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Currency war, also known as competitive devaluation, is a condition in international affairs

where countries compete against each other to achieve a relatively low exchange for their home
currency, so as to help their domestic industry.

Competitive devaluation has been rare through most of history as even at times when a system of
fixed exchanges rates has not been in place, countries have generally preferred to maintain a
high value for their currency or have been content to allow its value to be set by the markets. An
exception was the widely recognized episode of currency war which occurred in the 1930s.

The currency war of the 1930s is generally considered to have been an adverse situation for all
concerned; with all participants suffering as unpredictable changes in exchange rates reduced
international trade. The 2010 outbreak of competitive devaluation is being pursued by different
mechanisms than was the case in the 1930s and opinions among economists are divided as to
whether it will have a net negative effect on the global economy

Xinhua defined a currency war as "situation where one nation, relying on its strong economic
power, buffets its competitors and seizes other nations' wealth through monetary and foreign
exchange policies. It is a form of economic warfare with cold premeditation, specific purpose and
considerable destructive power."

Reasons for intentional devaluation

Currency devaluation has several adverse consequences on a state. It can lead to a reduction in
citizen's material standard of living as their purchasing power is reduced both when they buy
imports and when they travel abroad. It can push up inflation. Devaluation can make international
debt servicing more expensive if debts are denominated in a foreign currency, and it can
discourage foreign investors. A strong currency is sometimes seen as a mark of prestige while
devaluation is sometimes seen as a sign of a weak government.

However when a country is suffering from high unemployment or wishes to pursue a policy of
export led growth, a lower exchange rate can be viewed as a potential solution. A lower value for
the home currency will raise the price for imports while reducing the price for exports. This
encourages more production to occur domestically, which raises employment and GDP.
Devaluation can be especially attractive as a solution to unemployment when other options like
increased public spending are ruled out due to high public debt and also when a country has
a balance of payments imbalance which a devaluation would help correct. A reason for preferring
devaluation common among emerging economies is that maintaining a relatively low exchange
rate helps them build up their foreign exchange reserves, which can protect them against future
financial crises.

What's the currency war about?

Which country will be left holding all the cards?

Over the past decade, the world has been divided into "deficit" countries and
"surplus" countries.

Deficit countries, like the US and the UK, borrow from the rest of the world, so they can
import more than they export.

Surplus countries, like China, Japan and many other Asian countries, do the opposite.
They lend to other countries to help finance their exports.

The eurozone has typically imported about as much as it exported, staying in balance.

But within the eurozone there are also big imbalances: Germany runs a big surplus,
while Spain, Greece and others run deficits.

Tension builds
During the financial crisis and global recession, imports by the deficit countries - and
exports from the surplus countries - briefly collapsed.

But with the recovery, the latest trade data suggests that the old imbalances have begun
to reassert themselves.
This has led to tensions. The US says it wants to export more, to help its economy
recover. But the surplus countries don't want their exporters to lose their competitive

The quickest way to gain a competitive advantage is through a weaker currency.

And with the global recovery so weak, nearly all countries have been complaining that
their currencies are too strong.

Unfastening the lynchpin

During the 2008 financial crisis, most currencies fell against the dollar. Investors bought
the dollar, because they saw it as a safe haven.

But since then most currencies have slowly risen against the dollar again. US interest
rates are near zero and the US is stuck in a weak recovery, making the dollar less

The Chinese pegged their currency to the dollar in 2007, and stuck with the peg
throughout the crisis.
The People's Bank of China has bought up trillions of dollars in order to keep its
currency weak against the dollar.

And the US is not happy, saying that it helps keep Chinese exports artificially cheap.

China's critics complain that the country runs a huge trade surplus, even though China is
booming, while much of the world - notably the US - remains economically weak.

In June this year, Beijing finally agreed to loosen the peg - marginally - after months of
US pressure. But the US says it is not enough.

The Chinese point out that - unlike many other exporting nations - they did not let the
yuan fall against the dollar during the financial crisis.
Despite weak growth in the US, Chinese
exports just keep on arriving
Privately, the Chinese also worry that if they raise their currency too quickly, it could
bankrupt many export companies and seriously destabilise their economy.

And China is not the only one to manipulate its currency. Korea and others have also
intervened to keep their currency values down.

But the US sees China as a lynchpin - if it can get Beijing to strengthen its currency, it
thinks other smaller exporters will follow.

Land of the rising yen

Meanwhile, spare a thought for the Japanese.

Japanese Prime Minister Naoto Kan was not

altogether pleased by China's intervention
The yen has risen and risen since the 2008 crisis, hurting Japanese exporters and
pushing the country back towards recession.

For years the yen used to be weak, because of Japan's zero interest rates made it a
cheap currency for currency speculators to borrow in and sell.

But now the US, UK and Europe have near-zero interest rates as well, taking away the
yen's advantage.

In September, the Japanese intervened to weaken their currency.

And the country exchanged angry words with Beijing after the Chinese suggested they
might start buying up yen instead of dollars.
But the respite was short-lived, and since then it has strengthened even more against
the dollar.

What can be done?

All this leaves one big question - what can countries like the US and UK do to reduce
their deficits?

Mr Geithner is much more wary of threatening

trade sanctions than many of his colleagues in Washington
One option is austerity. Consumers and companies are already cutting back on
borrowing. If governments do the same, the entire country borrows less, and its deficit

The problem is that austerity in the deficit countries can lead to recession, especially if
the surplus keep on lending.

Another option is looser money. But with interest rates at zero, central banks are left to
resort to quantitative easing - printing money and using it to buy up debts, or intervening
directly in currency markets.

But these are limited tool - as the Japanese have learned over the years.

Many in the US Congress hope that Washington will try another option - trade sanctions
against China.

But that raises a spectre that is haunting the G20 meeting - the ghost of the 1930s, when
protectionism started by the US led to a collapse of trade that was a big contributor to
the Great Depression.