The cocktail of weak growth, rising protectionist sentiment and experimental monetary policy is increasing the risk of competitive currency devaluations, argues Mary Nicola.


The shock 1.9 per cent devaluation of the Chinese renminbi on 11 August 2015; the surge in the yen following ever looser monetary policy by the Bank of Japan and the 8.4 per cent record fall in sterling on 24 June are three recent examples of currency trends driving financial markets.

Changing perceptions on the outlook for monetary policy are often the cause of such moves. However, as the counter-intuitive appreciation of the yen illustrates, central bankers are not always ‘masters of the universe’: sometimes actions aimed at weakening a currency backfire. With central banks essentially in competition amongst themselves to achieve their policy goals, there will be winners and losers in this new era of currency wars.

European Central Bank president Mario Draghi said as much in June at the ECB’s annual forum in Sintra, Portugal. In the wake of the sharp depreciation in sterling following the UK’s vote to leave the European Union in June, and with nationalism on the rise, Draghi said competitive currency devaluations were a “lose-lose for the global economy, since they only lead to greater market volatility, to which other central banks are forced to react”.

Global trade has been worryingly weak in recent years, leaving aside the potential for rising nationalist tensions in Europe and the US to spark more protectionist trade policies and dent trade flows. Indeed, in September, the World Trade Organisation cut its 2016 growth forecast for trade to 1.7 per cent from 2.8 per cent, below predicted annual economic growth of 2.2 per cent1.

Forex market

The $5.1 trillion traded daily in foreign exchange markets on average, while down on the $5.4 trillion daily average seen in 2013, remains a powerful ‘measuring machine’ of sentiment towards currencies and economies2. Whether explicitly or not, the extraordinary monetary easing we have seen by central banks in recent years has been at least part motivated by a desire to weaken currencies, and in so doing help them meet their inflation and growth objectives. 

Central bank intervention

The accumulation or selling off of foreign exchange reserves allows central banks to either prop up or weaken their domestic currencies, according to the policy goals of the time. The Chinese authorities have been particularly active in terms of intervention in the currency markets in recent years.

Chinese foreign exchange reserves have soared this century (see figure one) as the country’s phenomenal export-driven growth saw China’s gross domestic product increase to $10,866 billion in 2015 from $1,205 billion in 2000 – sucking in foreign exchange via increased capital inflows, inward investment or otherwise3


Figure 1: Foreign exchange reserves
Country US$ (billion)
China 3,166.4
Japan 1,260.1
Russia 397.7
South Korea 377.8
India 367.6
Brazil 370.4
Euro zone 344.1
UK 146.7
US 120.3
Source: Trading Economics, as at 20 October 2016

The desire to accumulate substantial financial exchange reserves partly reflected the scar left after the 1997 Asian financial crisis, which ravaged economies in the region. Indeed, China’s accumulated foreign exchange reserves account for over a quarter of the global figure of $11,463.5 billion4.

Chinese reserves peaked in June 2014 at $3,993.2 billion before plunging by a fifth, prompting policymakers to defend the currency in the face of capital outflows. It has since stabilised at around $3.2 trillion. And, as downward pressure on the Chinese currency heightened in August 2015 in the wake of the surprise currency devaluation, foreign exchange reserves shrank by $93.9 billion during that month, the second largest monthly fall on record5.



With questions over China’s future growth trajectory, a weaker currency suits policymakers for the time being, as it should help the country’s exporters. The currency has depreciated by 6.6 per cent6 against the dollar since October 2015, while its effective exchange rate against a trade-weighted basket of currencies has weakened by around seven per cent (see figure three) over the same period.

Unlike the one-off devaluation seen in August 2015, the larger depreciation seen since in the renminbi’s effective exchange rate has largely been ignored by markets. In so doing, the Chinese authorities have been able to ease financial conditions at home without destabilising global markets. The gradual depreciation in the Chinese currency is likely to persist, perhaps of the order of between three and five per cent over the next twelve months.

Potential devaluation triggers

If outright devaluations among leading currencies are unlikely, that is not to say that other events couldn’t. The first is the possible introduction of ‘helicopter money’ in Japan in an attempt to weaken the yen and spur Japanese exporters’ prospects.

While China may have seen a gradual depreciation of its currency over the last year, Japan has failed to see the same.  Despite the Bank of Japan (BoJ) running negative interest rates and its quantitative and qualitative easing (QQE) programme, the yen’s effective exchange rate has soared by around 20 per cent in the last twelve months (see figure three). Ironically, the nominal exchange rates of leading currencies in areas of negative interest rates designed to weaken the currency – Japan and the euro zone – have appreciated more in the last year than leading currencies in areas of positive rates.

The BoJ disappointed markets in September by introducing QQE, with a focus on controlling the yield curve rather than more policy easing. The fine tuning of QQE is designed to expand the monetary base so that the 10-year government bond yield remains around zero rather than fixing asset purchases at 80,000 billion yen (£623 billion) a year.

Over the longer term, the onus of meeting the two per cent inflation target is likely to fall on the Japanese government. However, the government’s appetite to embark on a large fiscal stimulus package seems limited, with Prime Minister Shinzo Abe more focused on delivering constitutional reform. Should Abe’s poll ratings suffer and economic revival be more in doubt, then something close to helicopter money, perhaps in the form of central bank-financed tax rebates or infrastructure spending, may result. Such a drastic move to further ease monetary policy would likely spark a currency war as a retaliatory gesture, especially among Japan’s Asian trading partners. 



Further risks could arise were Republican candidate Donald Trump to win November’s US election. Such a result would rock markets, though the initial effect on the dollar is uncertain given the lack of clarity on his economic agenda. We would expect investors to look to reduce risk exposure, which would typically be supportive of the dollar. This is particularly likely against emerging-market currencies, which could also face a more serious headwind should rhetoric around more protectionist policies reduce world trade.

An alternative scenario could see the US dollar weaken against other major currencies. If sentiment towards the US turns negative – Moody’s Analytics has forecast that Trump’s policies could lead to a “lengthy recession” – the yen and euro, as the most liquid currencies other than the dollar, would be likely be viewed as safe-haven assets.

Turning to Europe, even if the ECB extends its asset-purchase programme beyond March 2017 by six months, as we expect, this is unlikely to have a significant impact on the euro. Currency markets have seemingly largely discounted such a move by the ECB. That said, extended QE is likely to be positive for euro-zone equities. Furthermore, the euro would still be vulnerable to heightened political risk, disappointing growth or another flare up in fears over the region’s banks.

December’s Italian referendum is the first hurdle, but general elections in France, the Netherlands and Germany in 2017 will keep political risk in the spotlight. Given the rise in nationalistic tendencies bubbling away in the developed world, such as seen in the US presidential campaign and UK referendum vote in June, the threat of a shock euro-zone election result destabilising the euro cannot be discounted.

As for Japan, it looks like any BoJ action, except some form of helicopter money, is unlikely to have a significant impact on the yen. In the short term, the yen may weaken somewhat against the dollar on the elevated expectations that the US Federal Reserve will hike rates in December.


1 Source: The World Trade Organisation, September 27 2016

2 Source: Triennial Central Bank Survey, Bank of International Settlement, September 2016

3 Source: The World Bank, measured in current US dollars, October 26 2016

4 Source: International Monetary Fund, foreign exchange reserves in US dollars as at September 30 2016

5 Source: Trading Economics, October 26 2016

6 Source: Trading Economics, October 26 2016

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 26 October 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.