If the stronger European Union economies fail to bail out their distressed partners, we may see attempts to peel off from the European Union to re-establish their own domestic currencies. Greece could then presumably print drachmas, weakening the currency and inflating away the value of its debts.
A euro zone bailout/restructuring will happen because Germany and France want the euro to survive. On a stand-alone basis, the German deutschemark would be a much stronger currency than the euro—hampering German exports. There also are political pressures working to keep the euro experiment from failing.
The debate over the future of the euro leads us into the complicated world of foreign currencies, where nothing is ever black or white. The foreign exchange market, which encompasses the trading of currencies across the globe, is by far the largest asset class in the world with $4 trillion of daily volume.
All global currencies have a value relative to one another. As I write, one U.S. dollar is worth 0.693 Euros—and one euro is worth $1.44. Exchange rates are determined, at least in theory, by purchasing power parity. Goods in one country should equal the cost of goods in another country after taking into effect the difference in exchange rates. Likewise, interest rate parity assumes that, after adjusting for risk, the interest rates between countries should allow for equal rates of return.
These theories assume that arbitrage activities will keep exchange rates in balance. For example, if iPhones were cheaper in Canada than in the U.S., one would expect American consumers to buy Canadian iPhones. The exchange rate should negate the price difference. Or if interest rates in Sweden were 5 percent versus 3 percent in the United States, one would expect money to flow out the U.S. and into Sweden. The Swedish krona would appreciate in value versus the dollar until the exchange rate accounted for risk expectations between the two countries.
Of course, reality is never as simple as theory. How do we explain the strong yen versus the dollar when 10-year bond rates in Japan are 1 percent versus 2.2 percent here and the Japanese economy has been stalling for two decades? Yet, with the dollar having fallen 33 percent against the yen over the past five years, global investors surprisingly view the yen as a safe-haven currency.
Another confusing factor is that a strong or a weak currency can have both pros and cons. A strong currency hurts a country’s price competitiveness on the export market. On the other hand, the citizens of a country with a strong currency can buy imported goods at lower prices and travel overseas cheaply. And corporations possessing a strong currency can acquire foreign businesses at bargain prices.
Governments occasionally will intervene in the market to influence the value of its currency. The Chinese government exerts control over the yuan, for example, keeping it weaker than free-market pricing would suggest so that Chinese exports continue to sell well.
In our global economy, foreign exchange rates represent the relative value of a country’s economic and governmental policies, so investors must pay attention to the long-term trends.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or firstname.lastname@example.org.