322: Why Currency Exchange Rates Matter

Welcome to Money For the Rest of us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today’s episode, 322. It’s titled “Why currency exchange rates matter.”

We Hedge Everything

Hakan Bulgurlu, the chief executive of Arcelik, Europe’s second-largest home appliance manufacturer, was recently quoted in the New York Times as saying “We hedge everything. We don’t take any currency risk. That’s a principle we adopted a long time ago. It helps us management just focus on our business, and not worry what happens in the currency market.”

Arcelik is based in Turkey. He is saying the company’s business revenue, expenses and income is not affected by fluctuations in the currency exchange rate between the Turkish Lira and the Euro or between other currencies in the countries Arcelik operates.

Berat Albarak—president Recep Tayyip Erdoğan’s son-in-law—was Turkey’s finance minister from 2018 until a few weeks ago. During his tenure, the Turkish lira lost 46% of its value relative to the U.S. dollar and the Euro.

Albayrak said in September, “For me, the exchange rates are not important at all,” “I don’t look at that.” Except he actually really did care. The Turkish government, in coordination with the Central Bank of the Republic of Turkey, has spent billions of its currency reserves trying to keep the lira from weakening further. They’ve spent so much money that their foreign currency reserves; essentially, their holdings of dollars and Euros and other currencies are down 40% this year. Their total net foreign currency assets—so their gross dollars and Euros minus foreign liabilities and borrowings is negative. “They have run out of ammunition”, said Ozlem Derici Sengul of Spinn Consulting (an advisory group).  “If they continue like this, they may have no hard currency left.”

Now, most of us, including me, don’t think much about exchange rates, unless we are about to travel to a different country. But if your domestic currency has fallen 40% over a period of months or years, that will get your attention. If anything, because the cost of imports will be significantly higher.

If a country’s economy was completely domestic, with all of its production, earnings, and spending taking place within its own borders, that nation wouldn’t have to worry about exchange rates. But as soon as a country’s households and businesses buy or sell goods and services from foreign companies, or borrow money from foreign banks, then exchange rates make a big difference.

Financial Flows

Let’s think about some of the financial flows, which are called the balance of payments, but look at it on an individual level. Let’s say I run a bakery. As part of my business and my household, if I spend more on goods and services than I sell in bread and pastries, I’ll run a spending deficit. Let’s call it a current account deficit; my daily inflows and outflows.

If I have a shortfall, I have to fund that deficit somehow. I can take it out of savings, but if I don’t have any savings, then I will need to raise the funds. I’ll either have to borrow the money, or I’ll have to attract other investors into my business. Those are called capital flows, or a capital account. 

So I have the current account, my daily spending and sales based on goods and services, and I have the capital account, which is the investment flows; money I might invest if I run a surplus. Or if I run a current account deficit, then I need to take in those capital flows. If I take in capital flows, that’s called a capital account surplus. A goods and services deficit needs to be offset by a capital account surplus.

These same principles apply to a country. If a country, based on the individual decisions of households and businesses at the country level, imports more goods and services than it exports, then it runs a trade deficit, or what’s called a current account deficit. That country will need outside currency to fund that deficit.

Let’s say the deficit is completely in dollars. It needs dollars in order to pay for those goods and services because it ran a deficit. Those dollars can come from outside investors through capital flows, these investment flows, which is called the capital account.

A country that exports more in goods and services is running a current account surplus, so it has extra foreign currency that it can then invest overseas. This is known as the balance of payments. It’s an accounting identity.

Current account deficits need to be offset by capital account surpluses, and current account surpluses are offset by capital account deficits. Currency exchange rates are what allow that balance of payments to not get out of line. It’s the fluctuation in the currency that keeps this balance of payment in line, so there aren’t excesses.

For example, if a domestic currency weakens, then imports will become more expensive for those households and businesses, which means they won’t buy as much. And their exports as they sell their product overseas, their exports will be cheaper for overseas buyers. And as a result, the country will import less, export more, and the current account deficit will narrow because the currency weakened. There was an adjustment in the exchange rate.

Likewise, as that currency weakens, overseas investors in that country will see that their returns are lower. Because as they try to translate that domestic currency back into their home currency, they won’t get as many (let’s say) U.S. dollars when they do that translation and they convert it back. So a country whose currency is weakening is a less attractive place to invest. Investors will pull money out and they’ll put less in, and so the capital account surplus will narrow. And again, it’s the exchange rate that allows that correction.

Unfortunately, many countries—their governments, their central banks—don’t allow their currencies to fluctuate, or to prevent them from weakening. Because when they do weaken, again, import prices go up, and that can lead to rising prices, it can lead to inflation, it can lead to a recession. It’s not popular when a currency weakens. But these are necessary adjustments.

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