The foreign exchange market is one of the world’s largest and most liquid financial markets. Any currency can be expressed in terms of another currency called an exchange rate. For example, the U.S. dollar can be converted into dozens of foreign currencies, from the euro to the Israeli shekel.
The value of a currency can be influenced by all sorts of variables—including politics, monetary policy and interest rates. In general, though, it is inflation that causes paper currencies like the dollar to lose purchasing power over time.
A strong domestic currency usually connotes economic stability and liquidity—a trustworthy and fiscally prudent government. The U.S dollar is considered the world’s “reserve” currency. For example, oil revenues in the Middle East are converted into dollars (known as petrodollars). And much of China’s massive foreign currency reserves have been reinvested in dollar-denominated U.S. government bonds.
Lately, there has been concern expressed by global bankers that the world is engaging in a “currency war.”
There are plenty of gray areas. Is it better to have a weak or strong currency? A strong currency will attract foreign funds for investment. And residents of a country with a strong currency can buy goods from another country at cheap prices. On the other hand, a weak currency makes a country’s exports cheaper and more attractive to foreign buyers.
The U.S. Treasury’s public rhetoric has typically advocated a strong U.S. dollar. And yet our country’s actions in the marketplace, like the Fed’s quantitative easing strategy, are clearly policies that should have the effect of weakening the dollar.
Although few central bankers will admit it, countries will sometimes take actions to “influence”—or daresay manipulate—the value of their currency. Hence the nerdy economist joke I have heard: “He lied like a finance minister on the eve of devaluation.”
Japan is a recent example of a government determined to devalue its currency. The Japanese yen has weakened about 16 percent versus the dollar in the past three months, a huge move for a currency.
The economy in Japan had barely recovered from the credit crisis when the tsunami hit in March 2011. Since then, Japan’s export-driven economy has been moribund. After a change in political leadership this fall, officials made it clear they would pursue monetary policies to effectively weaken the yen and help jump-start the country’s export markets. Just a few months ago, $1 equaled 80 yen. Today, it is 92.5 yen.
With large developed economies pursuing currency-weakening strategies—Europe is the odd case, with the euro strangely showing recent strength—some of the strongest currencies can be found in emerging markets.
Yet bankers in countries like the Philippines, Singapore, South Korea and Mexico worry that their smaller countries may not be able to handle large, short-term foreign capital flows. These bouts of fast money can cause asset bubbles to form and disrupt economies.
The markets are hopeful that weakening currencies will help kick-start global growth. Otherwise, a race-to-the-bottom type currency war combined with loose monetary policies might spur widespread global inflation.•
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.