Thursday, May 29, 2014

Competitive currency devaluations a threat no one can win

If we have a stronger currency, then American companies have currency-translation losses. Their earnings in euro terms, through exports or operations within the eurozone, translate into fewer U.S. dollars.

The second effect is more subtle, and it really has to do with a string of competitive devaluations. When domestic economies are weak, the urge is to increase exports. You don’t have domestic demand, so let’s let foreigners fill the gap by demanding more of our exports. Well, how do you do that? How do you make exports cheaper? Because everybody wants to export, nobody wants to import.

There are various ways, though. For example in Greece they've had what’s called internal devaluation. Their labor costs are about a third what they were before the crisis started, they’ve simply fallen because their economy’s so weak. Because they’re a member of the eurozone, there's no Greek Drachma that they can depreciate anymore, so they've got to do it internally.

Another example is France. France put on a scheme, which the Germans invented, where they simply cut corporate taxes. The idea was to lower costs and therefore lower their export prices to get more exports. And, at the same time, they offset that with a higher value-added tax. Now with the value-added tax, you can add on to import costs, which raises the price of imports making them less attractive, and subtract it from exports, making them cheaper for foreigners. So they get a triple-whammy there.

Then there’s explicit currency devaluations, that's what we seen in Japan where the government of Prime Minister Abe is deliberately trashing the yen. We may see that in the ECB, now, we see that in South Korea. The Chinese, of course, are manipulating their currency. They’re trying to drive out speculators, but they're making it weaker in the process.

The risk is that if you get into this pattern of competitive devaluations, which means nobody really wins because it offsets. I think that most countries end up devaluing their currency against the dollar. But how can the dollar devalue? The greenback is the reserve currency, there’s nothing to devalue against.

This works to the disadvantage of U.S.-based companies in terms of the currency translation losses, but also with these competitive devaluations. They tend to offset, and the net effect is lower economic growth all the way around. It actually ends up reducing everybody's exports, because exports go down when your trading partners’ economies suffer. They don’t demand as much of everything, including your exports.

So I think that's the risk. It’s a little more subtle and down the road. But the translation losses are fairly direct.


- See more at: http://www.equities.com/editors-desk/economy-markets/economic-data-news/economist-gary-shilling-potential-deflation-crisis-europe-affects-us-all