, that rate has been marginal.
Nevertheless, some economists argue that it could be higher during times of elevated inflation.
For example, Citigroup Inc. chief economist Nathan Sheets, who previously worked for the US Treasury and Federal Reserve as well, said that in In an era of rampant inflation the pass through rate is of greater benefit, 10% increase in the value of the dollar would have been expected to dampen decreases only about half a percentage point when inflation was subdued.
But at the current high pace of inflation, the pass-through coefficients could be more than double that [a full percentage point].
As a result, other countries began to talk openly about the relationship between exchange rates and inflation, and their central banks began to take immediate measures in order to confront the strength of the dollar and fight their internal inflation at the same time.
The Swiss National Bank President, Thomas Jordan, said that they shall allow the Swiss franc appreciate. He also added that “This is one of the reasons why in Switzerland inflation is lower than compared to the euro zone or the United States.”
On June 16, in order to push the Swiss franc appreciation, Jordan suddenly raised interest rates which was the first in 15 years.
Thomas Jordan Why did he do that?
He said it is an attempt to face inflationary pressures due to the rise in fuel and food prices all over the world.
What happened to the Swiss franc after that?
Exactly, it rose to its highest level in seven years.
What did Britain do to get through the currency war?
Hours later, Britain also did the same for the pound sterling so that it would not be weak among currencies, it raised interest rates and stated that it would continue to increase in value in the future. Thus, the British pound rose against the dollar as well.
What did Canada do to get through the currency war
Two months earlier, in April, the Governor of the Central Bank of Canada, Tiff Maclem, was unhappy with the depreciation of the Canadian dollar against the US dollar. So on June 1st, he too raised the interest rate. Thereby the Canadian dollar value raised, not only that, he pledged more rate hikes as well.
Many officials in the European Central Bank talk about the risks of the euro's devaluation against the dollar. For example, on May 16, the Governor of the Bank of France and member of the Board of Directors of the European Central Bank Francois Villeroy de Galhau said that “a euro which is “too weak” would go against the inflation curbing efforts of the European Central Bank.
How is that?
The weakness of the euro makes imported goods denominated in dollars such as oil more expensive and this fuels inflation, which has reached record levels in the euro area. Therefore, policy makers at the European Central Bank openly announced that they will raise interest rates at the next monetary policy meeting, on July 21, by a quarter point for the first time in more than 10 years, in order to control inflation and raise the value of the euro against the dollar.
Now, after the race of central banks in the major economies to revalue their currencies to control inflation.
A nerd might have a question: Doesn't a currency appreciation affect a country's exports as it makes them more expensive in international markets?
That's right, exports got more expensive, so one of the main victims of the reverse currency war are the exporters themselves. Looking at the United States as the first country that started that war, we will find that American exporters are between a rock and a hard place because of the strength of the dollar. Even companies that depend on foreign sales will be losing part of their final profits.
How is that?
For two reasons:
The first reason: a strong dollar reduces foreign revenue when translated back into dollars.
The second: it makes their products in international markets less competitive because they have become more expensive, which leads to a decrease in demand/consumption.
Gina Martin Adams, director of equity strategy at Bloomberg Intelligence's advanced research unit, said about 35% of US companies have a significant portion of their revenue coming from abroad and therefore a strong dollar has a financially negative effect on their dividends.
One of the largest technology companies in the United States is one of them as it has complex global deals and it also makes more than a third of its sales outside the United States. Therefore, we have seen some American companies over the past few days complaining about the appreciation of the dollar.
Microsoft, for example, has accused the rise in the dollar's value of affecting its profits, the same for biotech company Biogen and retail giant Costco and others.
The question now is why.
If corporate profits are affected by the rise in the value of the dollar, why is the value of the dollar raised against the exporters interest? The answer is simply that it has a greater and more important interest than the interest of exporters, which is to enhance the purchasing power of the whole nation in light of the high cost of everyday needs [from fuel to food to equipment, etc...].
This is not to mention the disruptions in the supply chains and the inability to export all production. Exporters have to take their lot in the crisis. Apart from the exporters' crisis, as we say, the central banks of the major economies seem to have entered into an anti-currency war and started competing with each other over who should go the mile further.
Yet, if the situation remains unchanged, we will witness high pace fluctuations in the value of the dominant currencies thereby the burden of inflation will be shifted to other countries that may not be able to play this perilous game with major economies.