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The writer is a former banker and author of ‘A Banquet of Consequences Reloaded’ and ‘Fortune’s Fool’
Currency wars, like military conflicts, have evolved. Conventional economics assumes that devaluation affects trade, corporate earnings, prices, and capital flows. It does, but the relationships are now more nuanced than some might expect.
First, the impact of a weaker exchange rate on export competitiveness might be diminishing. Since the 1985 Plaza Accord, companies, led by automobile manufacturers at the time, diversified supply chains to locate production in or near final markets. The threat of disruptions from extreme weather, pandemics, and more recently, geopolitical pressures, has encouraged the “reshoring and friend-shoring” of operations. This reduces or alters currency exposures.
The effects depend on the export, especially its demand elasticity, relative production costs, available capacity, competition, switching costs, as well as factors like quality, technological complexity, specifications, transport expenses, and supply reliability. However, many goods and raw materials are priced in dollars, muting currency risks. Sales under long-term contracts are partially protected from short-term exchange rate fluctuations.
Second, devaluation boosts accounting incomes, with foreign earnings translated at a more favorable rate, but it does not improve cash flow unless the amount is repatriated and converted. Exporters often keep their foreign earnings to meet commitments in the relevant currency, reducing the influence of variable exchange rates. The location of ultimate business owners and the actual cash flow to them are crucial.
Some businesses, such as resource companies, regardless of their domicile, use the dollar as their functional currency, further complicating matters. Foreign exchange amounts are often hedged by derivatives or borrowing and sourcing inputs in the revenue currency. The real financial consequences require a detailed understanding of individual business operations, which can vary within the same industry or country.
Third, at a macroeconomic level, devaluation is theoretically inflationary, but in practice, the link is weaker. Higher import costs may not result in higher price levels due to the mix of local and overseas-produced products, availability of substitutes, and the inability or unwillingness to pass on higher expenses to end users.
Finally, in terms of capital flows, currency weakness is assumed to make a country a less attractive investment destination due to potential losses. However, this depends on the instrument’s denomination and whether the buyer is domestic or foreign. The ability to attract foreign capital is also influenced by available investment options, relative currency-adjusted returns, and special considerations such as the dollar’s status as a reserve currency.
Japan’s ability to finance itself from domestic savings and its central bank has limited the problems caused by a declining yen. In contrast, for the US, the value of the dollar is more consequential due to the need to attract foreign investors to fund its current account and budget deficit.
For emerging market borrowers funding in non-indigenous currencies without offsetting export income, a devaluation can reduce the capacity to service commitments. However, devaluation can also be an effective mechanism for decreasing real debt levels, where borrowings are in the national currency and held by overseas investors. In practical terms, it can amount to a selective default.
The importance of currency may further diminish over time if deglobalization leads to lower trade and cross-border capital flows. Greater emphasis on direct intervention, such as tariffs, embargoes, sanctions, subsidies, restrictions on investments, and asset seizures, may also reduce the role of exchange rates.
This shift, in part, reflects the practical difficulty of targeting specific currency values, especially when every nation desires an advantageous exchange rate. Such targets may conflict with inflation and monetary objectives and risk retaliation, complicating economic management. For policymakers, the reduced importance of exchange rates as a policy tool may change the balance of power between central banks and governments.
Investment decisions need to incorporate these realities rather than relying on existing preconceptions about currency influences. As John Kenneth Galbraith said, the march of events is the enemy of conventional wisdom.