How to create a hypothesis for analyzing currencies Pt II

This is part two of this series on currencies. For part one, please see here.

 

Why do currencies move anyway?

Consider what kind of folks are interested in swapping Japanese yen for US dollars. They tend to primarily be Japanese companies that make too many cars and electronic devices to sell within Japan, and who wish to sell them on the international market, or companies requiring something like corn or wheat, which need to be purchased outside Japan.

There are also Japanese companies (and investors) moving large amounts of money across borders in response to changes ideas about where they would like to invest in a company, or to park their money because of getting a better return in different places.

These items (trade and capital flows) basically should be in balance. The reason for this is that if Japan imports too much corn and wheat, in other words if it imports more than it exports, then the country as a whole will need to come up with the US dollars for the extra corn and wheat from somewhere.

The money can come from places such as borrowing US dollars from other countries, transfers of bank balances from other countries, running down Japan’s reserves, or selling assets to other countries. You can imagine that the importer of the corn does not have any US dollars on hand, so she will run down to the local bank, which will have a few dollars on hand, but to get the rest of the dollars, the local bank will then in turn have to go to its big brother bank in Tokyo, who would then turn to the market to buy the US dollars.

But, wherever the currency for the extra grain comes from, importing more stuff into Japan requires selling the Japanese yen and buying US dollars. This will make the price of the Japanese yen fall.

Obviously, the opposite is also true in the converse case. Exporting more will push up your currency.

 

Money moves move markets

The other thing that can change the level of your currency is movements in capital.

Japan has had low interest rates for a very long time. Until recently, many Japanese people used to park their assets in high-yielding currencies. This means that they would go to their bank, convert the Japanese yen to something like British pounds or Australian dollars, and earn an interest-rate of something like 4% or more instead of basically zero.

The trouble was when hedge funds got involved in borrowing yen as a cheap source of funding (meaning a way to get loans as a low rate of interest). They would do the same thing as individuals but instead of putting their money in a bank, they would buy more exotic assets. The trouble was not the fact that one or two hedge funds were doing this. It was the fact that everybody was doing this.

Large disparities in interest rates will move currencies, making the one with the lower interest-rate less desirable to savers, and vice versa.

Therefore, the yen was artificially cheap for a long time, despite the country having a massive current account surplus.

In the 1980s, Japan was earning huge amounts of foreign currency, particularly the US dollar, because it was exporting a lot and obstructing imports (like it does today), but despite that, it was universally accepted that the yen did not reflect this accumulated currency (i.e. everyone knew that the yen was too cheap). From 1980 to 1985, the yen stayed fairly stable, between 200 and about 262 the dollar, while Japan’s foreign currency earnings ballooned.  The reason for this was mainly low interest rates in Japan relative to those in the US. The US was fighting inflation, which meant that it had high interest rates, attracting capital from other countries.

In 1985, the US, West Germany, the UK, and Japan agreed to make the US dollar fall and allow the Japanese yen and Deutschmark to rise (the Plaza Accord). The yen rose, and there was a bit of a recession, so Japan reduced interest rates, giving rise to an asset bubble.

One interesting observation is that during the period following the Plaza Accord, US manufacturers watched in despair as Japanese export volumes continued despite the value of the yen surging. I will tell you the reason for this in detail and other time, but basically this is because Japan has an economy organized on a military-production basis, meaning that production is valued for production’s sake rather than for the profits it generates, and the country operates in a more communist fashion than anyone outside the country seems to notice.

So you can see that although exports and imports play a major role, historically, interest-rate differentials (or, more specifically, their compression) have given rise to bigger moves.

However, in a world with very low interest-rate differentials, other factors now take the driving seat. This means that the country should start to operate in the way described in an economics textbook. Namely, increasing exports given rise to a stronger currency, which reduces exports.

But wait a second – that is not the end of the story. Japanese companies have been increasing productivity.

This means exporters are becoming better at dealing with a stronger yen.

 

So, what will cause the yen to fall?

You can answer this question for yourself by thinking about the factors mentioned above:

 

-What would change Japan’s competitiveness relative to other countries going forwards?

-What would move investors to move funds into or out of Japan?

-What will happen to interest rates in Japan relative to other countries?

 

Also, you need to consider is that it might not fall from here, but continue to rise. This would happen if you had continued deflation in Japan, continued current account surpluses and no meaningful interest-rate differentials. You should firstly have a view of interest rates in different countries before you can have a view of the currency. I will not give you one here, you have to think about yourself.

What about Japan’s bond bubble? I will talk about that elsewhere, but Japan’s debt is dominated in yen, and the country does not need funding in dollars. If the country wants to, it can print as much yen as it wants, so comparisons with Greece and the euro are ridiculous. This does not mean that they will not be a problem, it just means that you cannot have a currency crisis where you hold the printing press (think about whether the US can run out of dollars).