The economic decline over the past few years has triggered a growing awareness of the importance of currency exchange markets, especially for exporters. Any manufacturer doing business overseas must have at least a basic grasp of currency levers and influences.
Exporters’ financial success depends on the currency exchange rate, its cyclical nature and fluctuations. An exporter-centric monetary policy essentially means lowering the value of the domestic currency compared to those of international trade partners.
Devaluing the Canadian dollar by 10 percent for instance, would make exported products 10 percent cheaper to foreign buyers. A devalued currency typically creates employment to support the production of exported goods. In fact, currency devaluation of 10 percent translates to an increase of 0.5 percent to one percent of a country’s GDP.
Unfortunately, the central banks’ efforts to devalue domestic currency often meets resistance by trading partners, leading to diminished results, or outright failure. As a result, countries start to notice a decline in international trade, leading to financial challenges and from a broader perspective, contributing to the liquidity crisis and the economic upheaval we’ve seen since 2008.
When the liquidity crisis first hit several years ago, central banks responded with a concept called “quantitative easing.” Basically, it’s a monetary policy whereby the central banks bought specified financial assets from commercial banks and other private institutions.
But quantitative easing caused radical and unexpected currency fluctuations among many exchanges; a situation referred to by politicians as a “currency war.”
Central banks around the world sought to lower the value of their own currency in an attempt to increase exports, create employment and minimize their deficits. To counter the trend, bankers and financial ministers of G20 countries calmed the surface waters of the currency market with more coordinated quantitative easing.
Due to the actions of the US Federal Reserve, the support of the European Union Central Bank and Chinese Central Bank, the currency world has generally settled, with the exception of a few, such as the Japanese Yen and Swiss Franc.
But looking back, the Great Recession of 2008 exposed weaknesses in the global financial system, and demonstrated the limits of a speculative economy. In recent years, the global financial system has gone through the liquidity crisis, credit crisis, trust crisis and political crisis.
The recession also taught us about the increased influence of certain factors on currencies, such as the strength of national financial institutions, the dominant role of a few central banks, budgetary reforms, and bilateral agreements.
The importance of a strong central bank has increased. Announcements or statements from the Federal Reserve Chairman or the governor of a central bank impact currency exchanges more than leading economical indicators.
Central bank leaders’ statements are analyzed and re-analyzed. The placements of words, the length of sentences, and the implied meaning behind a message are used to predict the central bank’s next move. Today, markets react more to words and the intonation of the central banker’s voice than to the financial news itself.
US, Britain and China
The most important power in the currency market hierarchy is the US Federal Reserve (the Fed) and US investment banks. The Fed’s financial policies have the power to change currency exchanges drastically and decisively. Its policies may also impact currencies unrelated to the US dollar.
Next in the hierarchy are the European Union Central bank and the British Central Bank (together with the British financial institutions) due to the size of currency transactions in the Euro. Third in hierarchy is the Chinese Central Bank, given the size of the Chinese economy, US debt related issues, and monetary policy.
Aside from the central banks, currency is also influenced by a country’s budgetary structural problems. Structural problems might include the percentage of its annual budget spent on healthcare, pensions, military and social programs.
Structural problems have grown (for many years) in developed countries and today, the challenges are starting to restrict future growth of these countries. The recent difficulties in increasing the debt limit in US for instance, signal the importance of structural problems.
Though opinions differ on how to resolve the structural problems, to its credit, the US is the first country approaching head-on resolutions; whereas other countries tend to neglect the problem.
Another influence on currency is the ‘excessive financial economy’ (especially bond markets). The speculative power of influential investment banks and companies, pension funds, hedge funds—all of which are managed by profit-driven groups of people—are able to cause short term fluctuations even in the most dominant currencies.
The financial economy has more leverage in currency matters than the real economy. This may come as a surprise to some manufacturers, importers and exporters.
Finally, bilateral international trade agreements, as a reflection of countries’ efforts to revive the real economy, also influence central bank monetary policies.
Currency markets have seen upheaval these past few years and though they’ve calmed somewhat, manufacturers should closely monitor domestic monetary policy, budget challenges and decisions by the most influential central banks, when planning growth or expansion in export markets.
Related: Global tensions driving up US dollar
Darek Wozniak is president of JW Investrade, a currency exchange consulting firm in London, Ont. He may be reached via email.
Watch for Darek’s next article, focusing on currency pairs and the importance of foreign exchange markets to exporters and importers’ bottom line.