Currency Wars!

Last month, on September 15, Japan's finance ministry intervened in the currency markets for the first time in six years.  The ministry sold yen to weaken the currency.  The yen fell from below 83 yen to the U.S. dollar, to over 85 yen to the dollar in one day.  For the past several years, China has been pressured primarily by the U.S. to let Chinese yuan appreciate.  And China is proposing an international reserve currency system independent of a single country, as China has grown more anxious about the health of the U.S. dollar.  Furthermore, earlier this October, the International Monetary Fund concluded two days of talks in Washington without reaching a solution to address rising tensions about currency exchange rates.

The tensions about exchange rates have surfaced as developing nations, who have a tendency to manage their currencies compared to developed nations, have grown to become a larger part of the global economy.  A cheaper currency gives a nation an edge because the country's goods will have a price advantage on international markets, while imported goods into that nation will become more expensive.

However, I find it astonishing for a country try to devalue its currency.  One of the axioms in finance is that "people prefer more to less." And I agree.  I prefer the cash in my pockets to buy, for example more gasoline, than less gasoline.  Yes, undervalued currencies help developing countries create export markets in the beginning, but devaluation can never be a long-term strategy.  Sustainable growth can only be achieved through innovation, productivity and investments in capital.   

Jim Rogers, one of the greatest investors of our time, explained this so well in his book, "Investment Biker", published in 1994.  His story starts with both Chevrolet and Toyota selling similar cars for $10,000.  If the U.S. dollar is devalued, say by 30 percent, the Chevrolet will still be $10,000 but the Toyota will now sell for $13,000.  Let's hear the rest of the story from Jim Rogers:

 "At first blush, this looks good.  Finally American automotive workers' jobs will be protected.  How can it hurt us if we make it difficult for the Japanese to sell in our market?... Except for short periods, that policy has never, ever worked in the history of the world.  You can sell only so far on price.

…In the real world what happens is that under the umbrella of the devalued currency, Chevrolet will raise its price to, say, $11,500, as now it is easy to underprice the foreign competition.

     

Some say it is worth it if we keep our people employed, if we make America first.  Unfortunately, it does not work that way.  Because the dry cleaner on the corner has paid 15 percent more for his Chevrolet - as has every one of his suppliers - he must raise his prices to reflect the increase.  He and his suppliers must also collectively pay 30 percent more for all the things we Americans import, be they palladium, titanium, cobalt, chrome, tin, coffee, cocoa - the list is endless.  Add these to the domestic increases brought about by devaluation, and its seemingly no-cost benefits disappear in a year or so.

In addition, when you sell on price, you do not innovate and make your products better; they get shoddier in comparison with your competitor's. You become fat and lazy and sloppy.

Now inflation starts.  The Chevrolet creeps up in price till it sells at $13,000 or even $14,000.  Toyotas sell for less, and Chevrolet loses more market share.  As this scenario is repeated, a powerful noose tightens around the country's financial jugular that it only rarely escapes.  Your costs again catch up with you and you have to devalue again…  Devaluation creates a never-ending, vicious circle."

Again, there is empirical evidence that undervalued currency helps developing countries achieve higher economic growth when these countries are in low-income settings.  There is also empirical evidence that the relationship between the level of real exchange rate and economic growth disappears for advanced countries.  In other words, as masterfully described by Jim Rogers above , currency devaluation is much less likely to help an advanced, service-based economy in the long-run.