The Effects Of Currency Fluctuations On The Economy

By Investopedia Staff AAA

Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. The exchange rate of one currency versus the other is influenced by numerous fundamental and technical factors. These include relative supply and demand of the two currencies, economic performance, outlook for inflation, interest rate differentials, capital flows, technical support and resistance levels, and so on. As these factors are generally in a state of perpetual flux, currency values fluctuate from one moment to the next. But although a currency’s level is largely supposed to be determined by the underlying economy, the tables are often turned, as huge movements in a currency can dictate the economy’s fortunes. In this situation, a currency becomes the tail that wags the dog, in a manner of speaking.

Currency Effects are Far-Reaching
While the impact of a currency’s gyrations on an economy is far-reaching, most people do not pay particularly close attention to exchange rates because most of their business and transactions are conducted in their domestic currency. For the typical consumer, exchange rates only come into focus for occasional activities or transactions such as foreign travel, import payments or overseas remittances.

A common fallacy that most people harbor is that a strong domestic currency is a good thing, because it makes it cheaper to travel to Europe, for example, or to pay for an imported product. In reality, though, an unduly strong currency can exert a significant drag on the underlying economy over the long term, as entire industries are rendered uncompetitive and thousands of jobs are lost. And while consumers may disdain a weaker domestic currency because it makes cross-border shopping and overseas travel more expensive, a weak currency can actually result in more economic benefits.

The value of the domestic currency in the foreign exchange market is an important instrument in a central bank’s toolkit, as well as a key consideration when it sets monetary policy. Directly or indirectly, therefore, currency levels affect a number of key economic variables. They may play a role in the interest rate you pay on your mortgage, the returns on your investment portfolio, the price of groceries in your local supermarket, and even your job prospects.

Currency Impact on the Economy
A currency’s level has a direct impact on the following aspects of the economy:

Merchandise trade: This refers to a nation’s international trade, or its exports and imports. In general terms, a weaker currency will stimulate exports and make imports more expensive, thereby decreasing a nation’s trade deficit (or increasing surplus) over time.

A simple example will illustrate this concept. Assume you are a U.S. exporter who sold a million widgets at $10 each to a buyer in Europe two years ago, when the exchange rate was EUR 1=1.25 USD. The cost to your European buyer was therefore EUR 8 per widget. Your buyer is now negotiating a better price for a large order, and because the dollar has declined to 1.35 per euro, you can afford to give the buyer a price break while still clearing at least $10 per widget. Even if your new price is EUR 7.50, which amounts to a 6.25% discount from the previous price, your price in USD would be $10.13 at the current exchange rate. The depreciation in your domestic currency is the primary reason why your export business has remained competitive in international markets.

Conversely, a significantly stronger currency can reduce export competitiveness and make imports cheaper, which can cause the trade deficit to widen further, eventually weakening the currency in a self-adjusting mechanism. But before this happens, industry sectors that are highly export-oriented can be decimated by an unduly strong currency.

Economic growth: The basic formula for an economy’s GDP is C + I + G + (X – M) where:
C = Consumption or consumer spending, the biggest component of an economy
I = Capital investment by businesses and households
G = Government spending
(X – M) = Exports minus imports, or net exports.

From this equation, it is clear that the higher the value of net exports, the higher a nation’s GDP. As discussed earlier, net exports have an inverse correlation with the strength of the domestic currency.

Capital flows: Foreign capital will tend to flow into countries that have strong governments, dynamic economies and stable currencies. A nation needs to have a relatively stable currency to attract investment capital from foreign investors. Otherwise, the prospect of exchange losses inflicted by currency depreciation may deter overseas investors.

Capital flows can be classified into two main types – foreign direct investment (FDI), in which foreign investors take stakes in existing companies or build new facilities overseas; and foreign portfolio investment, where foreign investors invest in overseas securities. FDI is a critical source of funding for growing economies such as China and India, whose growth would be constrained if capital was unavailable.

Governments greatly prefer FDI to foreign portfolio investments, since the latter are often akin to “hot money” that can leave the country when the going gets tough. This phenomenon, referred to as “capital flight", can be sparked by any negative event, including an expected or anticipated devaluation of the currency.

Inflation: A devalued currency can result in “imported” inflation for countries that are substantial importers. A sudden decline of 20% in the domestic currency may result in imported products costing 25% more since a 20% decline means a 25% increase to get back to the original starting point.

Interest rates: As mentioned earlier, the exchange rate level is a key consideration for most central banks when setting monetary policy. For example, former Bank of Canada Governor Mark Carney said in a September 2012 speech that the bank takes the exchange rate of the Canadian dollar into account in setting monetary policy. Carney said that the persistent strength of the Canadian dollar was one of the reasons why Canada’s monetary policy had been “exceptionally accommodative” for so long.

A strong domestic currency exerts a drag on the economy, achieving the same end result as tighter monetary policy (i.e. higher interest rates). In addition, further tightening of monetary policy at a time when the domestic currency is already unduly strong may exacerbate the problem by attracting more hot money from foreign investors, who are seeking higher yielding investments (which would further push up the domestic currency).

The Global Influence of Currencies – Examples
The global forex market is by far the largest financial market with its daily trading volume of over $5 trillion - far exceeding that of other markets including equities, bonds and commodities. Despite such enormous trading volumes, currencies stay off the front pages most of the time. However, there are times when currencies move in dramatic fashion; during such times, the reverberations of these moves can be literally felt around the world. We list below a few such examples:

  • The Asian crisis of 1997-98 – A prime example of the havoc that can be wreaked on an economy by adverse currency moves, the Asian crisis began with the devaluation of the Thai baht in July 1997. The devaluation occurred after the baht came under intense speculative attack, forcing Thailand’s central bank to abandon its peg to the U.S. dollar and float the currency. This triggered a financial collapse that spread like wildfire to the neighboring economies of Indonesia, Malaysia, South Korea and Hong Kong. The currency contagion led to a severe contraction in these economies as bankruptcies soared and stock markets plunged.
  • China’s undervalued yuan: China held its yuan steady for a decade from 1994 to 2004, enabling its export juggernaut to gather tremendous momentum from an undervalued currency. This prompted a growing chorus of complaints from the U.S. and other nations that China was artificially suppressing the value of its currency to boost exports. China has since allowed the yuan to appreciate at a modest pace, from over 8 to the dollar in 2005 to just over 6 in 2013.
  • Japanese yen’s gyrations from 2008 to mid-2013: The Japanese yen has been one of the most volatile currencies in the five years to mid-2013. As the global credit intensified from August 2008, the yen – which had been a favored currency for carry trades because of Japan’s near-zero interest rate policy – began appreciating sharply as panicked investors bought the currency in droves to repay yen-denominated loans. As a result, the yen appreciated by more than 25% against the U.S. dollar in the five months to January 2009. In 2013, Prime Minister Abe’s monetary stimulus and fiscal stimulus plans – nicknamed “Abenomics” – led to a 16% plunge in the yen within the first five months of the year.
  • Euro fears (2010-12): Concerns that the deeply indebted nations of Greece, Portugal, Spain and Italy would be eventually forced out of the European Union, causing it to disintegrate, led the euro to plunge 20% in seven months, from a level of 1.51 in December 2009 to about 1.19 in June 2010. A respite that led the currency retracing all its losses over the next year proved to be temporary, as a resurgence of EU break-up fears again led to a 19% slump in the euro from May 2011 to July 2012.

How can an investor benefit?
Here are some suggestions to benefit from currency moves:

  • Invest overseas: If you are a U.S-based investor and believe the USD is in a secular decline, invest in strong overseas markets, because your returns will be boosted by the appreciation in the foreign currency/s. Consider the example of the Canadian benchmark index – the TSX Composite – in the first decade of this millennium. While the S&P 500 was virtually flat over this period, the TSX generated total returns of about 72% (in Canadian $ terms) during this decade. But the steep appreciation of the Canadian dollar versus the U.S. dollar over these 10 years would have almost doubled returns for a U.S. investor to about 137% in total or 9% per annum.
  • Invest in U.S. multinationals: The U.S. has the largest number of multinational companies, many of which derive a substantial part of their revenues and earnings from foreign countries. Earnings of U.S. multinationals are boosted by the weaker dollar, which should translate into higher stock prices when the greenback is weak.
  • Refrain from borrowing in low-interest foreign currencies: This is admittedly not a pressing issue from 2008 onward, since U.S. interest rates have been at record lows for years. But at some point U.S. interest rates will revert to historically higher levels. At such times, investors who are tempted to borrow in foreign currencies with lower interest rates would be well served to remember the plight of those who had to repay borrowed yen in 2008. The moral of the story – never borrow in a foreign currency if it is liable to appreciate and you do not understand or cannot hedge the exchange risk.
  • Hedge currency risk: Adverse currency moves can significantly impact your finances, especially if you have substantial forex exposure. But plenty of choices are available to hedge currency risk, from currency futures and forwards, to currency options and exchange-traded funds such as the Euro Currency Trust (FXE) and CurrencyShares Japanese Yen Trust (FXY). If your currency risk is large enough to keep you awake at nights, consider hedging this risk.

Conclusion
Currency moves can have a wide-ranging impact not just on a domestic economy, but also on the global one. Investors can use such moves to their advantage by investing overseas or in U.S. multinationals when the greenback is weak. Because currency moves can be a potent risk when one has a large forex exposure, it may be best to hedge this risk through the many hedging instruments available.

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