In this article we will look at why central banks weaken their currencies.
When you understand how and why this happens you will know how to profit from this phenomenon.
We will be looking at the following concepts throughout this post:
- Why exporting products is so important
- The case study of the Bank of Japan
- How weakening the currency hasn’t always been successful
To begin, we will look at what this means and how it happens.
When we talk about a weakened currency it is important to understand what this means too. Currencies can only be valued in relation to other currencies.
According to Currency Exchange International the USD is the worlds most traded currency.
In 2016, the Bank for International Settlements reported that USD accounted for over 87% of all global currency transactions.
Most central banks are trying to adjust the value of their own currency against that of the USD.
To deliberately weaken its own currency means one of two things. Either, the bank has lowered its interest rate or manipulated the money supply.
Investopedia reports that lower interest rates reduce investment into the country. This is due to the reduced returns they can expect to generate.
This encourages people to buy less of the nation’s currency which causes the price and value to fall.
Manipulating the money supply is a more direct way of influencing the currency’s value. If there is more money in the system then the value of it naturally falls.
We will be looking at these concepts in more detail later on.
Selling Things Abroad
Central banks weaken their own currency to make it easier for foreign people to buy products.
Let’s illustrate this with the example of Germany. They sell their cars to many different countries around the world.
In fact, according to the World Economic Forum, Germany sell over $1.4 trillion worth of products abroad, each year.
To give you an idea of how reliant Germany are on foreign sales we can look at an interesting statistic from 2017.
Their total export sales averaged out at $18,000 USD per person. The US average for exports was only $5,000 per person.
Americans that want to buy German cars need to first of all exchange their USD into Euros. They can then use the Euros to buy the car.
If the Euro currency was expensive then it would deter Americans from exchanging currencies.
This, in turn, would put them off buying German cars. Selling fewer cars means lower income for Germany as a whole.
As you can see, it is in the interest of each country to make sure that their currency is cheap and affordable.
It is the responsibility of the central bank to make sure that the currency doesn’t become too expensive.
This is why those banks adjust interest rates and manipulate the money supply.
They have the responsibility of the entire economy on their shoulders. This is why they take monetary policy so seriously.
Bank Of Japan Easing Programme
Currency devaluation is more common than you might think around the world.
One of the most famous currency devaluations was conducted by the Bank of Japan. Exports to foreign countries accounted for over 17% of total GDP in 2018.
Electrical machinery and manufactured goods made up almost 30% of those exports alone. Japan has a long history of producing technological products.
As of 2018, Japan had a negative birth rate of -0.23%. This means that the population is slowly decreasing over time.
The result is less new money being borrowed and injected into the economy. This causes prices of things to fall over time.
When people expect prices to fall they delay their purchase which in turn slows down the economy.
To counteract this the Bank of Japan launched a massive easing programme in 2013. The goal of the bank was to devalue the JPY and force prices higher in the economy.
This is called quantitative easing. It is one of the direct ways in which banks manipulate the money supply.
The idea is simple. The bank print vast sums of money and then inject this into the economy.
As more money starts to appear, the laws of supply and demand kick in. This causes the price of the currency to fall relative to other currencies.
Other countries to have weakened their currency’s include China, Russia and Switzerland.
Impact Of Currency Intervention
The actual impact of currency weakening has long been debated.
Often, the rumour of central bank activity is enough to cause speculators to act. They will trade as if the currency was already weaker.
This creates a self-fulfilling prophecy. Traders sell the currency because they think everyone else will start selling it.
This phenomenon was evident when the BoJ announced its initial QE programme back in 2013. The following 18 months saw the JPY lose almost 10% of its value.
But then there is the story of the Swiss National Bank. In 2010 they were trying to weaken the CHF against the Euro.
The value of their currency was rising making their economy less competitive. They started printing money and buying Euros to try and shift the momentum.
Their initial efforts were fruitless. The CHF rallied to an all-time high against the Euro.
The SNB then decided to abandon its attempt. They then started selling off the Euros that had bought in the first place. As the market started speculating the CHF gained even more strength.
The end result was a currency stronger than when they first started trying to weaken it.
Despite this mixed success the concept of currency intervention is still popular.
Most central banks have engaged in the practice of weakening their currency. And it seems likely that this practice will continue into the future.
Correctly predicting these moves is one the best ways to profit from the FX markets. This was made famous by the story of George Soros.
He personally made over $1 billion in profit from a single trade on the future of the GBP.
Why Central Banks Deliberately Weaken Their Own Currencies
Central banks deliberately weaken their own currencies to keep their economies competitive.
Attracting foreign investors to purchase goods and services is a primary driver of GDP for developed economies.
Foreign people will only invest into other countries if prices are competitive.
When too many people invest and trade with a nation the currency rises in value due to supply and demand laws.
To counteract this the central bank will manipulate the money supply. They sometimes also adjust the interest rate.
Most Central Banks have conducted some form of currency intervention in recent history.
The quantitative easing programme conducted by the Bank of Japan in 2013 is a famous example.
Deliberately weakening the currency doesn’t always work as intended. Despite this, it’s still a main policy tool of all major central banks.
FX traders try to monitor the actions of the central bank and try to ride the waves that their policies will cause.
Speculators generate the move they are predicting and acts as a self-fulfilling prophecy.
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