April 15, 2015

Seven Keys to Understanding the Strong Dollar

By Kristen Fanarakis

SMITH BRAIN TRUST -- More is better than less. “It’s not complicated,” AT&T explains in its popular television ads. Similar reasoning does not apply in foreign currency exchange, where strong is better than weak — except when it isn’t.

For U.S. consumers the dollar’s recent surge means cheaper imports, lower inflation and hot deals on international travel. This can translate to cheaper tickets for Americans at the Eiffel Tower or bargain rates for FedEx to acquire Dutch shipping company TNT Express. Unfortunately, a strong currency also means lower demand for exports, which cuts into corporate profits at home and slows economic growth. This partly explains why French President François Hollande has cheered the plunging euro, while Federal Reserve officials lament the surging dollar. “It’s a double-edged sword,” MarketWatch explains.

The up-is-down logic can leave anyone confused. Here are seven principles that can help explain the latest headlines.

1. It’s all relative. Investors trade currencies as an asset class. But unlike stocks or bonds, currency trading is a zero sum game because products are evaluated on a relative basis.  If some currencies go up, others must come down. The U.S. Dollar Index, for example, tracks the currency’s performance against six of its counterparts. This means the dollar can rise even if the U.S. economy is sluggish because other regions might be worse by comparison.

2. Everybody exchanges currency. Currency values fluctuate for a variety of reasons, but mostly because people need to buy stuff. If a country produces something that everyone wants, such as Swiss chocolate or watches, people in other countries must sell their currency and buy Swiss francs to obtain the item. Many shoppers don’t think about this when they use their local currency at the register. But somewhere along the line, someone had to exchange the local currency for Swiss francs when they decided to import the good.

3. Lines are blurred. Almost all supply chains are global in the 21st century, even when the label says “Made in USA” or “Hecho en Mexico.” Even something as simple as a pair of blue jeans can have parts and labor from 13 countries. By the time most products reach store shelves, currency already has been exchanged multiple times.

4. Importers win when exporters lose. Countries that ship lots of goods overseas don’t want strong currencies because that makes their exports more expensive. Higher prices typically hurt sales, which explains the incentive for currency rigging. (The U.S. recently hinted at problems in China, Germany and South Korea.) On the flipside, a strong currency drives down prices for importers. Similar principles apply to foreign direct investment, another type of trade flow that happens when an individual or group acquires real estate in another country. A strong currency discourages outside investment, while a weak currency invites bargain hunters to come and explore opportunities.

5. The dollar is different. The U.S. dollar functions as the world’s reserve currency, which means it is held in savings accounts at central banks around the world. Some countries even peg their exchange rates directly to the dollar, partly as a show of confidence in the U.S. Federal Reserve. One result is that the dollar sometimes appreciates in times of global financial turmoil, as it did during the 2008 subprime loan crisis. This happened even though the Lehman Brothers bankruptcy and housing collapse were centered in the United States.

6. Multinationals feel the pain. One downside of a strong currency, which has been in the news of late, is that multinational corporations take a hit because their overseas cash loses value on exchange. Consider the case of Apple, which lost $3.73 billion to currency fluctuations in the final three months of 2014 — more than Google earns in a quarter.

7. Currency isn’t everything. Companies must think about more than just currency values when choosing a trade or investment location. Other factors include interest rates, inflation, economic performance and political risk. ExxonMobil learned this lesson in 2007, when Venezuela evicted the company and seized its oil projects in the country.

Kristen Fanarakis is Assistant Director of the Center for Financial Policy at the University of Maryland’s Robert H. Smith School of Business. She has more than a decade of experience on Wall Street and an MBA from the University of North Carolina’s Kenan-Flagler School of Business. She also holds a Master of Science in international economics from Suffolk University.


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