The Trouble With Exchange Rates

Currency exchange rates have always troubled me.  Some are orchestrated, others occur because of shortfalls in the business model of the particular country, some because of a catastrophe.  No matter the reason, there are unintended consequences.

To have a chance to understand what happens we need to recognize a few things.

  • All change is relative to some other currency.  Frequently the US dollar.
  • Local fiscal management will eventually move the exchange rate. Do a bad job and it shows up quickly.
  • In the short run, a relative increase or decrease may have little effect within the country.
  • Exports and imports are profoundly affected by significant moves.
  • Government bond interest rates can be dramatically affected. No one will lend at low rates if the currency is falling.
  • In the long run significant decreases tend to harm unless the country is self-sufficient in resources and imports few manufactured articles.

The orchestrated changes, like Japan presently, are usually intended to improve the local economy.  Local manufacturers create things using local currency to pay wages, rent, most inputs, and other operating costs.  The selling price in local currency will remain as before, but in some other currency the selling price may be lower.  The Yen is about 117 to the $US now and that is about 15% more advantageous than just six months ago.  A Luxus has become cheaper outside Japan.  All good.  On the other side of the equation, imports have increased in price.  Ones that have a local substitute will decline in volume.  Also good.  It will be more expensive to outsource.  Good too.  But non-replaceable imports cost more.  Not so good.

This kind of policy is a bit like a business that cuts price to increase volume.  A short-lived advantage only until others do the same.  Eventually everyone goes broke.

Shortfalls in the business model are not uncommon.  The current Russian problem is one of those.  Their economy is very susceptible to a change in energy prices.  Oil revenues, when the price is north of $100 per barrel, account for 45% of the federal budget.  There are large dislocations in spending when revenue suddenly falls.  This similar to the dominant customer problem that some businesses must deal with.  The sanctions that resulted from the Ukraine misstep make it even more telling.

Sometimes a natural disaster destroys a piece of a local economy.  Like Haiti.  This would be similar to the loss of a large factory to fire or similar event for a business.

Currencies tend to behave a little like stock prices.  The way they move can give you insight into how people see the prospects for that country.  A falling currency is like a falling stock price.  Prospects are dubious.

Many people have financial plans that intuitively depend on stable currency.  In Canada, from Spring 2011 to the end of 2014, you would have a gain on American ETFs of about 26% even if the underlying American security was unchanged in value.  Be careful drawing inferences like how good the American economy is compared to Canada.  Relative currency issues can hide a good deal of risk.

Be aware of currency in your spending.  If travel or a home in another country is a large part of your budget, you should hedge your currency risk.

Growth rates do not tell you everything you need to know.  Find what the exchange rate adjusted numbers mean.  To you!

Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. Contact: don@moneyfyi.com 

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