Q & A: I keep hearing about currencies? What does this mean and why are they so volatile?

January
28

Written by: Jon McGraw

I keep hearing about currencies? What does this mean and why are they so volatile?

The financial news often reports about what’s just happened or newsworthy comments made by various policymakers. Of course, some is overblown but there is often a shred of truth to the underlying story. Currency futures have always been volatile.

A long-running theme in global economic development in recent years (decades, actually) is the general improvement in the fiscal balance sheets and credibility of emerging market nations like Brazil and Malaysia, and the balance sheet deterioration of ‘developed’ nations of Western Europe, Japan and the United States. This effect would be more pronounced if it weren’t for the legacy of ‘stability’ the developed nations historically that has kept their currencies and bond interest rates lower than they normally would be.

Currencies seem mysterious because of their nature—there is no absolute method for consistently measuring their value (there are some theoretical models, such as ‘purchasing power parity,’ but even these are unreliable, especially over the short-term). On a relative side, currencies only have value based on the confidence a depositor/investor/citizen has in that nation’s government or central bank policies outright as well as relative to other nations’ currencies, i.e. Japanese Yen vs. U.K. Pound, Euro vs. Brazilian Real. Aside from basic national stability (which is why developed nations tend to have more ‘expensive’/stronger currencies than traditionally-less-stable emerging market nations). Currencies are a product with supply/demand characteristics like any other, just more nuanced.

 Factors than can strengthen a nation’s currency value:

  • ‘Legitimate’/stable regime (such as a pro-Western style democracy or at least a trustworthy government) and track record of paying their bills in a timely and willingness to continue to do so;
  • Capable monetary policy with sufficient central bank independence and ability to keep inflationary forces in check;
  • Economic growth, which can include a strong industrial/service base or abundant natural resources;
  • Good fiscal conditions and/or lower levels of debt.

Factors than can weaken a nation’s currency value:

  • Unstable government, or one that is anti-business or anti-developed world (a caveat: a poorly regarded but stable regime that still pays their bills can sometimes buck this trend);
  • Defaulting on government debt (one-time or repeatedly, like Argentina);
  • High levels of debt in general—which can raise chances for a future default;
  • High inflation, which erodes currency value, either by itself or coupled with a less credible central bank;
  • Low or unrealized economic growth, or resources that can’t be fully taken advantage of due to any of the conditions noted above.

Other factors:

  • A cheaper/weaker currency can help a nation by making their exports cheaper, so industries are more competitive with foreign manufacturers. This is why many governments are pressured to ‘devalue’ their currencies, as long as it’s done in a moderate way and doesn’t affect citizens’ purchasing power in the short run.
  • A stronger currency, especially in the case of an emerging market, can be a source of national pride and reinforcement that the nation has ‘arrived,’ so to speak.

This issues can get murky, such as the case of Japan—which is seen as a global manufacturing powerhouse with a stable governmental system (despite frequent PM changes) and high levels of debt, mainly held internally by the Japanese people. During the financial crisis, their ‘safe haven’ status pushed the Yen higher than perhaps it should have been due to this legacy. As Prime Minister Abe has announced stimulus plans and a goal of higher growth and inflation targets, the Yen has sold off in recent months—not a surprise, considering inflation should erode a currency’s value—if this policy works as intended. On the other hand, emerging market currencies are still in the process of earning that all-important trust. They’ve come a long way, but there is further to go.

This is a short summary of the world of Currencies.  Hopefully it has helped to answer questions!