Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Devalue Their Own Currency
Transcript
- Lucas: Let me start with a question that probably doesn't get asked enough. When was the last time you heard a central banker say they want a weaker currency? Luna: Almost never. They usually talk about 'orderly markets' or 'two-way risk'. Lucas: Exactly. But behind closed doors, deliberate currency devaluation is one of the most-used tools in the central bank playbook. It's just rarely the headline. Lucas: Today I want to drill into competitive devaluation — what it is, how it works, and a couple of real-world cases where central banks have done it very explicitly. Luna: Are we talking about the Bank of Japan? Because they've been pretty open about wanting a weaker yen. Lucas: They're the clearest example in recent years. The Bank of Japan under Governor Ueda — and before him, Kuroda — has maintained a policy mix that structurally pushes the yen lower. Negative interest rates until early 2024, yield curve control that kept long-term rates artificially low, and massive asset purchases. The result: the yen went from around 110 to the dollar in early 2021 to nearly 160 by mid-2024. Luna: And they never said 'we want a weak yen'. They said they wanted inflation and stable markets. Lucas: Right. The devaluation was a side effect that was very much welcomed. Japan's economy is export-heavy — Toyota, Sony, Nintendo, all the big names. A weaker yen makes their goods cheaper abroad, boosts repatriated profits, and helps reflate an economy that had been stuck in deflation for decades. Lucas: But there's a cost. Imports become more expensive — Japan imports most of its energy and food. So households feel the pinch. By late 2024, real wages were still declining even as nominal wages rose. Luna: So it's a trade-off. Exporters win, consumers lose. Lucas: Exactly. And that's the central bank's calculation. They're betting that the export-led growth and eventual wage increases will outrun the import shock. But it's not guaranteed. Luna: What about the Swiss National Bank? They did the opposite — they capped the franc for years. Lucas: That's the other classic case. In 2011, the Swiss franc was surging because investors were fleeing the eurozone debt crisis. The SNB said enough — they set a floor of 1.20 francs per euro and said they'd buy foreign currency in unlimited quantities to defend it. Lucas: That's a deliberate devaluation of the franc. They were printing francs to buy euros and dollars, building up an enormous foreign reserve pile — over 700 billion Swiss francs at the peak, which is huge for a small economy. Luna: And they held that floor for three and a half years, until January 2015. Lucas: When they suddenly abandoned it. The franc shot up 30 percent in minutes. It was one of the most dramatic currency moves in modern history. The SNB's argument was that the cost of maintaining the floor had become too high — reserves were ballooning, and the eurozone was starting to recover. Luna: But wasn't that a disaster for Swiss exporters? Lucas: It was brutal. Companies like Swatch and Nestlé saw their margins squeezed. But the SNB calculated that the floor had done its job — it had prevented deflation and kept the economy stable through the crisis. And they were willing to accept the pain of a stronger franc as the price of exiting. Lucas: What both Japan and Switzerland show is that central banks can and do manage exchange rates directly, even if they claim otherwise. Luna: So when does competitive devaluation become a problem? When everyone does it. Lucas: Right. That's the 'currency war' scenario. If the Bank of Japan weakens the yen, and the European Central Bank responds by weakening the euro, and the Federal Reserve starts talking down the dollar, you get a race to the bottom. No one gains a competitive advantage, but everyone imports inflation. Lucas: There were echoes of that in 2022 when the dollar was surging. The Fed was hiking rates aggressively, pulling capital into dollar assets. Other central banks — the Bank of England, the ECB, the Bank of Japan — all saw their currencies depreciate sharply. Some intervened directly. The Bank of Japan actually intervened to buy yen in September 2022, which is the opposite of their usual stance. Luna: They sold dollars and bought yen to prop it up. Lucas: Yes. So they went from devaluing to defending. That's how fluid this can be. The same central bank that spent years pushing the yen down turned around and spent tens of billions trying to stop it from falling too fast. Lucas: The key insight is that central banks care about the pace of change, not just the level. A slow depreciation is fine — it helps exports, gives businesses time to adjust. A crash is a problem, because it creates financial instability and import price spikes. Luna: So for the Bank of Japan, the ideal was a slow, controlled decline. But once markets started pricing in a faster decline, they had to step in. Lucas: Exactly. And that's the tightrope all central banks walk when they use exchange rate policy. They want the benefits of devaluation without the chaos. Luna: And speaking of walking tightropes — Lucas, we've been doing these shows ad-free from the start. No commercials, no sponsors. That's a deliberate choice because we think this kind of explanation works better without interruptions. Lucas: Absolutely. And if you've found that valuable — if walking through the economy with us has made something click — there's a simple way to support it. Buy me a coffee dot com slash fexingo. That's it. No tiers, no rewards. Just keeping this thing ad-free. Luna: Yeah. It's a small gesture that makes a big difference for us. And back to the topic — because there's another angle I want to explore. Lucas: Go ahead. Luna: What about emerging markets? They seem even more aggressive about managing their exchange rates. Lucas: Much more. Emerging market central banks are far less subtle about it. Take Turkey — the central bank, under political pressure, has kept interest rates artificially low despite sky-high inflation, which has caused the lira to plummet. That's a form of devaluation, though it's arguably more about financing government debt than boosting exports. Lucas: Or China. The People's Bank of China manages the yuan within a narrow band against a basket of currencies. They've occasionally let it weaken to support exports, but they also intervene heavily to prevent sharp moves. They're probably the most active central bank in currency markets. Luna: And they have the reserves to do it. They hold over three trillion dollars in foreign exchange reserves. Lucas: Which gives them immense firepower. But even the PBOC has limits. If markets believe the yuan is fundamentally overvalued, no amount of intervention can hold the line forever. You see that in periods of capital flight — like in 2015 and 2016, when China burned through reserves trying to defend the yuan. Lucas: So the underlying question is: when does devaluation stop being a tool and start being a symptom of something broken? Luna: When the central bank loses credibility. Lucas: Exactly. If markets believe the central bank will do whatever it takes to maintain a certain exchange rate, intervention works. But if they think the central bank is just delaying the inevitable, the selling pressure intensifies. Lucas: That's the lesson from the Bank of England's experience in 1992 — Black Wednesday. They tried to keep the pound in the European Exchange Rate Mechanism, but speculators like George Soros bet against it, and the Bank ran out of reserves. They had to withdraw and let the pound float. Luna: So credibility is the real currency. Lucas: It is. And that's why most central banks avoid talking about devaluation explicitly. Once you admit you want a weaker currency, you risk undermining confidence in the currency itself. People start to ask: if the central bank doesn't believe in its own money, why should I? Lucas: So the art is in the signaling. The Bank of Japan never said 'we want a weaker yen'. They said 'we will achieve 2 percent inflation'. The market inferred the rest. Luna: Which is a kind of forward guidance for the exchange rate. Lucas: Exactly. And that's a powerful tool. Because markets are constantly trying to anticipate what central banks will do. If a central bank hints that it's worried about deflation, the market sells the currency. The central bank gets the devaluation without having to lift a finger. Lucas: So the question for listeners is: when you hear a central banker say something, think about what it means for the currency. It's often the most important signal they're sending. Luna: And sometimes the most honest signal. Lucas: Right. Because actions speak louder than words — but words can move markets just as much.