Or Do FX Rates Matter?
To ask the question “Do FX Rates Matter” is most astonishing to a Forex trader. Certainly an exchange rate matters, he/she will answer and say, that a country with a cheaper exchange rate is able to sell more products because they will cost less on the global market. This gives a current account surplus and pushes the GDP upwards.
A long-term perspective
We are of the strong opinion that Forex rates for certain countries do not matter in the long-run. The best proof is the following graph, the long-term rate for USD/CHF since 1970. Does Switzerland have a competitive disadvantage now? Should the SNB move the USD/CHF floor back to 4.25?
The main driver is the nearly always positive Swiss current account and the regular US current account deficit and the need for the United States to devalue the dollar especially in the 1970s. The simple economic principle is that local goods are paid with foreign currency. Therefore there is too much offer of foreign currency (the USD) and it must depreciate.
Since the financial crisis in 2008, the United States managed to reduce the deficit.
By general rule, a US trade deficit inside the Bretton Woods system resulted into a transfer of gold reserves from the U.S. to the countries with a trade surplus. Since it did not make sense to transport the gold from the America to Germany, the gold reserves remained in the country with the trade deficit.
A similar picture applies to the German and the Japanese current accounts and their ever rising currency. The following graph shows that the United States needed to devalue the dollar already even during times of fixed-exchange rates, according to the Bretton Woods rules.
The U.S. and the U.K. achieved a stronger capital base until the 1950, while Europe and Japan managed to recover until 1973. The long-term real effective exchange rate graph below shows the strength of the Japanese and Swiss economies between 1970 and 2012 outpacing the US and the UK, while South Korea still had to catch up and pass the stage from a less developed country to one of the strongest emerging market between 1970 and 1999. This meant that until the year 1999 South Korean wages rose more strongly than in other countries relatively to productivity resulting in higher inflation and a devaluation of the won. This however changed from 1999 onwards. Similarly as the Swiss National Bank, we judge that South Korea might go the same path as the Swiss and Japanese in the future.
Due to demographic effects the Japanese might see a weaker yen, older people consume more and work less. Strangely this argument could be applied to Germany, Italy or the United States with a smaller and smaller participation rate.
The real mean reversion for currencies
Some economists like Goldman’s O’Neill, in the case of the Swiss franc think: “what strongly falls or rises must come back to mean again”.
The mean reversion is valid for P/E ratios. The P/E ratio must come back to average Shiller Price Earning Ratio. A strongly performing stock like Apple, must return towards the mean, because the competition is able to produce similar products. Stock prices rise over time according to GDP growth and inflation rate (see the Gordon growth model). Indices are positively influenced by a survivor-ship bias and includes sometimes even dividends (Performance indices).
A mean reversion for currencies does not exist neither: currencies with low inflation and current accounts surpluses must appreciate over the time, pairs like USD/CHF or USD/JPY must follow a descending channel.
Real mean reversion is the mean reversion to the real FX rate.
This is valid under the following conditions:
- There are no expectations for big interest rate differentials, that could lead to a carry trade. Effectively the yen was depressed especially between 2003 and 2007.
We will establish in the following some theoretical basis for the concept of a “strong economy”.
The Penn Effect
Entirely tradable goods cannot vary greatly in price by location (because buyers can source from the lowest cost location). However, most services must be delivered locally (e.g. hairdressing), and many manufactured goods have high transportation costs. The Penn effect usually occurs in the same direction: where incomes are high, average price levels are typically high (see in Wikipedia).
The Balassa–Samuelson effect
The Balassa-Samuelson effect states that productivity growth-rates vary more for a country’s traded goods than in other sectors. This implies:
- Workers in some countries generate greater productivity than those in other countries and this acts as the source of income differences.
- For some labor-intensive jobs productivity innovations will have smaller effects. No matter their education or location a burger flipper will manage the same number of burgers/hour.
- Fixed-productivity sectors produce goods that cannot be transported (e.g. haircuts, the hairdresser has to be able to physically touch the hair to cut it).
- For local wages to be equalized the same job might be worth more in one location than another (e.g. flipping burgers in Zurich and Nairobi).
- The CPI is local goods (will be more expensive in rich countries) and tradables (same price in all countries).
- PPP (purchasing power parity) is used to peg the exchange rate for tradable goods (this is testable).
- Money exchange rates vary related to productivity of tradable goods (more than average productivity); and, for real goods the differential is less than for money.
- Productivity becomes income, meaning real income is not affected by changes in money as much.
- This is like stating that real income can be exaggerated by money exchange rates. Alternatively, items will cost more in richer countries.
Tradable goods, manufactured in Switzerland
The following graph shows that when compared to the year 2000, manufacturing costs in Switzerland (valued in EUR) rose as much as the ones in Greece, but they remained very low in Germany.
The question is why do the Greeks have big problems and the Swiss do not?
The reason is that the Swiss were able to replace labor with capital, human capital and technology. The products they sell are capital-intensive. Moreover, they use sophisticated production models, where the main part of the production factor “labor” often does not reside in Switzerland (see more details below).
Switzerland might have a competitive disadvantage against Germany for labor costs; but, they have other factors, such as more capital, highly educated workers, that moved from Germany and other countries to Switzerland, or cheaper taxes and a more efficient infrastructure. The stronger Swiss currency and negative Swiss bond yields even improved the Swiss financial position.
Does Germany need a weak euro?
In Germany there is a strong industry lobby suggesting that the (weak) euro only helps the country. The problem is that austerity in the periphery kills some of their exports. Giving the periphery money to pay for the goods with loans (like before 2008) does not make sense any more.
Switzerland has maintained a strong current account surplus despite a 25% revaluation of its currency since 2007. Until the 1990s, the German Mark appreciated continuously, but the German current account surplus remained stable. When labor became more expensive, Germans improved the efficiency of the processes and technology. Labor was simply replaced with capital and technology that became cheaper with a stronger currency. New more sophisticated jobs were created. Consumers were happy about low inflation and spent money.
Only a rapid revaluation of a currency imposes a threat, because technology and process improvements cannot match it quickly enough. Therefore the SNB performed interventions in 2009 and 2010 knowing that it would not help in the mid-term.
A (controlled) appreciation of a currency is not a weakness and does not lead to unemployment.
The opposite is the case for a weak currency: when inflation is high, consumers are likely to stop spending. Often companies are too inflexible to use the cheap labor or they lack capital to do new business and projects based on it. Therefore, it generally takes two to three years to see a significant improvement (for example, Argentina). If the euro zone had kicked out Greece in 2010, the improvement phase would have started by now.
As Jim Rickards says:
That you help exports with a cheaper currency is not true. Germany has been an export power house for 50 years and they had a strong currency for 50 years. Education, innovation, investment, technology, good business climate, low taxes.
Comparative Cost Theory
Comparative Cost Theory is based on Ricardo‘s work “On the Principles of Political Economy and Taxation” that recited earlier work of the entomologist William Spence. The idea was that each country should concentrate on what they can do best, on its comparative advantage. The Heckscher-Ohlin theorem refines the comparative cost theory.
Vermont’s product life cycle theory (see an example below) defended comparative cost theory against critiques from Leontief, against the so-called “Leontief paradox“.
The Heckscher-Ohlin model is based on four critical theorems, with the Heckscher-Ohlin theorem being one. This states that a country will export goods based on its abundant factors and import goods based on factors it lacks. For a two factor case it states: “A capital-abundant country will export the capital-intensive good, while the labor-abundant country will export the labor-intensive good.”
The critical assumption is that the countries involved are identical, apart from for the specific resources. A capital rich country will produce goods that are capital-intensive more cheaply than they would be produced in the labor-abundant country.
At the start when the counties are not trading:
- Capital-intensive goods in the capital-abundant country will be priced lower than in the other country.
- Labor-intensive goods in the labor-abundant country will be priced lower than in the other country.
The after trade is allowed, products will be moved to markets that have a temporally higher price. Resulting in:
- Capital-intensive goods being exported by the capital-abundant country.
- Labor-intensive goods being exported by the labor-abundant country.
We have extended the Heckscher-Ohlin theorem by some more factors that can constitute a comparative advantage versus other countries:
- Cheap labor is available e.g. in India, China, or Eastern Europe. Due to problems in the US educational system many US workers are able to deliver labor rather than other production factors. US workers without high school have a 45.1% labor participation rate (down from 46.9% one year ago), but university graduates 75.9% (down from 76.4%). The stronger fall since last year implies that certain easy US work is still outsourced to other countries.
- Capital is available in countries like the US, UK, Switzerland, Germany, or Japan. It allows them to build new technology easily.
- For us commodities have become somehow a production factor: Australia, Russia, and Brazil are three countries that focus on commodities. This is their comparative advantage, but often connected to the Dutch decease problem.
The following production factors are summarized in the term “productivity” or sometimes total factor productivity.
- Countries with an elevated level of human capital are Germany, the Scandinavian countries, Japan, and Switzerland, with the most recent wave of highly qualified people, since the Swiss-EU bilateral contracts. In the US human capital is an important factor; university level education in the US is one of the best in the world.
- Cheap tax and efficient infrastructure already represents a competitive advantage. It will become more important when more and more states start to tax the wealthy. Rich people, global companies (like Glencore), companies from the European periphery (latest example Coca-Cola Hellenic Bottling), well-educated immigrants will flee into low-tax countries, such as Switzerland and Singapore. An efficient infrastructure for doing business is also closely connected to this.
- Political freedom leads to more economic freedom and, in most cases, to less corruption. Similarly as China got economic freedom in 1978, recently Myanmar got economic freedom.
- Last but not least, mentality or geographic factors may influence productivity. This is, however, under dispute.
We have ordered the production factors by the period when they became important.
- Labor: From the beginning of humanity till 1800 it was the most important factor.
- Capital/technology: Capital always. Technology from the industrial revolution.
- Commodities: are important in the current commodity super-cycle that started in the year 1998. They are overpriced from a long-term perspective thanks to cheap central bank money and an over-estimation of emerging markets’ capabilities and an under-estimation of what human capital and technology can achieve. The falling price of natural gas, thanks to shale gas, is an example of the commodities super-cycle that will end one day. The rise of commodities, for example copper, is strongly connected with the real-estate bubbles in many countries.
- Human Capital: This is currently, and since the IT revolution, the most important production factor. Apart from aging, the lack of human capital is a major factor that might cause China, but even more other emerging markets like Brazil to struggle to deliver the largest share of global growth in the future. For more details why Chinese growth rates will go down due to a lack of human capital. See UBS senior advisor George Magnus great paper “Asia: Is the Miracle Over?” (also as “The Great Recoupling” on Zerohedge)
- Tax and efficient infrastructure: have become an important production factor in recent years and will become more important. Companies and workers decide where they should work based on these factors. In international trade, tax questions decide where the sales department is situated, because profits are made in this country
Product Life Cycle Theory
This graph depicts an application of Vermont’s product life cycle theory for the global export model of a Swiss or German company. Most labor-intensive work is done in cheap countries like China, Slovakia, or Estonia. Research is done in Switzerland or Germany. Advanced components are produced in Germany. Swiss employees execute global sales. Since a considerable part of the work force is situated in Switzerland the firm can charger a lower transfer price and can move a bigger part of the profit taking into Switzerland and benefit from lower taxes. A similar model is the “double Irish sandwich“.
My presentation on Dukascopy TV summarizes some of these points.
For further insights read also the section on “carry trade and reverse carry trade“.
Bela Balassa, An Empirical Demonstration of Classical Comparative Cost Theory, Vol. 45, No. 3 (Aug., 1963), pp. 231-238, Published by: The MIT Press
George Magnus, UBS Senior Economic Advisor: “Asia – Is the Miracle Over”, Online
Murray N. Rothbard, Classical Economics (LvMI) (An Austrian Perspective on the History of Economic Thought), April 13, 2010, Ludwig von Mises Institute, ASIN: B003H4R8N8, Extracts on Ricardo online
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and we encourage you to complete your own due diligence when making an investment decision. Even if we often write about Forex trading, our advices aren't written for day traders who follow technical channels, but rather for mid- and long-term investors. Our aim is to show discrepancies between fundamental data and current asset valuations, which can lead in mid-term to an inversion to technical channels.