Currency: The importance of performance standards

Everyone knows currency is a medium of exchange for goods and services. What may be less known is the fact that this essential mechanism, fundamentally, becomes the basis for trade. If we are interested in the effects of currency and its impact on the economy, typically, we calculate purchasing power. This allows us to gauge the strength of a particular currency. In the financial world this is generally seen only as an indicator that can be obtained either from fundamental data, like economic performance and interest rates or by observing predefined currency baskets that compare multiple currencies with one another.  And while not delving too deeply into the technical definition of purchasing power, it is still important to note that this number is, of course, describing a situation that has been adjusted for inflation.

To say the effects of currency performance are pervasive would be a gross understatement. For example, while Canada, has historically been a stable economy during economic downturns, recently it has not been able to escape low oil and commodity prices. Assessing what this means for the Canadian economy is a mixed bag. The general believe among the average voter is that a strong domestic currency is a good thing. But, this myth is a fallacy. In reality, we know that often the opposite is true. As a currency becomes stronger, certain industries become less competitive. In other words, a strong currency is bad for exporters whose goods become more expensive for foreign buyers.

Therefore, the opposite situation, one where a weak currency exists, can result in economic benefits. This is because, currency has direct and indirect affects on the interest rates, the price of goods, even the unemployment rate.

Having established some of the effects of currency fluctuations. We know want to turn our attention on its potential impact on the economy. The increase of globalization has led to heightened currency volatility and essentially caused changes in exchange rates to have a substantial influence on companies’ operations and profitability. Exchange rate volatility affects not just multinationals and large corporations, but small and medium-sized enterprises as well, even those who only operate in their home country. (We will delve into economic exposure and how to calculate it on a subsequent post).

Some famous examples of the impact of the currency performance include:

·      The devaluation of the Thai baht in 1997 caused The Asian crisis of 1997-98.

·      China’s decade long (1994- 2004) steady of it’s Yuan resulted in China becoming an export juggernaut, which in turn prompted a growing chorus of complaints of artificial suppression of the value of the Chinese currency in order to boost exports.

This highlights, that currency moves can have a wide-ranging impact not just on a domestic economy, but also on the global one.

Currency fluctuations have spawned what is typically referred to as currency hedging. Investors use movements in currency to their advantage by investing overseas or in multinational companies when the domestic currency is weak. Because currency moves can be a potent risk when one has a large foreign exchange exposure, it may be best to hedge this risk through the many hedging instruments available. At recent levels of exchange rate volatility, hedging currency exposure greatly enhances the diversification potential of foreign investments. (Perold & Schulman, 1988) In order words, hedging is similar to taking out an insurance policy.

But back to the impact of currency performance on the economy, a traditional viewpoint is one that suggests a currency crisis is retribution for governments that have mismanaged the economy and essentially lack credibility. However, in 2000, Aghion, Bacchetta and Banerjee argued that in the case of east and southeast countries, the 1990s crisis was a result of lack of regulation.  This finding would later be echoed in the 2008 global financial crisis.

Canadian Dollar 2017

The loonie has dropped about two per cent against its American counterpart since early January. According to the Bank of Montreal, the loonie is the “worst-performing major currency this year.”  And to be fair, the bank of Canada probably wants the loonie low. While a lower loonie makes imported goods more costly for businesses and consumers, it also makes Canadian exports and Canadian labour more competitive globally. This would explain why the loonie has broken with the tradition of following world currencies when they rise against the US dollar. The Huffington post recently put together the following chart using DataStream via National Bank Financial and Bloomberg.

By,

Kaha Haji-Mohamed

Works Cited

Aghion, P., Bacchetta, P., & Banerjee, A. (2001). Currency crises and monetary policy in an economy with credit constraints. European economic review, 45(7), 1121-1150.

Perold, A. F., & Schulman, E. C. (1988). The free lunch in currency hedging: Implications for investment policy and performance standards. Financial Analysts Journal, 45-50.

Shin, D. H. (2008). Understanding purchasing behaviors in a virtual economy: Consumer behavior involving virtual currency in Web 2.0 communities. Interacting with computers, 20(4), 433-446.

Picture titled, "5 roubles coins", taken by Waltie on November 15, 2007, obtained through creative commons (https://flic.kr/p/472b9c