Friday, November 25, 2011

Understanding “cheap currency" policy

To understand long-term currency trends, it is useful to understand cheap vs strong currency policy and the resulting export-oriented economy vs consumption-led economy.  These two models for managing the economy, of course, are two sides of the same coin. 

Why do countries run a trade surplus?
When a country runs a trade surplus, it consumes less than it produces and ship a fraction of its total production abroad as exports to foreign countries.  This net export is a trade surplus.  In exchange for these exports, the country receives foreign currencies, bonds, corporate securities and hard assets.  An easy way to understand annual trade surplus is to think of it as the country’s annual savings; it is what the country produces but does not consume. 

So why might a country wish to delay current consumption and save?  The reason is surprising simple and intuitive.  Countries experience demographics life-cycle; that is, a country goes from young to matured to old before becoming young again.  For example, the post-War baby boom for the Western world means that Western developed nations had a thriving young workforce in the 60s, which became increasingly more experienced and productive over the course of the next 40 years, and which will experience rapid decline over the next 10 years as a significant fraction of the workforce retires.  

When a country is hit with a retirement boom, it will begin to experience a dramatic reduction in domestic production of goods and services, while consumption demands remain constant.  This suggests a potential significant decline in the standard of living as per capita consumption declines.  One way to reduce this dramatic decline in the standard of living is through accumulating savings in foreign assets.  These foreign assets can then be traded for foreign goods and services to offset, in part, the reduction in domestic production when the country faces its retirement boom.

A country, which has saved diligently, will have run decades of trade surpluses against the world and would have built up a large central bank foreign reserve and gold reserve in addition to holding many foreign financial and hard assets.  The logic is no different than households saving for retirements.  These foreign asset holdings are like retirement savings for a country to buffer against its decline in productivity as it ages.

The nature of an export-oriented currency policy
When we understand the nature of trade surpluses, it becomes easy to understand the reason behind an “export-oriented currency policy”--or sometimes referred to as a cheap currency policy.  An export-oriented currency policy induces cheaper home currency value to aide a country’s export industries.  Traditionally, economists focus on the subsidy effect created by the cheaper currency, which benefits the export-oriented firms.  However, it could be argued that the policy has a significantly greater impact on inducing national savings by reducing domestic consumption and increasing wealth accumulation.  The accumulated wealth of foreign assets can then be converted into future consumption when the country most needs it.

For countries facing more severe demographics decline or greater uncertainty about its ability to offset its demographics headwind through technological innovation, it is advisable to pursue a cheap currency policy, which induces aggressive national savings through higher trade surpluses.

Aging Demographics and the Reversal of the Trade Surplus
Of course, it is irrational to run perpetual trade surpluses.  An apt analogy is a miser who saves aggressively through his working years, accumulates large wealth but never spend any money before death.  At some point a country should reverse its trade surplus and run a trade deficit by consuming more than it produces and financing the excess consumption (which consist of foreign imports) by selling its foreign assets.  Essentially, we are asking the Asian producers to transform themselves into American consumers.  Optimally, countries with strong trade surpluses should begin to stem exporting and begin net importing as its domestic per capita consumption growth begin to decline due to aging demographics.  This would suggest a policy coordination, which abandons the cheap currency policy leaning in favor of a strong currency leaning. 

A strong currency policy will help shift the heretofore export-driven economy into a consumption-led economy.  The wealth building process associated with exporting domestic goods to foreign consumers becomes one of wealth decumulation (and potentially even debt accumulation) as the country import from foreigner to buffer domestic production shortfall in order feed domestic consumption. 

The "Tale of Two Cities": Japan vs. the U.S.
One might suspect that Japan, more recently, has begun its process of shifting from a cheap currency leaning toward a strong currency stance.  Yen has appreciated by more than 55% over the last 4 years.  It would make sense for Japan to prepare for the eventual need to run trade deficits to buffer the severe decline in domestic production due to the retirement of its own baby boomers.

However, while the U.S. also faces aging demographics, it is unlikely to be able to buffer its production decline with foreign imports.  The U.S. has not run a sustained trade surplus for near 30 years.  It has not built a reserve of foreign assets, but rather has built an external debt of 14 trillion dollars.  The U.S. has no foreign assets to sell in exchange for the needed imports when its baby boomer retirement wave hits.  Instead, it must run, for the first time in a long time, a trade surplus against the asset rich aging Asian economies, as Asian asset owners make demand on American debt repayment.  In a reversal of fortune, American consumers will bear much of the pain of the aging Asian demographics over the next 30 years as Asian currencies strengthen, making Asian goods unaffordable to American consumers.  At the same time, to compound the problem, American producers would be shipping goods overseas for better prices, and American professionals, seeking ex-pat positions for better wages.

Conclusion
One of the deciding factors for long-term currency appreciation are aging demographics with low (or negative) external debt.  This hypothesis differs from and augments the traditional theories on currency movements, which focus on sustained trade surpluses and/or interest rate and purchasing power parity.  The novel insight is that countries trade for more reasons than gains from specialization of their comparative advantages.  Countries also trade to accomplish their desire to buffer their demographics shocks.  In that context, "cheap currency" policy can often be more than an export subsidy but as a coordination mechanism to induce more domestic savings.

by jason c hsu

12 comments:

Sharky Sue said...

Jason. Read this with interest if not 110% comprehension. You kept it accessible to non-economists. Now an expat in singapore, I hear a lot that the Sing government, which is apparently very asset rich (cash), is holding back its currency to protect ability to trade. Is this true (or something like it)? And do you think this all means that expats SHOULD indeed get paid in Asian currency right about now? That seems like a "yes' from the above. THANKS!

Larry Kornman said...

Jason. I am enjoying the education on macro markets. Sometimes I look at economic systems as natural systems in nature. Is not part of what is going on is the natural rebalancing of economies once they are freed up. The US basically represented 50% of the worlds economy after WWII, that is unnaturally high. We still represent approximately 25% of the world GDP. That still seems high. Is that correct? Does a rebalancing still need to occur. Is it not better to have a smaller part of a larger pie?

CrimsonDye said...

Thanks all! I must admit that GDP accounting is goofy and not terribly comparable. There is so much going on that GDP doesn't properly account for. For example, home making--in many developing countries women specialize in homemaking, which is an incredibly important activity. Homemaking does not show up in GDP, unless you hire household help. So the U.S. really isn't 50% of global economic activities.

Carly Wolowitz said...

I have had some confusion regarding the Cheap Currency policy and this article somehow answered some of the vague concepts in my mind. Point of inquiry, what does a sovereign coin cover regarding domestic savings?

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