In memory of Dr. Andreas Höfert

The art of currency war or how to stay put

Two weeks ago the G20 backed away from the ubiquitous concept of currency war. “We will refrain from competitive devaluation. We will not target our exchange rates for competitive purposes,” was the final statement.

Countries can thus go on weakening their currencies, as long as they do not state that they are doing so in the hope of boosting exports and hence growth.

I struggle to grasp the idea of currency war. The economic theory behind it is flawed. Devaluing a currency will not necessarily lead a country to higher exports. Intriguingly, countries with traditionally “strong” currencies like Switzerland, Germany or Japan have a much more important industrial sector than countries with traditionally weaker ones, like France, the UK or the US.

Exporting more does not ensure that a country will grow faster either. The US grew at 3% on average over the last 20 years but had an abysmal trade deficit, while until recently Japan had a sizable trade surplus, but stagnated during the same period.

If every nation tries to devalue its currency, no one really wins in the end.  This “beggar-thy-neighbor” game reminds us of what happened during the Great Depression. Faced with recessions, many countries then introduced protectionist measures in the form of tariffs (e.g. in the US the Smoot-Hawley Tariff Act). Effective at first, these backfired; international trade crumbled, exacerbating the recessions and depressions.

In my view, no one wins a currency war, just as no winner emerges if every country becomes protectionist. There are clear losers however: Consumers face higher prices for imports (due to tariffs in the case of protectionism and to a weaker currency in the case of a currency war).

So from an investor’s perspective, to focus on which country will devalue the most or the least in a currency war is ludicrous. One should see this war rather in the larger context of loose monetary policy and the likelihood of derailing inflation.

A conservative strategy would be to stay in the home currency, insure a portfolio against currency risks by hedging foreign-denominated assets and – since the home currency might ultimately be the weakest one – to protect against inflation risks through “real” assets.

An alternative, more aggressive strategy would be to diversify the currency exposure as much as possible and to look for currencies that might not take part in the war. Since the present war is being fought mainly among industrial nations still struggling with the aftermath of the financial crisis, a closer look at emerging market currencies, where some countries are reluctant to let inflation get out of hand, might be worthwhile.