Effects of Currency Conflicts on the German and European Economy

Tasks

The US government officially accused China of currency manipulation on 5 August 2019 and announced appropriate countermeasures. Furthermore, the US Department of Commerce is currently discussing a regulatory proposal. According to this proposal, currency manipulation can be classified as an illegal subsidy and punitive tariffs can be imposed. These measures come at a time when, for the first time since the end of the 1990s, there is open speculation about foreign exchange market interventions and global competitive devaluations. This expertise describes and quantifies the causes of various forms of currency manipulation and its effects on the German and European economy.

Methods

In the first part of the expertise, we show what is meant by a currency war. In the public debate, the manipulation of a currency is usually diagnosed on the basis of an observed change in the exchange rate. However, it is often overlooked that exchange rates also react to economic policy measures that were not decided with the aim of influencing the exchange rate. We begin by classifying the exchange rate regimes between the US, China and the euro area since 2000 using the official IMF classification scheme. We discuss the intervention intensity of the central banks of these countries over the past two decades on the basis of changes in currency reserves and official intervention statistics. The most recent debates on a possible currency war are then described in more detail. On the one hand, the recent policies of quantitative easing in the US and the euro area and its transmission via the exchange rate are discussed. On the other hand, the effects of the trade conflict triggered by the USA on exchange rates are described.

In the second part of the expertise, the effects of a currency war on the German and European economy are quantified with the help of the ifo DSGE model using the scenarios defined in the first part. We begin with a historical shock decomposition of the effective euro exchange rate, which allows us to identify the driving forces of the fluctuations of the nominal euro exchange rate in the past. Special attention is paid to the contribution of monetary policy shocks to changes in the exchange rate. Eight scenarios of a possible currency conflict are then simulated. These scenarios are selected according to criteria of economic plausibility and feasibility of implementation in a DSGE model.

Data and other sources

European Central Bank, Eurostat, US Federal Reserve, International Monetary Fund, People’s Bank of China.

Results

Overall, the effects of the scenarios of a currency conflict on the German and European economies are small. In particular, the effects of the introduction of permanent import tariffs in the rest of the world on real gross domestic product in the euro zone and on the external value of the euro are negligible in quantitative terms. By contrast, Germany in particular benefits in the short-run from a currency conflict in the rest of the world, which is initiated by an unexpected and temporary cut in policy rates of these central banks. However, due to the temporary nature of this interest rate cut, the positive economic effects will turn into negative ones in the medium-run. The results are similar if the central banks in the rest of the world use the exchange rate directly as an instrument and devalue their currency against the euro. The most significant short-term effects occur in a competitive devaluation, in which the ECB reacts to the trade and currency conflict initiated in the rest of the world with a cut in policy rates, which counteracts the appreciation of the euro. Especially in the first year, annual growth rates are 0.3 to 0.4 percentage points above their long-term average. As in the pure currency conflict scenarios, the effects of the devaluation race are not permanent, so that the annual growth rates are again below average in the medium-run.