Currency War A-Brewin’

Brace yourselves, forex folks! Some economic hotshots warned that the world could be on the brink of a world war – a global currency war, that is!

According to First Deputy Head of the Central Bank of Russia Aleksey Ulyukaev, several countries might resort to exchange rate manipulation in order to maintain their economic competitiveness. In other words, central banks might start devaluing their own currencies just to boost demand for their exports, a crucial component of overall economic growth.

As we learned in our forex trading experience, as the value of one currency goes down, the relative values of other currencies go up and therein lies the rub. An economy aggressively trying to keep depreciating its local currency could end up hurting the competitiveness of other economies.

World Bank chief economist Kaushik Basu shares the same sentiment even though he predicts that such currency war might not take place until next year. He pointed out that the European debt crisis and the U.S. budget fiasco pose the biggest threats to global exchange-rate stability for now.

If you think about it though, some countries have already begun the fight.

The Swiss National Bank is has been actively staving off buying pressure on the franc by setting a floor on EUR/CHF. It has successfully kept the pair above 1.2000 since September 2011.

The Bank of Japan has also adopted an aggressive strategy towards curbing the yen’s strength, expanding its asset purchase program five times in 2012 alone. No doubt this has had a hand in USD/JPY’s remarkable rally, which has gone on for about 1,100 pips from last year’s low.

Even European officials are starting to complain about the euro’s strength. Earlier this week, Eurogroup head Jean-Claude Juncker described the euro’s current trading levels as “dangerously high,” showing that he’s uncomfortable with the fact that the shared currency has gained over 8% in about six months.

However, Adam Posen, who is a former Bank of England member and currently the President of the Peterson Institute for International Economics, predicts that Brazil and Australia may be next in line to actively intervene in the markets to combat their rising currencies.

If this currency war worsens, forex price action could be dictated more and more by central bank intervention rather than fundamentals or risk sentiment. We’ve already seen a sneak peek of this situation last year when the SNB strongly defended the EUR/CHF peg, making the pair somewhat indifferent to updates regarding the euro zone debt crisis.

While it’s highly unlikely that we’ll see such an extreme lack of action on other pairs altogether, it does show us how detrimental central bank interventions can be to market volatility. On top of that, this could lead to even lower trading volumes in the retail trading sector, just as we witnessed last year. Note that one of the biggest factors that weighed on overall trade activity was central bank intervention!

The biggest danger that this each-country-for-itself mentality presents is that it can easily lead to imbalances in the world currency system and cripple the global economy. The currency war in the 1930s led to unpredictable exchange rates and weaker international trade. History might just repeat itself if we’re not careful.