Seeking Alpha

Currency Wars: Weaker Currency Good And Bad

by: Charles Schwab
Summary

China was labeled a currency manipulator by the United States after its currency fell in response to increased tariffs imposed by the United States.

A weaker currency can help an economy by potentially boosting exports, jobs and stave off inflation, as well as increasing corporate earnings.

Over the short term, hedging for currency moves, since any gains in foreign currency may be worth more in dollar terms if the dollar fell or less in dollar terms if the dollar rose, can boost returns.

Over the longer term, currencies tend to even out, making hedging less attractive for long-term investors.

By Michelle Gibley

In recent years, central banks from Europe to Japan have sparked criticism they were fomenting "currency wars" by making monetary policy moves that weakened their currencies. It's true that the moves they have made - cutting interest rates and increasing the supply of money by purchasing their own government bonds - have historically been known to suppress the value of an economy's currency.

Adding to the currency war narrative, China was labeled a currency manipulator by the United States in August 2019. China had been intervening to avoid yuan weakness, and its action in response to a tariff increase by the U.S. offered less support for the yuan - which resulted in a decline in its currency.

The policy moves rekindled a debate about whether a weaker or stronger currency is best for a given economy. In a world where interest rates are already very low, a weaker currency has become a desired way to stimulate growth. But there are also downsides.

Why would you want a weaker currency?

When economic growth is running below trend and interest rates are historically low, central banks around the world have turned to unconventional means to try to boost growth. While most central banks don't explicitly target weaker currencies, many believe it has become an unspoken policy objective.

To be sure, there are some positive potential implications of a lower currency:

  • Export growth. A country's exports can gain market share as its goods get cheaper relative to goods priced in stronger currencies. The resulting increases in sales can boost economic growth and jobs, as well as increase corporate profits for companies that do business in foreign markets.
  • Rising inflation. Inflation can climb when economies import goods from countries with stronger currencies, since it takes more of a weak currency to buy the same amount of goods priced in a stronger currency. Inflation can be desirable when low economic growth threatens to lead to deflation or falling prices. A deflationary mindset is undesirable, because once consumers begin to expect regular price declines, they may start to postpone spending and businesses may begin to delay investment, resulting in a self-perpetuating cycle of slowing economic activity.
  • Relief for debtors. When inflation rises due to a weak currency, it boosts incomes and tax receipts while the value of debt stays the same, making it easier for local currency borrowers to pay down debts. However, a weak currency makes paying back debt issued to foreign investors and priced-in foreign currency more expensive. Much of the developed world still has high debt burdens, making inflation in those economies somewhat desirable.

The zero-sum game of currency competition

While some countries may benefit from lower currencies in the short term, those benefits may be counterbalanced by negative effects elsewhere. Recall that exchange rates are relative: As one currency declines, another must go up. Therefore, for every winner there's a loser. In other words, it can be a zero-sum game.

If multiple countries try to compete by devaluing currencies for too long, there can be longer-term costs to the global economy. If competing on currency fails to bring an increased market share of global exports, countries may resort to protectionism, instituting trade barriers. Increased trade tariffs in the U.S.-China trade war that started in 2018 reduced business confidence and global economic growth.

What do weaker currencies mean for international stock investors?

While earnings can get a lift in countries with weak currencies, it's important to remember that investment returns can be reduced by the translation back to U.S. dollars - when the U.S. dollar is rising. Alternatively, a falling U.S. dollar can boost investments made in foreign currencies.

For companies that earn foreign revenues in currencies stronger than the currency of their home country, the size of the gain in earnings depends on where costs are incurred. For instance, sales generated in the U.S. translate into more euros for eurozone companies when the euro is falling. If the costs to generate these sales were denominated in euros, the impact on earnings could be higher than if they were denominated in U.S. dollars.

When you own a foreign stock in a falling local currency, your investment returns can be reduced because it takes more of that currency to translate back to U.S. dollars. The reverse also holds true - when the U.S. dollar is falling relative to foreign currencies, international returns are boosted, as it takes less of the foreign currency to translate back to U.S. dollars.

Hedging currency exposure can boost returns over the short term if you believe that the U.S. dollar could rise further. Because using derivatives to hedge currency is expensive for individual investors, we prefer products such as ETFs and mutual funds that hedge currency exposure for international stock allocations. Over the longer term, currency moves tend to even out, making currency hedging less favorable.