* WHAT TO DO NOW: Learn more fundamentals. In this lesson we continue our review of why currencies move and look at more fundamentals that affect the value of currencies.
* EZ PROFIT: Find countries with strong Current Accounts. See how these accounts affect currencies. Read the case study on page five.
* EZ CURRENCY DIVERSIFICATION: Find countries with low debt and trade surpluses. Countries with low debt have currencies that are likely to be strong. A long term, healthy balance of trade makes the currency even stronger. Study this lesson’s Contacts for more about a country with low debt and continued trade surpluses, Switzerland. Page nine.
Colonial breakfast in the tropics was at its best, outdoor dining under ancient ceiling fans that turned in lazy arcs and coaxed a gentle breeze. Shafts of morning sun, that shone on crisp white linen and filtered through the cool morning air. Traveller palms swayed in soft harmony with grackles, katydids and all was gracious and genteel.
Singapore, 1971-The Raffles Hotel-at an outdoor restaurant just next to the Long Bar. There was something comfortable in the old fashioned pots of thick cut marmalade and slightly burnt toast that stood in racks of sterling silver. This elegant setting, quiet service was an easy, wonderful way to start the day. I felt in place, relaxed and comfortable, part of an ancient tradition, the modern link in a rite that this hotel had offered for so many generations past. I sat back feeling that all was well. I felt in control and on top of that modern era.
All that suddenly changed. I opened the morning Straits Times and the headlines declared “U.S. Dollar Devalues”. That comfortable era had just come to an end.
Twenty-four years ago, I was an American, traveling only with dollars. From centuries past, history had seemingly supported my financial well being up to that very moment. Britain’s colonial days leading to the emergence of America, the World Wars, modern technology, Yankee know- how, puritan work ethics and unbounded natural resources had all worked on my behalf to form the greatest economy recorded time had ever known.
This history had created a world economy vastly dominated by the United States of America. Forces, building before and throughout the twentieth century, lead to incredible economic power within the United States. This domination made the U.S. Dollar the bastion of global currencies and made it the reserve currency of the world.
In previous lessons we have learned how 1971 was the year when the U.S. dollar began its long slide that has lasted even to this day. We have learned in earlier lessons that fundamentals have been changing since 1945 (from the time of the Bretton Woods Agreement). Last lesson we began looking at the fundamentals that cause currencies to rise and fall. In this lesson we continue to examine these fundamentals.
More Long Term Factors of Currency Movement
Last lesson we viewed the first three long term factors that affect the value of currencies. These factors were a nation’s production and consumption, government debt and the nature of government debt.
The next long term factors are below.
* Long-Term Factor #4: Trade Balance (Surplus Deficit). When two countries trade with each other, it’s unlikely that the sum of the imports and exports between them will add to zero. Most often, one country sells more to the other country than it buys. Thus, there are always surpluses and deficits in a country’s balance of payments.
A country has a surplus in its balance of payments when it sells more than it buys. Put another way, a country has a surplus when it exports more than it imports, or when it produces more than it consumes.
A surplus in balance of payments results in a positive flow of cash into the country from its sales and/or investment income out of the country. A country has a deficit in its balance of payments when it buys more from outside the country than it sells outside the country. A deficit in balance of payments results in an outflow of cash from the country because of its excess purchases and expenditures abroad.
The relative value of two currencies depends primarily on the balance of payments between the countries. The following list shows the potential credits that can accrue to a country’s balance of payments. Note that each of these items pertains to all private individuals, private organizations (businesses and others) and public organizations (the government and its branches).
1. All receipts of foreign money. 2. Earnings from investments in foreign countries. 3. Sales of goods or services (exports). 4. Gifts or foreign aid from foreign countries. 5. Sales of stocks or bonds.
The following list shows the potential debits that can be applied against a country’s balance of payments. Again, each item pertains to all private individuals, private organizations, and public organizations.
1. All payments to foreign countries. 2. Investments within foreign countries. 3. Purchases of goods or services (imports). 4. Gifts or aid to foreign countries. 5. Purchases of stocks or bonds (private and public).
A term often used in connection with balance of payments is “current account” or “current balance.” This is a measure of all sales or purchases of merchandise and services, flows of income to and from a country’s foreign investments, etc. The term “current account” is often confused with the term “balance of payments, The current account can be called the balance of trade because it reflects the difference (positive or negative) between exports and imports. Those who use the two terms balance of payment and balance of trade (current account) as one are wrong. There is a difference between the current account and the balance of payments as is explained below.
We can understand the concepts of current account (balance of trade) and balance of payments and the difference between the two by looking at the international financial position of nations in simple accounting terms. A simple double entry system of accounting is used in which each nation uses debits (for goods and services each nation buys from abroad) and credits (for goods and services each nations sells abroad).
Since double entry bookkeeping requires that debits and credits must always balance, the import of a good or service on one side must be matched by the outflow of money to pay for it on the other side.
A nation’s imports cannot exceed exports in the long term because the nation will run out of money to pay for the foreign goods purchased.
To help understand this better I have put a hypothetical balance of payments below:
Debit Credit Balance (Imports) (Exports) Goods & Services -175 +110 -65 Investment Income - 35 + 45 +10 Current Account Balance -210 +155 -55 Capital Account - 12 + 62 +50 Reserve Account 0 + 5 + 5 Balance of Payments -222 +222 0
The first balance above of the goods and services and investment income is the Current Account Balance (often called the Balance of Trade which can be confused with the Balance of Payments, the second balance above).
The difference between the Current Account (Balance of Trade) and the Balance of Payments is the nation’s stock or capital. The Current Account is a measure of current flow and the Balance of Payments is a measure of total equity (or capital).
The Balance of Payments is all the accumulated assets of the nation, either financial or real. A positive Current Account adds to this balance. A negative Current Account reduces this balance.
A nation’s Reserves are the measure of the net additions or reductions from the nation’s assets. Nations accumulate reserves if they sell more abroad then they buy or they accumulate them in gold if they mine gold, or they accumulate reserves in credits if they are given reserve credits from the International Monetary Fund which serves as the central bank to the world.
The Current Account (Balance of Trade) can be stated in any time length desired. Usually it is stated in annual terms, such as “The United States last year had a Balance of Payments deficit of $70 billion with Japan.” But it can be stated in weekly, monthly, quarterly — or any other terms, including two-year, five-year, or decade-long terms.
Exchange Rates and Balance of Payments
What is the mechanism that causes a change in the exchange rate when there is a surplus or deficit in the balance of payments between two countries? Let’s use trade between Japan and the U.S. as an example to answer this question.
First, remember that U.S. companies, headquartered and operating in the U.S., need to be paid in dollars for their products and services, because they need dollars to pay their bills, workers’ salaries, etc. For the same reason, Japanese companies need to be paid in yen. A Japanese company, headquartered and operating in Japan, cannot use dollars to pay salaries and bills. It can only pay salaries and bills in yen.
Therefore, when a U.S. company or private citizen buys something produced in Japan, at some point dollars must be converted into yen. Similarly, when a Japanese company or private individual buys something produced in the U.S., at some point yen must be converted into dollars.
Therefore, whenever a country buys something from another country, its own currency must be converted, or exchanged, into the other country’s currency.
Since the U.S. is currently buying more from Japan that Japan is buying from the U.S., more dollars are being exchanged into yen than yen into dollars. Every time a transaction is made, any place in the world, in which some individual or some organization in the U.S. buys something manufactured in Japan, dollars are exchanged to yen.
In each of these transactions, a currency trader places an order on the world’s foreign exchange markets, asking for the price of exchanging dollars for yen. When this happens over and over, demand for yen becomes greater, and demand for the dollar becomes less. As a result, the price of the yen rises, and the price of the dollar falls.
Important Point to Remember: (This point is absolutely crucial to the understanding of foreign exchange.) Whenever goods or services are purchased from a country, that country’s currency must be bid for and bought on the world’s foreign exchange markets to pay for the goods or services. This is also the case for foreign investments, for financial transfers of a multinational company to one of its divisions within a foreign country and for foreign aid given to a country. In each of these activities, currency of the country must be purchased, because any money used or distributed within that country has to be in the currency of that country.
When a U.S. company buys auto parts from Japan, dollars are exchanged into yen, which increases the demand for yen and raises the price of the yen on the international exchange market. Correspondingly, the value of the dollar falls because dollars are let loose in the international market. A balance of payments deficit or surplus between two countries affects the relative demand (and hence price) of the two currencies.
But two countries never trade in a vacuum. The world of international trade and finance involves all countries. Japan trades with and invests in hundreds of different countries, as does the U.S. Therefore, the value of the yen on international foreign exchange markets is the sum total of all the trade surpluses and deficits Japan has. The same is true of the U.S. Every moment of the day, seven days a week, a foreign exchange broker is converting U.S. dollars into some foreign currency.
Take a three way view as an example. Imagine that the U.S. has a trade deficit with Japan (as is the case) and that the U.S. has a trade surplus with Mexico (as has been the case). If Mexico has a trade surplus with Japan that equals the trade deficit the U.S. has with Japan, then the trade between all three nations balances out. In this example there is no overall deficit.
From this understanding, we can see why a sudden fall in the Mexican peso versus the U.S. dollar could cause the U.S. dollar to fall versus the yen!
Imagine that the current account of Mexico, the U.S. and Japan all balance as explained above. The U.S. is buying many manufactured goods (such as cars auto parts and computers) from Japan and runs a current account deficit with Japan. The U.S. in turn sells many manufactured goods to Mexico (TVs, computers and cars) and runs a surplus equal to its deficit with Japan. Japan buys raw materials from Mexico (silver, petroleum, minerals) and runs a deficit with Mexico (equal to its surplus with the U.S.).
Now picture a peso devaluation and see the peso-dollar parity shifting to six pesos per dollar. Overnight U.S. goods cost Mexicans twice as much. Suddenly Mexicans cannot afford to buy expensive U.S. goods and as they stop buying, the trade surplus between Mexico and the U.S. disappears. Suddenly the U.S. has a deficit with Mexico as well as Japan.
At the same time, the Japanese are able to buy more Mexican goods with far less yen. Their deficit with Mexico shrinks. The U.S. then has a larger deficit (now created with two countries) and Japan has a larger surplus (now created with two countries). The greater surplus in Japan adds strength to the yen and the increased deficit in the U.S. adds weakness to the dollar.
What we can learn from this Case Study: A surplus in the balance of trade can cause the value of a currency to rise against many other currencies. A deficit in the balance of trade can cause the value of a currency to fall against other currencies.
The important point to understand from this case study about trade balances is that they represent a future supply and demand factor for a currency. When a country purchases more goods from other countries than it sells to other countries, it has to buy foreign currencies to pay for the goods. This puts a long-term downward pressure on the currency.
The chart next page, obtained from the Bank of Japan’s “1994 Comparative Economic and Financial Statistics,” shows the year-by-year current balance of many leading countries. These figures are in millions of U.S. dollars. Figures with a minus sign (-) mean that the country had a negative current balance for the year. In other words, they imported (consumed) more goods than they exported (produced). These countries will tend to have falling currency prices over the long term compared with countries that do not have minus signs in front of their current balance figures.
CURRENT BALANCES (Current Accounts)
Note in the Balance of Trade chart below that Japan’s current balance was a surplus in 1985 of $49,170 million (or $49,170,000,000). Canada’s current balance in 1985 was – $2,279 million. In 1993, the Japanese surplus was $131,448 million and Canada’s deficit was -$19,601 million. (We will review the 1994 balances later).
The chart above shows that the United States continues to pile up massive deficits, while Japan and Germany pile up surpluses.
The U.S. Balance of Trade Deficit
One reason that the U.S. dollar has fallen and fallen over the past decade is because the United States is currently running an enormous overall trade deficit, not only with Japan but with many other countries.
The U.S. imports many more goods than it exports. Also, it gives a tremendous amount of aid to foreign countries, as well as direct loans to foreign governments. As a result, dollars are exchanged into foreign currencies, while a lesser amount of foreign currencies are exchanged into dollars. When too many dollars are turned into foreign investments, goods, loans, aid, and other payments, the value of the dollar falls on exchange markets. This makes the dollar weaker worldwide year by year.
It should now be easier to see why the dollar fell so dramatically versus other currencies after 20 billion dollars were loaned to Mexico to stop a total collapse of the peso. The loan created a greater trade deficit in the U.S. while at the same time a weakened peso reduced the current account surplus between the U.S. and Mexico. All this happened at a time when there was little confidence in the dollar. Shortly after the loan, record U.S. trade deficits were announced which enhanced a 40% fall of the U.S. dollar (versus the Japanese yen) in one year.
There are two other fundamentals of dollar weakness we must consider in the context of trade balance. First, in the 1980s, Japanese and other overseas investors kept buying dollars as investments (treasuries, corporate bonds, stocks, real estate, etc). This created demand for the U.S. dollar. The huge U.S. trade deficits (imports) were financed by capital inflows (investments of foreign investors). Then the crash of the Japanese stock and real estate markets in the early 1990s, caused yen investments in the U.S. to shrivel. At the same time, the Japanese recession prompted Japanese consumers to stop buying goods from abroad — and to cut back on buying Japanese-made goods. Japanese manufacturers exported more goods, encouraging U.S. consumers to buy Japanese products. Thus, U.S. consumers continued buying goods from Japan, while Japanese consumers bought less goods from the U.S.. This fueled the rising U.S. trade deficit. This deficit increased demand for yen, causing the yen to rise versus the dollar.
Second, the weakening dollar caused even U.S. investors to look overseas for better investment prospects. In 1993 there was a net outflow of nearly $300 billion in private investment. This negatively affects the U.S. trade deficit, compounding the problem with the weakening dollar. The trade balances below which update those shown last page show that the U.S. trade deficit problem has not been solved.
TRADE BALANCE IN BILLIONS Latest 12 months USA -154.50 Canada +8.50 Japan +145.20 Australia -1.50 Germany +40.20 Switzerland +2.30 France +15.60 Italy +24.00 Netherlands +13.10 Belgium -1.90 UK -16.80
Size of U.S. Foreign Trade
The following charts show the share by percentage (%) of trade for each of the G-7 nations from 1981 to 1992. The first chart shows by percentage how much of the world’s total exports each country had. For instance, in 1981 Japan had 7.8% of the world’s total exports and the U.S. had 12.4%. You can see from these two charts that the U.S. still maintains tremendous economic clout in the world. This makes global currency turmoil even greater when the U.S. dollar sinks.
The following charts are supplied by the Bank of Japan.
Value of the Dollar
How far can the value of the dollar fall? The dollar’s real value depends eventually on the laws of supply and demand. We will see in later chapters how at the time this course was written the U.S. dollar was probably too weak because technical factors have over reacted.
So in the short term the dollar may rise. Yet the value of the dollar, over the long term, will fall until the supply of dollars meets the demand at a price of equilibrium. We can understand better just how far it can fall by looking at the value $1.50 per pound parity of the British pound today. At one time the pound was worth ten U.S. dollars!
Many times, the world financial community will intervene in the foreign exchange markets when a particular country’s balance of payments moves out of equilibrium and causes a sharp rise or fall in the price of its currency. This is especially so when the U.S. dollar becomes too weak or too strong, since the dollar is the unofficial but very real international key currency and is the basis of most international prices.
We saw last chapter that Switzerland has one of the lowest national debts in relationship to its GNP of any country. In this lesson we can see that from 1985 to current times that Switzerland also has maintained a trade balance surplus. These two important fundamentals mean that in the long run, the Swiss franc is likely to be a strong currency. Listed below are ways to invest in Swiss francs.
Swiss Volksbank, Le Continental, 3963 Crans, Switzerland. Tel: 011-41-27-409111. Fax: 011-41-27-409150. This is one of Switzerland’s biggest regional banks. Swiss Volksbank is owned by one of Switzerland’s largest international banks, Credit Suisse.
Julius Baer Multifund, PO Box 36, Bahnhofstrasse 36, CH-8010 Zurich, Switzerland. Tel: 011-41-1-228-5111. Fax: 011-41-1-211-2560. This is a subsidiary of a large private Swiss bank that offers stock, bond and money market funds in many currencies including Swiss francs.
Bank Von Ernst & Cie, Marktgasse 63/65, 3001 Berne, Switzerland. Tel: 011-41-31-311-4051. Fax: 011-41-31-311-6391. Another Swiss bank subsidiary, this manager offers equity funds in Swiss shares.
Rothschild Asset Management, PO Box 242, St. Peter Port, Guernsey, Channel Islands. Tel: 011-44-1481-713713. Fax: 011-44-1481-712575. This well known management company offers a money market umbrella that contains money market funds in 18 currencies including the Swiss franc.
JML Jurg Lattmann AG, Swiss Investment Counsellors, Germaniastrasse 55, CH-8033 Zurich, Switzerland. Tel: 011-41-1-363-2510. JML is an independent financial advisory firm in business since 1974 that specializes in Swiss life insurance and annuities.
Swiss policies are among the most conservative of policies. They provide an excellent option for investors who put safety and ease of operation first, capital growth last.
Swiss policies are an excellent alternative to Swiss franc bank accounts. They offer similar yields and are more private than bank accounts.
In addition, Swiss policies can help investors keep money in Switzerland. The fact that Switzerland has been viewed as a financial haven for centuries means that any time there is a global monetary crisis, fortunes flow into Switzerland. When this happened in the late 1970s, so much money flowed into Switzerland that the Swiss were forced to restrict the amount of Swiss francs non residents held in bank accounts. (They did so by placing a negative interest on all Swiss francs held above the maximum allowed.) This negative interest, however, did not affect Swiss franc insurance policies.
What To Do Now
Write to the contacts and look at ways in which you can invest in Swiss francs. Compare the returns you might make in money markets, shares, bonds and insurance. Be aware of a 35% withholding tax on interest and dividends on earnings in Switzerland. Look at ways to avoid this withholding (such as through insurance policies and overseas money market funds such as Rothschilds).
More Long Term Fundamentals
* Long-Term Currency Fundamental #5: Tax Rates. There are two ways — and only two ways — that governments can reduce debt: by reducing spending or increasing taxes. Few governments in the history of the world have been successful at reducing spending. Therefore, a government is dependent on raising taxes and increasing revenues which, hopefully, will be used to reduce the debt.
When a country has a very high rate of taxation in place, it is difficult to raise taxes further. There comes a point at which citizens will revolt, or at least begin to take serious measures to hide wealth and cheat on their taxes.
This is one factor in the weakness of the Canadian dollar, which has continually fallen against the U.S. dollar for several years. The Canadian government has a much higher debt to GNP ratio than the U.S., plus a higher tax rate. This means Canada will have a harder time reducing its debt than the U.S.
The key point to look for in the case of budget deficits is not the amount of the debt itself, but the relationship between the debt and the government’s ability to repay the debt and service interest costs. In 1994, U.S. debt tops off at over five trillion dollars. Estimates show that by 2010, interest payments alone on this debt will exceed all U.S. tax revenues. At that point, where is money going to come for payment? New taxes? Of course, but how much can an already-strained public endure. Create new money? Certainly, but from where? Thin air? Think what that will do to the value of the dollar worldwide.
* Long-Term Currency Fundamental #6: National Savings. The ultimate wealth of a nation is built upon the wealth of its individuals. If a nation is composed of individuals who save a greater proportion of their earnings than other countries, this adds strength to the currency of the country.
The national savings of a country can be used to finance debt (rather then borrowing abroad). The national savings placed in banks provides capital for the economy to expand without expanding the money supply at a higher rate then GNP.
This is a very deep currency fundamental but we can see it clearly again as one of the reasons why the dollar has fallen versus the Japanese yen. The Japanese have one of the highest savings rates in the world and the U.S. one of the lowest. The Japanese save much of their earnings. Much of it filters into Japanese bank accounts and Japanese yen bonds and equities. U.S. consumers spend their earnings instead. Much of the expenditure is for Japanese goods which creates additional demand for yen versus the dollar.
* Long-Term Currency Fundamental #7: Productivity. The value of a currency is affected by the productivity of a country. This is one area in which the U.S. is still very strong. The U.S. and Canada are among the most productive nations in the world.
Productivity is the amount of GNP per person. Surprisingly productivity in Japan is very low (about the same as Italy). This is because though Japanese industry is highly efficient, especially in exporting, there are many parts of the Japanese economy that are very inefficient, such as farming and domestic distribution.
This is why the Japanese have maintained trade barriers in commodities such as rice. U.S. farmers are far more efficient at growing rice then Japanese and would be able to sell U.S. rice in Japan at much lower prices than Japanese rice, if they were allowed.
At times when the U.S. dollar is very low, it is good to keep an eye on this fundamental, because in the long term it can have an important effect. This is a factor that is much harder to change then many others. The U.S. could suddenly cut its debt. The U.S. could stop buying so many Japanese goods. The task of making the Japanese economy more productive would not be so easy.
We must keep this fundamental in mind when looking at the long term view of a currency as it can add strength to a currency in the long term.
More Dollar History
Now that we have viewed many long term fundamentals that affect a currency’s strength, let’s look at the more recent history of the U.S. dollar and see how these fundamentals have caused it to fall.
The enormous U.S. debt and balance of payment deficits really began about 1973. At that time, the price of a barrel of oil was about $4.00/barrel. A few years later, the price was over $21/barrel as the OPEC nations consolidated and cut back production. The price of oil peaked in 1981 at over $31.00/barrel.
Did this stop the United States from burning oil? Hardly. Consumption did go down temporarily, then rose again sharply. The same was true of most industrialized countries, but the United States, as the major oil consumer, accounted for large percentages of worldwide oil purchases yearly.
The result was what has been called the greatest shift of wealth in the history of the world. Billions and billions of dollars went from the United States to the OPEC countries, mostly in the Middle East. These middle eastern countries essentially had no economy, other than the drilling and production of oil. They couldn’t just put their windfall of dollars into their economy because hyperinflation would result. So they sent the dollars back to the United States and other western European countries, depositing them in the form of bank CD’s, treasury securities, etc. Hence was born the term “petrodollars.”
The large U.S. banks, with a sudden influx of petrodollars (deposits from OPEC countries) needed to loan the money. How else do banks make money? But the U.S. economy was in a recession as a result of the sudden sharp rise in oil prices, and businesses weren’t in the market for big loans. Where could the banks go?
The banks lent their petrodollars to third world developing countries, which needed money badly because of the sudden boost in oil prices. The developing countries desperately needed oil — for industrial expansion and public consumption. They didn’t have the money to pay for it, so they borrowed dollars from the large U.S. and western European banks. They were willing to pay high rates for the loans, and for a brief (exceptionally brief) time, everyone was happy. OPEC nations had a safe place to park their influx of cash, large U.S. banks had a place to loan the petrodollars at decent rates, and developing countries had the funds to continue purchasing oil.
But this situation created a problem. The United States was sending billions of dollars yearly out of the country for a product that literally went up in smoke when consumed.
To make matters worse, many developing countries borrowed so much they could not repay their loans. Some couldn’t even pay the interest. Thus, dollars were not returning to the United States. These dollars were needed to help reduce the trade deficit.
The banks refinanced at lower interest rates, consolidated loans, issued new loans to help the countries make their interest payments and after a massive default by many emerging nations an entire restructuring of the third world debt took place (The Brady Plan).
But even today, the problem continues. Ten of the twelve largest U.S. banks have more loans to developing countries than they have total shareholders’ equity and the lending continues. Loans by U.S. banks to emerging nations has grown dramatically in 1993 and 1994.
This puts the U.S. in a vulnerable position. When just one of the developing countries appeared to be near default again (Mexico was the culprit, as it was also the first nation to default in the 1980s Third World Debt Crash), the U.S. was forced to defend Mexican debtors.
Had Mexico been allowed to default, the major U.S. banks may have fallen below their reserve requirements and would have been forced to stop making commercial and private loans altogether, with disastrous results to the U.S. economy. To prevent this default, the United States had to loan huge amounts to Mexico. Today the U.S. must also continue purchasing goods and giving aid to many of the developing countries, with the equally-disastrous result that the dollar becomes weaker and weaker.
There is no easy way to change this flawed structure. The third world economy is hooked on the dollar, but there are already so many dollars in circulation that they fall in value steadily. Signs of strength in several developing economies will help reverse this scenario. The weakening U.S. dollar makes American-made goods cheaper overseas, giving promise of increased U.S. imports and a potential lessening in balance of payments deficits. Hope is on the horizon. But overall, the value of the dollar is locked into a downward spiral. Without fundamental changes, the dollar will continue to fall.
Now that you know the long term fundamentals that affect the dollar and all currencies you know what to watch for to see if the dollar will reverse its trend in the long term. Next chapter we learn factors that cause currencies to rise and fall in the short term.