THE dollar has been flexing its foreign exchange muscles with a period of further strength. This provoked a flurry of comments about the prospects of a currency war, and the consequences of the stronger dollar for the US and other economies. However, much of the analysis surrounding the movement of foreign exchange rates ignores the hard facts that are presented by the data, and is therefore just plain wrong.
The theory goes that a stronger currency will lead to exporters passing on the currency cost to their customers overseas in the form of higher prices. This will make the exporters’ products less attractive to foreign buyers, competitiveness will suffer, and exporters will sell less.
Conversely, the exporters of a weakening currency will get a competitiveness boost that will give them a considerable advantage. This latter point is often heard in Asia with regard to the yen's weakness — the supposed competitive advantage that a weaker yen has given Japan is regarded with near universal hostility.
The problem with this is theory is just does not work at all. The best way to understand that is to consider the data. Over the past four years or so, the value of the yen against the dollar has dropped around 60%. This is pretty precipitous. One would expect the US to be sinking under the weight of Japanese-made products in the wake of so dramatic a currency move.
However, when we examine the market share of Japanese exports to the US, we find that Japanese exporters have lost market share over the same period. The US consumer is alive and well and happily visiting the shopping mall with reckless abandon – but even as he spends more and more, he is spending proportionately less and less on products and services that originate in Japan.
On the other side of the equation, the reverse is happening. US exporters are supposed to be wailing and gnashing their teeth at the strength of the dollar against the yen as something that is thwarting their competitiveness. In spite of this, US exporters to Japan (admittedly a relatively select group) have seen their market share in Japan increase over the past four years.
It is a similar story with the euro area. US exporters to Europe have gained market share in the recent past, in spite of the weaker euro. Meanwhile European exporters to the US have had an unchanged market share. That might not sound as bad as the Japanese experience, and it is not, but it is still pretty bad.
Remember that the international trade share of the global economy is rising at the moment (and has been rising for several years). Any country that has anything other than a rising market share for its exporters is doing something wrong. If exporters’ market share is failing to rise when the currency is depreciating, then it suggests that the competitiveness arguments around floating exchange rates are clearly wrong.
What is happening is that exporters do not react to every change in currency moves. Exporters have generally spent a lot of time, effort and money in building up their customer base overseas. It can take 15 years or more to establish brand loyalty in an overseas market, and with global trade now approaching 25% of the world economy, overseas markets are a lot more important to exporters today than they were 40 years ago when floating exchange rates first became a feature of the world economy.
Currencies tend to trend up or down for far shorter periods of time than it takes to build a brand — it is unusual to see a currency trending in one direction for more than five years. Why would a sensible corporate chief executive jeopardise 15 years of work in a foreign market in response to a shorter-term currency move?
So, companies choose instead to ride out the fluctuations of the foreign exchange markets, and in so doing prove the competitiveness theories of floating exchange rates to be wrong.
This means that the stronger dollar will not have a hugely negative impact on US GDP. Exporters keep making the same amount of product, and employing the same number of people to make the same amount of product, although profit margins on that product are squeezed.
It also means that the disinflation effect of a stronger dollar on the US economy is limited — confined to commodity prices. Conversely, there is little competitive advantage from the weaker euro and the weaker yen for exporters of either currency area. The benefits of the weaker currencies are felt mainly via profit margins.
Similarly, aside from commodity price effects, these economies’ currency moves are not a major source of inflation.
Paul Donovan is senior global analyst at UBS Investment Bank
This article first appeared in Forum, The Edge Malaysia Weekly, on March 30 - April 5, 2015.