Hot Potato

Why Having a Strong Currency Is Like Holding a Hot Potato


Having a strong currency can prove challenging for nations and their policymakers. While a robust currency has its benefits, it also makes a country’s goods and services more expensive relative to those denominated in less expensive currencies. Because such a situation creates winners and losers, having a strong currency can easily provoke a contentious situation that is difficult for policymakers to traverse.

Exports and a Strong Currency

If a nation has a strong currency, its consumers can purchase goods and services denominated in foreign currencies less expensively. However, as a country’s currency appreciates relative to others, its exports can suffer as they become more expensive to foreign buyers. Exports represent the flow of foreign money into a country, so decreasing them could create significant economic headwinds.

Central Bank Policy

One major variable that can impact currency values is central bank policy, and when these financial institutions opt to harness differing policy prescriptions, it can easily provoke notable fluctuations in foreign exchange rates.

In the years following the financial crisis of 2007-2009, a wide range of central banks leveraged aggressive monetary policy in an effort to fuel more robust expansion. These financial institutions cut benchmark interest rates to record lows and purchased trillions of dollars’ worth of assets.

The Federal Reserve cut interest rates close to all-time lows and harnessed three separate bond-purchase programs, with the final one concluding in October 2014. The Fed eliminated its quantitative easing (QE) before the central banks of other countries, as the U.S. economy grew more quickly than that of other developed nations.

One financial institution that kept up its bond purchases after the Fed ceased these transactions was the Bank of Japan (BOJ). In July 2016, the BOJ announced it would not only continue to buy fixed-income securities but also step up its purchases of equity-traded funds from 3.3 trillion yen to 6 trillion yen. Market participants responded by pushing the yen higher relative to other major currencies, a development that displeased Japanese policymakers and potentially undermined the appeal of the nation’s exports.

Policy Trends

Many central banks followed suit after the BOJ announcement, taking steps to create more aggressive monetary policy. The Reserve Bank of Australia (RBA), for example, cut its benchmark interest rate to a record low of 1.5% in August 2016. The minutes for the policy meeting where this move was decided mentioned that “there was a reasonable likelihood of further stimulus by a number of the major central banks” and suggested the RBA make this policy move primarily with the intention of taking steps to fend off a climbing value for the Australian dollar.

The Bank of England (BOE) also announced changes to monetary policy in August, stating it wanted to help mitigate any headwinds the nation’s economy would encounter following the Brexit. As a result, the BOE increased QE, lowered interest rates and committed 100 billion pounds in an effort to help improve lending.

The raft of central banks quickly making efforts to intensify monetary stimulus following the BOJ announcement has made the policy of central banks seem interdependent. In addition, Mario Draghi, president of the European Central Bank (ECB), stated during a June 2016 ECB forum that these financial institutions should align their monetary policies. He emphasized that diverging monetary policies could not only provoke volatility in foreign exchange markets but also impact capital flows, particularly those going into emerging markets. As a result, he suggested central banks work together to obtain alignment, meaning “a shared diagnosis of the root causes of the challenges that affect us all; and a shared commitment to finding our domestic policies on that diagnosis.”

Key Takeaways

Having a strong currency can create a difficult situation for both nations and their policymakers. Situations such as these can create economic headwinds by reducing the appeal of a country’s exports. These challenges can prove even more harmful during times of economic weakness. In these instances, many nations are loathing to have a strong currency.

 

 

 

 

Contributing Writer: Charles Bovaird

Reference: Investopedia

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