Ramifications of a Currency War

This post builds on,

The Global Currency War

The ramifications of an all-out currency war are wide ranging. Essentially such a sequence of events means that major economies in the world would compete to devalue their currency relative to the US Dollar, which acts as the reserve currency for global trade. The hope would be to preserve or increase trade with the US.

While devaluation (pegging) means that the prices of goods imported into the US are lower, it also means that purchasing power for citizens of other countries is lower and international profits, when converted to US Dollars, are less.

By pegging the Yuan to the US Dollar, China is reducing the purchasing power of its people who might be interested in buying imported goods. This is hardly a progressive, international approach to trade or the desire to built long-term, win-win relationships.

If a cycle of devaluation takes involving Central banking open market moves in China, Japan, and other Asian countries, then US multinational corporations will find operations in these countries to be less profitable. I think CEO's will decide to limit future Direct Foriegn Investment (DFI) in Asia as a result. The excess money will flow back to the US for investment, or perhaps to the EU or South America.

A recent article shows an initial glimpse of this developing trend:

Savitz, Eric J., 2010. The trillion-dollar challenge. Barron's, Sept. 18.

The gist of the article is that many American companies hold large amounts of cash overseas because of tax reasons. The example cited is Cisco Systems, which holds about $30 billion outside of the US.

At a time when the US economy is sputtering, it makes sense to invoke policies that are favorable to companies like Cisco Systems and allow them a profitable way to bring foreign cash back home for investment in domestic markets.

Of course, there is always a chance that a pull-back in DFI might cause further restrictions and regulations on existing foreign capital with the worst case being nationalization of specific industries. China has a history of taking such extreme steps. So do other countries. If any hint of this type of policy change exists, American companies will quickly pull out to preserve capital.

An all-out currency war would in my view force capital back to the US and put the global economy on a path towards less cooperation and long-term economic growth.

The basic principle of a free market for currency trade is the most effective tool known in allocating resources and producing efficiency. Government control, whether by China, Japan, or other Asian countries, will not have the desired impact of preserving economic growth. To the contrary, the past 40 years of establishing international trade would be set back, perhaps requiring many years to repair.