With economies like Japan, Germany, or China making policy moves to weaken their currencies, talk of the imminent "currency wars" is a serious topic among many market analysts. With its decision to initiate negative interest rates, the Bank of Japan sparked a reaction across stock markets and global economies. The world's foremost central banks like the Bank of Japan and the European Central Bank are trying to attain the same goal – economic stability. Yet, is the weakening of a currency actually good for economic growth?
What are currency wars? Why do countries initiate them?
A currency war is a situation where several nations deliberately seek to depreciate the value of respective domestic currencies in order to boost their economies. It's also known as "competitive devaluation." In this era of floating exchange rates, currency depreciation is engineered by a country's central bank through economic policies that push the currency down, such as reducing interest rates or quantitative easing (QE) measures. This can pose a real problem on a universal scale since many other countries may follow suit. For instance, if nation A devalues its currency, nation B soon does the same, followed by nation C.
A nation that depreciates its currency is pursuing its own interests above everything else. A feeble domestic currency makes a country's exports increasingly competitive in international markets, and makes imports expensive. Higher export volumes stimulate economic growth, while expensive imports make domestic consumers choose local alternatives compared to imported goods. This, in turn, encourages international investment in a country’s goods and services, helps to increase employment and stimulates GDP growth.
How Japan's decisions of adopting negative interest rates may trigger a currency war
On January 29th, 2016, the Bank of Japan adopted negative interest rates to boost inflation and growth by increasing consumer spending, along with depressing the yen. With this decision, Japan joined the ranks with other countries that introduced negative interest rates like Germany, Denmark, Sweden, and Switzerland. The move of lowering their interest rates helped keep the euro low. This helps Europe, which is battling economic stagnation and countries in the Eurozone wouldn't want the euro to gain in value against other currencies including the yen. That might make European exports expensive, and make the imports cheap just when the European Central Bank (ECB) is attempting to encourage inflation.
BNP Paribas economists stated that negative interest rates in Japan would increase the chances of the ECB further decreasing their rates. This is because the ECB is keen to avoid a decline in banks’ lending to companies in the Eurozone, who may choose not to borrow if interest rates are higher. Other central banks, particularly in Asia, will be forced to respond to this move by Japan and other global Central Banks. If China devalues the Yuan again, a chain reaction will follow. The US Federal Reserve will find it harder to raise interest rates. Instead, the Fed can also adopt negative interest rates to boost the US economy.
The Influence of currency wars on the financial markets
The obvious impact of a currency war between global economies is the weakening of the relevant currencies. The US dollar remains strong not only due to a growing US economy but also because other economies are struggling. Earnings would increase in countries with weak currencies. For companies that receive foreign revenues in currencies that are stronger than their domestic currency, the size of the earnings growth depends on that foreign country. For instance, sales generated in the US convert into more euros for Eurozone companies at present. This makes it attractive for EU companies to do business in the US right now.
Currency devaluation by an economy might cause a positive effect on the benchmark indices of the respective countries. The Bank of Japan's decision to devalue the yen caused the Nikkei 225 to gain 346.93 points in a day. However, considering the surge or decrease in the other major currencies such as the US dollar, such gains can be short-lived. Conversely, the beginning of 2016 saw a sharp decline in major European indices such as the FTSE 100, CAC40, DAX and their listed stocks, when China was preparing to devalue the yuan.
While economists are still analysing the effect of negative interest rates on boosting inflation and economic activity, they believe the policies have a strong impact on shareholders. In order to improve the accuracy of your trades when trading on currency pairs, it’s important to understand currency wars and the ways in which they are likely to have a knock-on effect on indices and stock values. Use this information to place informed binary options trades on currency pairs, stocks and indices.
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