Understanding what makes a currency war and the effect fluctuating foreign exchange rates have on investments is important, so let’s take a look behind the scenes to see what’s really going on.
Investment firm Schroders Senior Investment Director, Fixed Income Alan Cauberghs has agreed to explain the mechanics of a currency war.
Definition of a currency war
The explanation is simple, says Cauberghs, but applying the definition to the real world is much harder.
A currency war is when a country’s central bank devalues the national currency with the intention of increasing competitiveness and exports by making them cheaper compared to prices in other currencies.
Is China conducting a currency war?
On face value, the devaluation of the renminbi in August looks like a devaluation aimed at making the Chinese currency more attractive than the US dollar – which looks like a shift as part of a currency war, said Cauberghs, however when you scrutinise the move that was more of a by-product than the main intention.
So what’s China doing?
China wants the renminbi to become a reserve currency like the US dollar. The value of the renminbi was pegged against the US dollar for a number of years, but one of the International Monetary Federation’s rules for a reserve currency is for the rate to be set by the market, not a central bank.
So, the People’s Bank of China cut the link with dollar to let the renminbi float. Yes, this may help the economy, but the renminbi had to be freed from the peg at some time.
The measure looks like a calculated move in a currency war, but Cauberghs believes the real truth was China is switching from a manufacturing to a consumer economy and the devaluation was needed to ease the change.
Fall out for investors
Cauberghs reckons too much importance is given to currency wars, even though exchange rate moves are a factor in the wider global economy.
He explained emerging market currencies are expected to lack strength, likely to stay volatile and that the US dollar will remain the premier currency for some time yet.
Investors will have to live with uncertainty for some time – and one of the keys to sensible investing is coping with the inevitable US interest rate hike that will strengthen the US dollar even more against a host of other currencies, said Cauberghs.