Why Foreign Currency Movements Matter

Today’s topic is foreign currencies.  This topic can be a bit tricky to understand.  It even baffles quite a few professional investors for whom foreign currencies are not their primary investment focus.  Why do you care about how strong or how weak the dollar is relative to other currencies?  In fact, what does it mean for the dollar to strengthen or weaken vs. another currency?

Let’s start at the beginning.  The US dollar can be converted into other currencies, and other currencies can be converted into the US dollar.  For example, today’s closing quote for the Japanese yen is 81.8848 yen per dollar (or 81.8848 ¥/$).  This quote is known as the conversion rate. This means that if you want to convert a dollar into yen, that for each dollar you hand over to the financial institution you will receive 81.8848 yen.  There is another way to quote this same conversion:  How many dollars does one yen buy?  If you are converting yen into dollars, the quote would be $1/81.8848 ¥ or $0.0122/¥.  Normally, the Japanese yen is quoted the first way:  yen/dollar (¥/$).  In contrast, the euro and the British pound are normally quoted in dollars per euro ($/€) and dollars per pound ($/£).  There is no special reason for this, other than it is how it has always been done.

Some currencies are allowed to “float” versus other currencies.  That means that the exchange rate will go up and down, based on supply of and demand for each currency.  If more traders (individuals, hedge funds, speculators, merchants who trade internationally) are wanting to convert dollars into yen, there will be an imbalance in the supply of and demand for dollars and yen.  The yen’s value will rise, as investors have to “pay up” to entice yen holders to part with their yen in exchange for dollars.  A yen holder may not want to sell his yen for dollars if the exchange rate is 81.8848 ¥/$, but he may do so if he only has to part with 80 ¥/$.  This is similar to the Beanie Baby phenomenon of yesteryear, or any other market in which there are more buyers than sellers.

Other currencies are “fixed” to another currency.  This fixed conversion rate is known as a “peg”, as in “the Chinese yuan is pegged to the US dollar at a rate of 6.5216 yuan/$”.  China, Mexico, and many other emerging market countries have historically decreed that their currency will only convert to the dollar at a fixed rate.  A big reason that these countries pegged their currencies to the US dollar was so that their currency would be as well respected as the dollar. 

Another big reason that emerging market countries have pegged their currency to the US dollar is that they can, in effect, give up their ability to control their own economy to the US Federal Reserve Board (“the Fed”).  The Fed, which controls the US money supply, has a much better handle on how to effectively navigate through the global economic cycle.  By piggy backing onto the Fed’s monetary policy, foreign central bankers historically have had a way to control inflationary biases in their own economies.  It is a disciplined approach in the sense that these foreign central bankers are not motivated to take steps to increase their own money supply too rapidly in the face of pressure by politicians, thereby avoiding inflation that might otherwise occur.

There are problems that go along with this fixed exchange rate concept.  For example, the conversion rate that the foreign country has decided on may not reflect the true fundamentals of each economy.  For example, if the US has inflation building up in its economy that is at a higher rate than the rate of inflation that China is experiencing, then the dollar should fall in value vs. the Chinese yuan.  But if the “peg” is in place, speculators, who know the truth about the relative inflation rates of each economy, will put pressure on the peg by selling the currency of the country experiencing higher inflation and buying the currency of the country that is experiencing lower inflation.  Eventually, the central banks (the financial institutions that are responsible for the soundness of its country’s currency), have to take steps to neutralize these speculators’ trading activity.  Since speculators as a group usually have a lot more currency to work with than the central bankers, the peg can be broken.  In other words, the peg has to be readjusted to reflect the realities of each country’s underlying economic situation.

Another big problem with fixed exchange rates, as US employees of multinational corporations have experienced over the last couple of decades, is that jobs can be effectively stolen from other countries by pegging their currency at an unrealistically low level relative to other countries.  China has been using this strategy for years to siphon off manufacturing jobs from US workers.  China’s policy has positive and negative implications for Chinese citizens.  First, Chinese wages for similar jobs in the US are artificially depressed, which motivates US multinational corporations to move production of manufacturing goods to China.  Second, since Chinese workers’ wages are artificially depressed, their purchasing power is below what it would otherwise be if their wages were at levels similar to those of US workers.

Several months ago, I read President George W. Bush’s autobiography, Decision Points.  In it, he discusses his conversations with the Chinese head of state at the time, Hu Jintao.  Hu told President Bush that what kept him up at night is figuring out how to create 20 million new jobs per year, as rural Chinese migrated into the cities in search of a better life.  It is no wonder that China has been pursuing its weak yuan policy for years.

Speculators have not been able to break the yuan/dollar peg because China keeps its currency closely regulated.   And, the Chinese have allowed the yuan to appreciate very slowly vs. the US dollar, even allowing it to trade in a narrow band.

Lately, there has been talk of the US dollar losing its status as the world’s reserve currency.  While this may eventually come to pass, I do not believe that it is imminent.  Every time there is a major global crisis (financial or otherwise), investors run to the dollar as a safe haven.  The reason is simple:  the US has the rule of law, private property rights, and limited government as defined by the US Constitution that is the bedrock of capitalism.  Capitalism thrives only in a political environment that nurtures it.