Rethinking the Trade-Currency Relationship
[Published in Challenge, July-August 1995.]
A widely-held economic belief is that a decline in the value of a country’s currency relative to the currencies of its trading partners will improve its trade imbalance. The belief is based on the idea that a relatively cheaper currency will make the respective country’s products less expensive abroad and foreign products more expensive to that country’s consumers, thereby expanding its exports while curtailing its imports.
This is why the chief IMF (International Monetary Fund) recommendation to countries plagued by trade deficit is: “devalue your currency.” This is also why many in the Clinton Administration perceive the recent slide in the dollar against the German mark and the Japanese yen as a mixed blessing, hoping that it will curb the U.S. trade deficit. Even The Economist, the well-known staid economic publication, recently echoed this belief (in its 11 March 1995 issue, p. 15): “Arguably, a steep fall in the dollar is warranted by ‘fundamental’: without it, America’s external deficit will stay too large to be readily financeable.”
Yet, evidence shows that such expectations may not be realistic. Currency devaluation/depreciation not only has not helped many less-developed countries grappling with trade deficit, it has also not been very helpful to the U.S. trade deficit. The dollar has been steadily declining against the German mark and Japanese yen since the mid-1980s–from 263 yens and 3.45 marks in 1985 to 89 yens and 1.35 marks in 1995–without any appreciable improvement in the U.S. trade deficit.
While acknowledging the bewildering lack of progress, economists and policy makers alike attribute this lack of efficacy to longer than usual delays in the adjustment process (the “J-Curve” explanation). But how long could these delays reasonably be? One year? Two? … Five? . . . Ten?
At some point the failure of the deficit to diminish in the face of the drastic depreciation of the dollar raises doubts about the validity of the notion that the dollar drives the trade balance. Credulity of this notion is further strained by the experience of other countries, both less-developed as well as industrialized countries. Evidence shows that, over the decades, many weak-currency countries have been deficit-prone (Britain, Italy, and many less-developed countries), whereas strong-currency countries have been surplus-prone (Germany, Japan).
A Different Explanation
If the standard view of the relationship between a country’s currency and its trade position is thus questionable, how about an entirely different way of looking at this relationship? What if the causality is the other way around; that is, if instead it is the trade position that drives the currency? This may appear upside down to many, yet it can explain the actual developments in the trade-currency relationship.
It makes it more understandable why countries suffering from chronic trade deficits also experience weakening currencies. Close historical analysis indicates that changes in the dollar tend to follow, not to lead, changes in the U.S. trade position. Over the long term, increases in the trade deficit are usually associated with a weakening, not strengthening, dollar.
Some experts attribute the current slide in the dollar to a number of other factors: an abundance or over-supply of the dollar on a global level, lack of a clear currency policy in the Clinton Administration, U.S.’s $50 billion plan to help Mexico to cope with its current crisis, prospects of an inflationary upsurge in the U.S., and so on. While the influence of these factors on the dollar–at various times and varying degrees–is undeniable, they do not explain why the dollar is sliding primarily against the yen and the mark. The fact is that the current slide in the dollar is as much a weakening of the dollar as it is a strengthening of the yen and the mark, the currencies of the countries running trade surpluses with the U.S.
The reason is quite simple: like individuals, families or corporations, countries that run chronic deficits tend to accumulate debt and lose creditworthiness. This will then be reflected in a decline of their currencies. By contrast, surplus-countries tend to accumulate foreign currencies, expand their international reserves, and enhance their international creditworthiness, which will result in an appreciation of their currencies.
The standard view of the relationship between a country’s trade position and its currency has gone awry due to a number of implicit assumptions which often do not concur with real developments. One such assumption is that currency prices and exchange rates are determined purely by supply and demand conditions, or by faith, as some argue; that is, currency prices (like commodity prices) are scarcity prices. While, no doubt, supply and demand conditions greatly influence currency prices, they are not the sole determinants of those prices. More importantly, currencies have intrinsic values. Under the gold standard system, which prevailed until WW I, the gold content of a currency determined its intrinsic value. Today, the value embodiment of a currency is no longer defined by gold–at least not directly, or entirely– but by the strength of the economy it represents, as measured by its productivity and international competitiveness. Essentially, this is not very different from the gold standard system. Under that system, strong, surplus-prone economies meant accumulation of gold reserves, obtained in return for the export of goods and services, and hence strong currencies. Today, surplus-countries end up accumulating international reserves which may not be in the form of gold (only a small portion of today’s reserves are in gold) but equally representing real values, i.e., claims on real international assets, and hence leading to strong currencies.
Another implicit assumption is that international transactions are price elastic; that is, export expansion and/or import contraction resulting from a country’s currency depreciation are big enough to warrant a positive impact on its trade balance. This is obviously an optimistic assumption–and is, not surprisingly, called “elasticity optimism”–for it overlooks a number of scenarios that might unravel in response to a country’s devaluation of its currency. For one thing, that country’s trade partners might react in ways that will partially or totally offset the impact of the country’s currency devaluation on their exports to that country. For example, exporters from these countries will most probably be prompted to become more cost efficient, improve the quality of their exports, or simply cut their prices (and profits) to maintain their international market share. These are some of the strategies that Japanese exporters have been adopting in response to the steady decline of the value of the dollar against the yen since the early-1980s.
Likewise if a country’s imports are of an essential nature, whether consumer or industrial necessities such as raw materials and intermediate goods, their curtailment will be extremely difficult even when the country’s currency is depreciated and the prices of its imports have jumped up. Situations in many developing countries resemble this scenario, where a currency depreciation might in fact end up negatively affecting their balance of trade as demand for both their imports and exports is price inelastic.
Another implicit assumption that makes the standard view of the currency-trade relationship dubious is that currency depreciation will not affect the capital account of the balance of payments. In reality, however, loss of currency value usually prompts capital flight, especially in less developed countries, which will negatively affect balance of payments accounts.
Two conclusions follow. First, the power of currency changes to alter trade imbalances has been much exaggerated. While currency depreciation may temporarily appease some protectionist political forces, its ability to achieve its stated objective is highly dubious.
Second, the road to a strong trade position is, therefore, not currency manipulation, but productivity and international competitiveness; that is, the ability to be cost efficient and offer quality products in global markets. This requires efficiency-enhancing investment, investment in both material as well as human capital such as education and skills. Over the long haul, this will raise a country’s competitiveness, improve its trade position, and strengthen its currency.