Strategies for Central Banks & Private Investors
By JC Collins
The terms depreciation and devaluation are often used in an interchangeable context. Though this is not always a big issue, as the intent for the average layperson is clear, it is worthwhile to take a moment to clarify the terms and ensure we understand the difference.
Depreciation is brought about when there is a change in the supply and demand side of a currency’s exchange. When there is less demand for a currency, that currency will depreciate in value, like any other asset.
In turn, when the demand for a currency increases, the value of that currency will also increase. A suitable example of this process is the global demand for US dollar denominated assets in the foreign exchange reserve accounts of the world’s central banks.
Such demand pressures placed on the USD from holding the title of the international reserve currency has caused the dollar to appreciate. This appreciation has led to domestic challenges for America, especially in the form of decreasing exports and job losses, as American made goods become too expensive for the rest of the world.
Devaluation is brought about when the exchange rate of a currency is adjusted to decrease the valuation of that currency against other currencies or assets. Such an example can be found in China’s recent moves on lowering the daily fixed rate of the yuan against the dollar.
So which one of these scenarios will apply to the US dollar? Depreciation? Or devaluation?
On one hand, the amount of dollars in the foreign exchange reserve accounts must decrease in order for the US to begin adjusting the exchange rate pairings. No one wants to take the losses on this devaluation. But this decrease in reserves is also tantamount to a decrease in demand, as the rest of the world recognizes the need to diversify out of dollar denominated reserves and find a more balanced framework within a multilateral approach.
Such a multilateral approach will be initially realized by a mix of reserves that will be more balanced between the dollar, euro, and yuan. In the years to come we will see this reserve diversification take on the face of a true multilateral asset, such as represented by the SDR of the International Monetary Fund.
Until such a time we will live in a world of competing reserve currencies. Not necessarily such a bad thing.
The diversifying of dollar denominated reserves is in affect a lowering of demand for dollar denominated assets. In such a scenario the dollar would be faced with depreciation as opposed to devaluation.
Yet, it is necessary for the dollar’s exchange rate regime to change to reflect the realities of the emerging economies, and meet the domestic demand, and expectations, of increased exports and job growth.
I have chosen to use the term depreciation in the title of this post because the accumulation of dollar denominated assets in the foreign exchange reserve accounts is the primary and fundamental challenge which the international financial system has faced now for many decades. This amounts to a decrease in demand for dollar denominated assets. Whether through planning or accident, the decrease in demand is coming.
So how do countries, and central banks, protect themselves against this coming depreciation of the dollar? How do average Americans?
Let’s use the People’s Bank of China as an example. They hold over a trillion dollars’ worth of USD denominated assets. In the post Potential Path Forward on Fed Rate Increases – Sovereign Wealth Funds, Reserve Diversification, and Capital Flows, we reviewed how China could transfer their dollar denominated assets into their sovereign wealth fund. The SWF could than invest those funds into the equities markets.
Let’s take that logic further and consider the possibility that China’s SWF, called China Investment Corporation, could invest those funds into American equity markets, and American factories, corporations, mines, etc.
This would in affect amount to a hedge on losses when the dollar depreciates. As stated above, a dollar depreciation will increase US exports, which means factories fire back up, domestic job growth increases, and the economy as a whole expands.
Any sovereign wealth fund which invests into America will see a return on that investment which will offset any losses which are realized through a dollar depreciation. This is the perfect hedging strategy for central banks which hold dollar denominated reserves.
They could as well also invest those funds into other markets and commodities, including infrastructure development in the emerging economies. Commodities, which are now at record lows, will rebound and begin to increase on the momentum of large infrastructure development projects in emerging regions.
The average citizen can also use the same strategy as investing in commodities, mining, and American companies which will capitalize on the depreciation of the dollar, and said increase in production and exporting capacity.
This is just the broad strokes on a strategy which will be more clearly defined in the coming months, and into next year. The ability for Americans to re-invest back into themselves, and their own country, is wonderful in that real growth and sustainability can be achieved at the regional level.
As I’ve stated in previous posts, countries with large trade surpluses will have their currency appreciate in order to facilitate the decrease in exports and required adjustments to the surplus. Countries with large trade deficits, like the US, will have their currency depreciate in order to facilitate the increase in exports and required adjustments to the deficit.
The issue with the dollar is that this process is somewhat more challenging as it is the reserve currency and large amounts of it has accumulated in the foreign exchange reserves. This challenge has been addressed in this post, and in previous posts.
As such, keen investors can hold the currency of those countries with large trade surpluses, or assets denominated in those currencies, in the anticipation that an increase in valuation will ensue in the months and years during the transition process. Hedge the coming dollar losses. - JC