Observations

Currencies. What drives their value? Can central bankers change their trend?

These thoughts are the result of my experience in managing a one billion dollar currency portfolio designed to hedge Goodyear's foreign exchange exposure. Teaching the subject for many years has also allowed me to focus on this topic.

Dealing for several years with foreign exchange markets convinced me that the most important factor driving currencies over the long-term is the inflation differential between two countries. A country with 8% inflation will see its currency depreciate about 6% over the long-term against a country with only 2% inflation.

Past currency crises (Mexico, Latin America, Asia and Russia) are caused by the superficial belief that currencies can be manipulated. Policy makers try to resist market forces. However, eventually the currency sags to reflect long-term trends in inflation differential between two countries.

Differentials in productivity growth have exactly the same impact on a currency as inflation. A high productivity country is more efficient and likely to have low inflation. Capital flows away from a low productivity country and seeks stability of returns in countries with higher productivity and low inflation. The outcome is that the currency of the low productivity/high inflation country is sold and declines. The currency of the high productivity/low inflation country is purchased and strengthens.

High real interest rates favorably impact a currency because they reflect a monetary policy leading to low inflation and higher productivity. For instance, the US had very low real interest rates in the 1970s. The dollar sagged as inflation soared and productivity declined sharply. After 1982 real interest rates jumped and the dollar has been much stronger in an environment of low inflation and high productivity.

The size of the trade deficit has a long-term impact on a currency. There are two schools of thought on the subject. The first one maintains that a trade deficit is just a sign of economic health because the country is importing goods to improve its competitive standing. And this has a positive impact on the currency.

The second school of thought is concerned about the large amount of dollars held by other countries when the trade deficit becomes too large. These dollars will eventually have to be sold, thus impacting adversely the currency.

The US has a very large trade deficit. The good news for the US is that current productivity growth is very strong. Capital flows into the US because of lack of a better alternative.

Growth differential between countries is very important when the inflation differential is low. Capital leaves slow growth countries to move to stronger growth countries. When growth in the US declines, you can rest assured dollars will be sold and will be moved to other countries seeking better returns.

Political climate is also crucial, especially in less industrialized countries. Strong socialist policies, such as in Russia and Europe, have a very negative impact on the currency. Why should capital flow to a socialist country and be confiscated by central planning policies? This is what is haunting the euro. Capital flowing to Europe is not welcome because local industries feel threatened and are very protective of their markets. For this reason capital is flowing from Europe to the US looking for profitable ventures with considerable freedom.

As you can see, there are many forces influencing a currency. It is ludicrous to believe that central bankers can impact a currency in a meaningful way. The recent attempt to revive the euro should be interpreted as an act of desperation. It points to very serious political and economic problems in Europe and enhances the dominance of the US economic system in the world.

(This Observations appeared in the 10/30/00 issue of The Peter Dag Portfolio).

George Dagnino, PhD

Editor, The Peter Dag Portfolio. Since 1977

Ranked second best gold timer by Timer Digest

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