Q&A: Currency the latest threat to global economy

Saturday - 2/16/2013, 6:06pm EST

PAN PYLAS
Associated Press

LONDON (AP) -- The world economy faces a new threat. Instead of a banking collapse or too much debt, fears are growing that countries are using their currencies as an economic weapon.

History suggests that's never a good thing.

If too many countries try to weaken their currencies for economic gain -- sparking a "currency war" -- that could stifle business confidence and investment, sow turmoil in financial markets and derail a fragile global economy.

Following their meeting in Moscow this weekend, financial representatives from the world's leading 20 industrial and developing countries warned that "excess volatility of financial flows and disorderly movements in exchange rates have adverse implications for economic and financial stability."

Why is everyone talking about currencies?

-- Since the start of the financial crisis, central banks around the world have been trying to stimulate their economies by keeping interest rates extremely low. The goal is to encourage consumers and businesses to borrow and spend more. One way central banks drive down rates is to use their power to print money to buy up large quantities of bonds. But by boosting the amount of currency in circulation, there is a side effect: it can drive down the value of that currency relative to others.

As a country's currency falls, its exports become cheaper, while those of its neighbors become relatively more expensive.

Japan, the world's third-largest economy, is currently under the harshest spotlight. To get its economy motoring again after a two-decade bout of stagnation, the government has said it would like to see inflation move higher. Markets have interpreted this as a signal that Japan's central bank is prepared to take actions that would result in driving down the yen, to boost exports and also put upward pressure on prices. Earlier this week, the yen fell to a 21-month low against the dollar and a near three-year trough against the euro.

So is Japan actively trying to weaken the yen?

-- Yes and no. Though it's not directly intervening in the foreign exchange markets by selling yen and buying other currencies, strong comments from the new Japanese government have convinced markets that the Bank of Japan will create more money. Japan's Finance Minister Taro Aso insists the government isn't focused on exchange rates, but he has noted that the weakening yen has "brought huge benefits to the export sector" and that the world "has been awed" by the recent surge in share prices.

Why is that bad?

-- A falling yen will help exporters, such as Sony and Toyota, and boost Japan's economy. And it will it tend to push prices - and ultimately wages -- higher. But if other countries respond to the falling yen by devaluing their currencies -- to maintain the competitiveness of their own exports -- Japan will be back to square one and the world economy could suffer.

Sharp fluctuations in the value of currencies can hurt business confidence and investment. Prices for imported raw materials and components would be volatile, profits will be hard to come by as prices fluctuate wildly and the value of any investment a company makes in another country could quickly be wiped out.

Who's been feeling the effect of Japan's actions so far?

-- The euro, the currency used by the 17-strong group of European Union countries, has seen the biggest move on the foreign exchange markets. As the region moved on from its crippling debt crisis last summer, the euro has slowly gained in value. But since the change of government in Japan, its value against leading currencies such as the yen and U.S. dollar has shot up -- last December it was worth 113.19 yen and $1.29 and now it's at 124.93 yen and $1.33.

A rise in the value of the euro will do little to help the eurozone's businesses -- and will hardly help getting it growing again. Figures Thursday showed that the economic output of the region shrank at an annualized rate of around 2.5 percent in the last quarter of 2012.

What's been the reaction from other major economies?

-- Politicians have voiced concerns about the euro's rise versus other major currencies -- most notably French President Francois Hollande, who indicated he was open to calls for a more managed exchange rate. European Central Bank President Mario Draghi said last week that the bank will monitor the economic impact of the euro's rising value. Several analysts took that to mean the ECB could cut interest rates to bolster growth, which in theory could weaken the euro -- an indirect tit-for-tat response to the yen's fall, some say.