Currency wars are not what they used to be

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The writer is a former banker and author of ‘A Banquet of Consequences Reloaded’ and ‘Fortune’s Fool’

Currency wars, like military conflicts, have changed. Conventional economics assumes that devaluation affects trade, corporate earnings, prices and capital flows. It does but the relationships are now more nuanced than some might expect.

First, the impact of a weaker exchange rate on export competitiveness might be lessening. Since the 1985 Plaza Accord, companies, originally led by automobile manufacturers, diversified supply chains to locate production in or close to final markets. The threat of disruption from extreme weather, pandemics, and more recently from geopolitical pressures has encouraged so-called “reshoring and friend-shoring” of operations. This reduces or alters currency exposures.

The effects depend on the export — especially the elasticity of demand for it, relative production costs, available capacity, competition, switching costs as well as issues such as quality, technological complexity, specifications, transport expense and supply reliability. But many goods and raw materials are priced in dollars, muting currency risks. Sales under long-term contracts are partially immunised from short-term exchange rate fluctuations. 

Second, devaluation boosts accounting incomes, with foreign earnings translated at a more advantageous rate, but does not improve cash flow unless the amount is repatriated and converted. Exporters frequently keep their foreign earnings to meet commitments in the relevant currency reducing the influence of variable exchange rates. The location of ultimate business owners and the actual cash flow to them is crucial.

Some businesses, such as resource companies, irrespective of domicile, use the dollar as their functional currency further complicating matters. Foreign exchange amounts are often hedged by derivatives or borrowing and sourcing inputs in the revenue currency. The real financial consequences require detailed understanding of individual business operations — which varies within the same industry or country.

Third, at a macroeconomic level, devaluation is theoretically inflationary but in practice the link is weaker. Higher import costs may not flow into price levels because of the mix of local and overseas produced products, availability of substitutes and the inability or unwillingness to pass on higher expenses to end users.

Finally, in terms of capital flows, currency weakness is assumed to make a country a less attractive investment destination due to potential losses. But this depends on the instrument’s denomination and whether the buyer is domestic or foreign. The ability to attract foreign capital is also influenced by available investment options (such as the US technology sector), relative currency adjusted returns and special considerations such the dollar’s status as a reserve currency.

Japan’s ability to finance itself from domestic savings and its central bank has limited the problems of a declining yen. In contrast, for the US, the value of the dollar is more consequential due to the need to attract foreign investors to fund its current account and budget deficit.

For emerging market borrowers funding in non-indigenous currencies without offsetting export income, a devaluation can reduce the capacity to service commitments. However, devaluation can also be an effective mechanism for decreasing real debt levels, where borrowings are in national currency and held by overseas investors. In practical terms, it can amount to a selective default.

The importance of currency may reduce further over time if deglobalisation results in lower trade and cross-border capital flows. Greater emphasis on direct intervention such as tariffs, embargoes, sanctions, subsidies, restrictions on investments and asset seizures may also diminish the role of exchange rates.

This shift, in part, reflects practical difficulty of targeting specific currency values, particularly where every nation wants an advantageous exchange rate. Such targets may clash with inflation and monetary objectives and risk retaliation, complicating economic management. For policymakers, the reduced importance of exchange rates as a policy tool may alter the balance of power between central banks and governments.

Investment decisions need to incorporate these realities rather than existing preconceptions about currency influences. As John Kenneth Galbraith held, the march of events is the enemy of conventional wisdom.