Question

1) Another challenge for economic studies (especially manufacturing) is the projection of fluctuations in currency. How can currency changes alter an economic analysis? What are the specific challenges in forecasting currency fluctuations? How can a company protect against currency issues that can impact economic studies? Explain in detail?

Answer 1

Formal economic forecasting is usually based on a specific theory as to how the economy works. Some theories are complicated, and their application requires an elaborate tracing of cause and effect. Others are relatively simple, ascribing most developments in the economy to one or two basic factors. Many economists, for example, believe that changes in the supply of moneydetermine the rate of growth of general business activity. Others assign a central role to investment in new facilities—housing, industrial plants, highways, and so forth. In the United States, where consumers account for such a large share of economic activity, some economists believe that consumer decisions to invest or save provide the principal clues to the future course of the entire economy. Obviously the theory that a forecaster applies is of critical importance to the forecasting process; it dictates his line of investigation, the statistics he will regard as most important, and many of the techniques he will apply.

Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. The exchange rate of one currency versus the other is influenced by numerous fundamental and technical factors. These include relative supply and demand of the two currencies, economic performance, outlook for inflation, interest rate differentials, capital flows, technical support and resistance levels, and so on. As these factors are generally in a state of perpetual flux, currency values fluctuate from one moment to the next. But although a currency’s level is largely supposed to be determined by the underlying economy, the tables are often turned, as huge movements in a currency can dictate the overall economy’s fortunes – a currency tail wagging the economic dog.

The value of the domestic currency in the foreign exchange market is an important instrument in a central bank’s toolkit, as well as a key consideration when it sets monetary policy. Directly or indirectly, therefore, currency levels affect a number of key economic variables. They may play a role in the interest rateyou pay on your mortgage, the returns on your investment portfolio, the price of groceries in your local supermarket, and even your job prospects.

Currency Impact on the Economy

A currency’s level has a direct impact on the following aspects of the economy:

Merchandise trade

This refers to a nation’s international trade, or its exports and imports. In general terms, a weaker currency will stimulate exports and make imports more expensive, thereby decreasing a nation’s trade deficit (or increasing surplus) over time.

For example, assume you are a U.S. exporter who sold a million widgets at $10 each to a buyer in Europe two years ago, when the exchange rate was €1=$1.25. The cost to your European buyer was therefore €8 per widget. Your buyer is now negotiating a better price for a large order, and because the dollar has declined to 1.35 per euro, you can afford to give the buyer a price break while still clearing at least $10 per widget. Even if your new price is €7.50, which amounts to a 6.25% discount from the previous price, your price in dollars would be $10.13 at the current exchange rate. The depreciation in your domestic currency is the primary reason why your export business has remained competitive in international markets

Conversely, a significantly stronger currency can reduce export competitiveness and make imports cheaper, which can cause the trade deficit to widen further, eventually weakening the currency in a self-adjusting mechanism. But before this happens, industry sectors that are highly export-oriented can be decimated by an unduly strong currency.

Economic growth

The basic formula for an economy’s GDP is C + I + G + (X – M) where:

C = Consumption or consumer spending, the biggest component of an economy

I = Capital investment by businesses and households

G = Government spending

(X – M) = Exports minus imports, or net exports

From this equation, it is clear that the higher the value of net exports, the higher a nation’s GDP. As discussed earlier, net exports have an inverse correlation with the strength of the domestic currency.

Capital flows

Foreign capital will tend to flow into countries that have strong governments, dynamic economies and stable currencies. A nation needs to have a relatively stable currency to attract investment capital from foreign investors. Otherwise, the prospect of exchange losses inflicted by currency depreciation may deter overseas investors.

Capital flows can be classified into two main types – foreign direct investment (FDI), in which foreign investors take stakes in existing companies or build new facilities overseas; and foreign portfolio investment, where foreign investors buy, sell and trade overseas securities. FDI is a critical source of funding for growing economies such as China and India.

Governments greatly prefer FDI to foreign portfolio investments, since the latter are often akin to “hot money” that can leave the country when the going gets tough. This phenomenon, referred to as “capital flight", can be sparked by any negative event, including an expected or anticipated devaluation of the currency.

Inflation

A devalued currency can result in “imported” inflation for countries that are substantial importers. A sudden decline of 20% in the domestic currency may result in imported products costing 25% more since, a 20% decline means a 25% increase to get back to the original price point.

Interest rates

As mentioned earlier, the exchange rate level is a key consideration for most central banks when setting monetary policy. For example, former Bank of Canada Governor Mark Carney said in a September 2012 speech that the bank takes the exchange rate of the Canadian dollar into account in setting monetary policy. Carney said that the persistent strength of the Canadian dollar was one of the reasons why his country's monetary policy had been “exceptionally accommodative” for so long.

A strong domestic currency exerts a drag on the economy, achieving the same end result as tighter monetary policy (i.e., higher interest rates). In addition, further tightening of monetary policy at a time when the domestic currency is already unduly strong may exacerbate the problem by attracting more hot money from foreign investors, who are seeking higher yielding investments (which would further push up the domestic currency).