Currencies have fascinated me ever since I was a little kid. I used to collect bills and coins of different countries. So, this topic is near and dear to my heart. How do currencies work in the world economy?
Now more than ever, due to globalization, countries increasingly trade and depend on each other. Some countries primarily export, while others primarily import. In order for trades to happen smoothly, businesses use currencies to pay one another. When making payments, businesses would have to convert the currency in hand to that of the currency of the foreign business’s homeland. For example, if Apple is buying its microprocessors from a Japanese company, then Apple would have to convert USD to JPY in order to pay the Japanese company in Yen. There is an entire market around this idea of converting currencies – the Foreign Exchange (FOREX) market. If you thought that the New York Stock Exchange (NYSE) was big, you might want to sit down before I tell you how big the FOREX market is. Every day, NYSE (largest stock market in the world) trades about $22.38 billion. On the other hand, $5 trillion is traded in the FOREX market every day. Hopefully you can agree with me that with $5 trillion traded everyday, currencies are important for businesses and governments to function. Currencies are an integral part of the world economy. Let’s break the world down into 2 kinds of economies: export based and import based. In the next 2 paragraphs, we will take a look at how currencies influence these two economies.
Export based economies take advantage of the FOREX market by ensuring that their currency is weaker than the currency of those countries that import their products. In other words, countries like Switzerland, Japan, and China (export based economies) favor a weaker Swiss Franc, Yen, and Renminbi respectively. Why? Well, as an export based country, you want your products to be “cheap”. This way, businesses from importing countries (United States or Europe) would buy your products. It is cheaper for importing countries to import the product than manufacture it domestically. Exporting countries can weaken their currency either by lowering interest rates or make use of open market operations (buying/selling of government securities i.e government bonds). I have previously blogged about how China devalues its currency. If you want to know how exactly currencies can be manipulated for the benefit of export based economies, feel free to read my blog post here.
In the previous paragraph, we talked about how currencies are critical for export based economies to prosper. What about import based economies like the United States? When export based countries are weakening their currency, they are indirectly strengthening the currencies of import based countries. This means that when Switzerland or Japan or China is weakening its respective currency, the United States’s dollar is gaining strength. What does it mean when United States Dollar (USD) is gaining strength? It means that capital flows into the United States, US stock market appreciates, US businesses outperform, wages grow, people spend more, and businesses import more to fulfill the high demand. This cycle goes on. One of the biggest downside of USD gaining strength is that manufacturing in the United States gets expensive, which means that it is cheaper to import goods than produce it domestically. Strong dollar is precisely the reason why manufacturing from the United States have moved to China.
By now, you get the idea that currencies are crucial for economies to prosper. Globalization has brought countries close to one another, but currencies is what links every country in the world together. Governments can take advantage of currencies to help their respective economy prosper. Who would have thought that a strong dollar would cause manufacturing workers to lose their jobs, but at the same time make products in the grocery store cheaper? That is the power of currencies in the world economy.
Hope you learned a little and found this blog post helpful. We talked about how currencies influence import and export based economies. We briefly discussed the FOREX market and how currencies can be weakened. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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