Currency Wars: What You Need To Know As The Yen Falls Against The Dollar And Euro And The G-7 Tries To Calm Fears

Currency wars are back in fashion.

The term “currency wars” implies a deliberate attempt to gain competitive advantage by devaluing. Foreign exchange intervention has long had a bad reputation; it earned the “beggar-thy-neighbor” tag back in the 1930s -- the last time the world saw a fully fledged currency war after the U.S. abandoned the gold standard and devalued the dollar.

Beggar-thy-neighbor policies in the U.S. during the 1930s are generally attributed to major factors leading to the Great Depression. In 1930, the Hawley–Smoot Tariff Act raised U.S. tariffs on more than 20,000 imported goods to record levels. In order to protect their own industries, other countries followed suit. A race to the bottom resulted in a massive decline in international trade and domestic production in the U.S.

“[The phrase beggar-thy neighbor] condemns currency depreciation in a world of insufficient effective demand as a case of robbing the foreign Peter to pay the domestic Paul: Cheaper exports of the home country increase output and employment at the expense of sales and jobs in competing countries,” according to a paper published by the Bank for International Settlements.

On Tuesday, the Group of Seven countries, comprising the U.S., the UK, France, Germany, Italy, Canada and Japan, took the unusual step of issuing a public statement that reaffirmed a commitment not to target their own exchange rates, in a move seen as an attempt to cool growing international tensions over exchange rates.

Japan has come under fire recently for policies that critics say deliberately devalue the yen. Over the past three months, the Nikkei 225 Stock Average rose by about 31 percent, while the yen has fallen about 16 percent against the dollar in the same period.

Following is a Q&A with Karl Schamotta, an Alberta, Canada-based senior market strategist for Western Union Business Solutions. Western Union Business Solutions, or WUBS, is a division of the Western Union Company focused on the unique international payments and foreign exchange needs of companies large and small.

IBT: Do you think a currency war has started?

Schamotta: No, not in a conventional sense.

High-inflation countries cannot dilute their currencies on a sustained basis without damaging their own economies, as China's recent history suggests.

Also, global capital flows remain constricted by narrowing growth differentials. Japan's policies have not sent a tidal wave of capital into other countries, because they are simply considered too risky.

However, investors do need to watch out for destabilizing rhetoric. Central bankers and politicians have a lot to gain from accusing Japan of monetary malfeasance -- and these statements are likely to damage sentiment in the coming months.

IBT: What's the end game?

Schamotta: My guess is that this issue will simmer for a long time, without breaking into outright combat.

If I'm wrong, however, and reality begins to match rhetoric, a new, softer Bretton Woods agreement would assure markets that central banks are prepared to act against dangerous movements in a coordinated manner. I don't expect that we will actually see this transpire, but it is possible that something like this becomes an unstated policy across the major economies.

IBT: Who wins and who loses?

Schamotta: In the long run, almost everyone wins. If Japan successfully prints its way to growth, higher domestic demand will help the global economy accelerate.

I would be concerned about bondholders though. If central banks continue to print money while the economy accelerates, fixed-coupon instruments will lose value in relative terms.

IBT: What’s the message of the Group of Seven, or G7, statement on Tuesday about exchange rates, monetary policies and currencies?

Schamotta: The G7 statement approved the usage of unconventional monetary policy to achieve domestic policy aims, while making it clear that explicit exchange-rate targeting should only be done within a coordinated framework.

In essence, they said, we aren't at war. Finance ministers across the developed world understand that a recovery in the Japanese economy would be a win for the world -- and they understand that extreme measures are necessary to achieve that.

IBT: Will this really help Japan?

Schamotta: Fundamental economic reform is the only thing that will really help Japan, but these actions may generate the political capital that the LDP [Japan's ruling Liberal Democratic Party] needs to achieve this.

IBT: Will the Chinese yuan emerge as a global reserve currency?

Schamotta: The Chinese yuan is clearly on the path toward becoming a global trade currency, but the country's closed capital account prevents it from becoming a reserve currency. For now, that suits Chinese policymakers, but this will change in the coming years as they look to remove artificial influences on investment outcomes. Thus, we would expect to see central banks beginning to accumulate renminbi toward the end of this decade.

IBT: Will the euro zone be the prime casualty given its relatively hawkish stance?

Schamotta: Monetary tightening led by Europe's private sector is likely to hurt growth in the coming months. However, the European Central Bank and politicians in all major countries are committed to offsetting this if it continues, so investors must be prepared for additional easing measures from Mr. Draghi in the near future.

IBT: If the U.S. dollar continues to depreciate, will China and Japan (the two largest holders of U.S. Treasurys) keep buying U.S. debt?

Schamotta: Japan and China purchase U.S. debt to offset trade flows, not to act as an investment. Until the dollar loses its role as the global lingua franca for trade, those purchases will have to continue.

IBT: How can retail investors hedge against the risk of a currency war?

Schamotta: By treating the U.S., Europe and Japan as the new emerging markets. Investing in undervalued assets in the industrialized countries is an excellent hedge against overvalued assets in the developing world.