Analysis of Exchange Rate Risk

Analysis of Exchange Rate Risk – Currency Wars, by James Rickards

As a small business owner, it’s not very often that you will consider the global markets and reflect on how one country on the other side of the world can change your business model in the blink of an eye. The cause and effect of one country can drastically change the way you do business in all other parts of the world. Currency Wars has opened my eyes to see the fragile world of Currency and banking in a different light. The gold standard is equally impressive and should be implemented for stability. It is also fascinating to learn about the currencies in relation to each other. For example, multiple reserve currencies sounds fine on the surface but can really lead to debt and deficit and it can actually just move one problem to the next country, not really solving anything but making things worse.

Key Themes & Concepts

The book, Currency Wars, by James Rickards starts out by describing a game that was carried out by the Pentagon in a secret facility outside of Washington DC. It was the Applied Physics Laboratory on some farmland close to Baltimore, MD. where this game would take place. The facility was a top secret, high-tech applied physics and weapons research unit. With this facility was a Warfare Analysis Laboratory, “One of the leading venues for war games and strategic planning in the country”, according to Rickards. This would be the place where the games would take place as the Pentagon brought in “about sixty experts from the military, intelligence, and academic communities” to be a part of this group. The rules were simple, the only weapons were financial like currencies, stocks, bonds, and derivatives. According to Rickards, “The Pentagon was about to launch a global financial war using currencies and capital markets instead of ships and planes?” As the book progresses, Rickards explains some of the background and history of the ideas behind the game and what it has to do with monetary policies. Rickards explains how Gold was the standard in the “Golden Age” and how it proceeded through the Currency War I (1921 – 1936), then through Currency War II (1967 – 1987) and the current Currency War. The history was valuable to understand because it showed how we got to where we are today. It also shows us how to correct many of the mistakes that we have already made as a nation. The history also included a section about the G20 Solution and how China, the United States, Europe and Japan all tried to weaken their currencies as a strategy but found out that not everyone could do this at the same time.
So the game “The Next Global Crisis” begins and Rickards spells out the rules and regulations. The stage is set, Dubai, Moscow, Beijing, are just some of the major players in this economy. Rickards makes the United States continues to take its dollar for granted and China’s hard asset is one more ticking time bomb against the dollar. Much of the countries are in a position to be very close to a real life situation. Rickards wants it this way and explains why it needs to be as real as possible.

[sociallocker]One of the countries that I covered in my previous papers was China. China is a difficult country to get a handle on because most of their policy makers are able to lie about their GDP and make the rest of the global market think they are doing really well. The result is that China is able to have a competitive market and possibly be just smoke in mirrors. Rickards gives the example about China and Japan in that, “In July 2010, China announced a 72 percent reduction in rare earth exports, which had the effect of slowing manufacturing in Japan and other countries that depend on Chinese rare earth supplies.” Since these metals are so useful for electronics, this made Japan on edge. He goes on to tell how the story resolved itself when “China had attacked Japan with an embargo and Japan fought back with a currency devaluation while both sides postured over a remote group of uninhabited rocks…A much worse outcome had been avoided, but lessons had been learned and knives sharpened for the next battle.” The result was a sudden devaluation of the Japanese yen in international currency markets. The yen fell about 3 percent in three days against the Chinese yuan.

Rickards calls chapter 11 the Endgame: Paper, Gold or Chaos. He states that, “In the end, the IMF’s plan for the SDR as announced in its blue-print document is an expedient, not a solution. It confronts the imminent sequential failure of fiat money regimes by creating a new fiat money. It papers over the problems of paper currencies with a new kind of paper.” His answer is to return to the Gold Standard, “Gold is not a commodity. Gold is not an investment. Gold is money par excellence”. He also Uses the Taylor rule, named after John B. Taylor. In it he wants this rule to be the guide for monetary policy because it is reflective and simple. This is what the United States needs to remain as a dominant player in the global economy. The complexity of many of these newer policies has caused an alarming collapse in the infrastructure of the U.S. dollar.

A major theme that runs through Rickards book is reducing complexity and getting back to basics for the purpose of clarity. He suggest that we can reverse complexity by eliminating the corporate income tax, simplification of personal income tax, and reductions in government spending. He uses the idea that smaller government is safer because there is not much to collapse if the government is manageable.

Exchange Rate Risk

As I look at exchange rate risks, I consider the countries like Brazil, India, and China. They are starting to make strides in becoming more transparent in the global markets, but they are still far off in many respects. June 16, 2009: Reuters reports that Brazil, Russia, India and China, at a BRIC summit, call for a more “diversified, stable and predictable currency system.” In three years, China allowed the Yuan to rise by 21% against the dollar by 2008. Since then Brazilian real and South Korean won have seen highs of 42% and 36% against the yuan. The result is a dramatic erosion of their competitiveness in the market. China tends to do it’s own thing whether the market care bare it or if countries are pressuring them. As long as China continues to do their own thing, the rest of the world will continue to keep China at bay. Overall, if China did have a stronger yuan it would benefit China’s and the rest of the world economy by converting growth from investment towards consumers. Consumers would purchase more and the economy would benefit from the large number of Chinese people spending and consuming.

So what does this mean for American companies wanting to do business in China? Be careful! Any business done in China can lead to an exchange rate that is not fully adjusted and the company can lose out big. As we consider doing business in China, I think it would be prudent to continue to develop our courses in the States and deliver them online to China. If we were to produce the courses in China for a cheaper rate, we may find that the currency value could change over night, leaving us with an undervalued dollar and an expensive employee in China getting paid in yuans.

The monetary environment evaluated from a biblical perspective

As a Christian businessman, I try to find God’s will in every sphere of business I am involved in whether it is, Financial, Management, Sales, Marketing, etc. When I think of how Christ would want us to use currency in a proper way, I can’t help but think about the many verses in Proverbs that speak directly and indirectly to money and its uses. For example, Proverbs 13:11 States, “Dishonest money dwindles away, but whoever gathers money little by little makes it grow.” This verse can be applied to individuals or groups and nations. We know the ultimate outcome of China’s dishonesty in the market, it will dwindle away. Likewise, the country or individuals who gather money can make it grow over time. As a nation with Christian foundations, The United States needs to take a step back and simplify her currency so that we can grow little by little. Rickards says it this way about the United States dollar, “While all currencies by definition represent some store of value, the dollar is different. It is a store of economic value in a nation whose moral values are historically exceptional and therefore a light to the world. The debasement of the dollar cannot proceed without the debasement of those values and that exceptionalism.” If we lose our moral foundation in scripture, there is no need to worry about the dollar, it will be gone because we have dwindled it away. However, like all things good, it takes time to grow an economy and strengthen a currency. As Christians, our focus needs to be on the winning of souls to Christ. In return, Christ will illuminate our minds towards a proper understanding of money.

In conclusion, history does not forget. We will be awakened and stirred by our refusal to simplify the monetary policies that are in place. As Rickards states, “Currency wars are ultimately about the dollar, yet the dollar today is just a jumped-up version of a former self due to derivatives, leverage, printing and the derogation of gold. It is not past time to save it. Still, the time grows short.” As we seek to systematically awaken our neighbors to the alarm of the weakening dollar, let us not forget that Christ is first in all things, including our stewardship of the money he has given us as a nation under God.[/sociallocker]

-Jake Mansfield