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The Fuel of a Currency War, Part 1

The Fuel of a Currency War, Part 1

James Stanley, Senior Strategist

Article Summary: The world’s largest Central Banks have embarked on massive intervention efforts to stimulate their economies, many of which are based on currency policy that have been eloquently dubbed ‘The Global Currency Wars.’ In this article, we look at the consequences of a strengthening currency. In our next article, we examine currency devaluations.

Central Bank intervention, by many accounts, has saved the global economy from spiraling into a financial abyss. Five years from the start of The Financial Crisis finds the world’s largest Central Banks continuing to feed the financial system in an effort to keep it from melting down.

Intervention efforts are currently active in The United States, Europe, Japan, Switzerland, and they played a prominent role in China throughout 2012 as the country attempted to avert the ‘hard landing’ that so many had forecast.

Today, with the S&P sitting near 5 year highs after recently crossing the vaulted ‘1500’ psychological level, it appears as though disaster has been averted; at least for now, as these massive intervention efforts have offset some very worrying economic data.

Much of this intervention is based around what could become a worrying premise; and this is the very idea that prevented Central Banks from using larger stimulus efforts in years’ prior. This is something that has been practiced in many different forms since the dissolution of the Bretton Woods compact when currencies were allowed to free-float against the valuations of other currencies.

Currency Devaluation

This may sound somewhat counter-intuitive, but devaluing a currency is, in-and-of-itself, a form of stimulus. On the other side of the coin, a strengthening currency can add massive pressure to a nation’s exports; and for a country dependent on those exports, that stronger currency can bring catastrophic consequences.

Let’s take the case of Japan, a country with a strong export-based economy that has recently taken to massive devaluations of Yen in an effort to stimulate their economy. A major export of Japan is automobiles, so let’s look at the effect of a stronger or weaker yen on Japanese auto exports.

Let’s say that in 1999, with the USDJPY trading near 150.00, a Japanese auto manufacturer could sell a car in the United States for $30,000, and it cost them ¥3,500,000 to produce, ship, and sell the car.

Eight years later, and markets were much different – seeing a spot quote on USDJPY of 100.00, a loss of 33% on 150.00 USDJPY price that was looked at previously.

This change in the exchange rate has a drastic impact on our car manufacturer. The producer was previously looking at a profit – but now, they are looking at a loss.

What was previously a strong and tidy profit on each car sold, has now turned into a loss for every single unit. And our manufacturer didn’t do anything wrong! They were only continuing to make the same car, with the same costs and production methods as earlier – but now because of this strong currency, they are forced to take a loss on each and every unit sold.

As we can see in this example, a strengthening currency adds pressure to a nation’s exports, making it more difficult to sell goods in other economies.

In this situation, our car manufacturer has some tough decisions: Either increase the price of their car (making it less competitive), or absorb the loss. Neither of these are really great options from a business standpoint.

We can see the effect that a stronger currency has on an economy by focusing on Japan since the late 80’s. The erosion of the USDJPY quote has had some dire consequences for our automotive manufacturer in our above example, and this isn’t too different from the fate seen by many Japanese companies.

One need only to look at the value of the Nikkei over the past 25 years to see what strengthening Yen has done to the Japanese economy:

The Erosion of the Nikkei brought on by a Strong Yen

Competition in the Market Place

As mentioned previously, companies in this position don't have the luxury of many options to offset this stronger currency. By making their products more expensive (and less competitive), they stand to sell fewer cars. Or, alternatively – they can merely try to absorb the loss and retain their competitive position; hoping that, eventually, their currency will weaken, allowing for profit margins to come back in place.

Either way, companies in this position have a difficult road ahead – as they are dependent on exports that are more and more difficult to sell as a stronger currency makes them more expensive.

--- Written by James Stanley

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.