How do currency fluctuations affect banks?

Appreciation and depreciation of a currency

The fact that a currency can be revalued and devalued is not a specialist knowledge of economists. Attentive readers of daily political literature in particular know the term as soon as it comes back to Greece, whose membership in the euro has taken away the opportunity to restore international competitiveness by devaluing their own currency.

But what exactly is meant by an appreciation or depreciation? How exactly do you look, what mechanisms are behind it and what effects do they have?

Appreciation of a currency

  • Upgrading is good for imports, but bad for exports and domestic tourism.

An appreciation is an increase in the monetary value of a country compared to a currency of a reference country. In technical jargon, this process is called revaluation. Like almost everything in life, this process has advantages and disadvantages.

For a country like Germany, which exports a lot of goods abroad, this means that exports are becoming more expensive and foreign tourists have to dig deeper into their wallets when they visit. On the other hand, imports are becoming cheaper.

To illustrate what has been written with an example, let's assume that one dollar costs one euro. Now the euro is appreciating by 20 percent. This means that one euro now costs 1.20 dollars. For goods worth 100 euros, an American importer now has to pay 20 dollars more, so exporting from the country with a revalued currency will be more expensive.

On the other hand, however, imports are becoming cheaper. If a product from the USA costs 100 dollars, an importer from the euro zone only has to pay 83.33 dollars after the revaluation. Since all raw materials are traded in dollars, these are now also cheaper. Consumers are most likely to notice this at the gas station, when gasoline prices are falling.

It is therefore not generally possible to say that an appreciation of the currency is always good or bad. One factor is of course the economic structure of the individual country. If a country is dependent on exports, an appreciation is rather bad. The same applies to countries that are heavily dependent on tourism.

Devaluation of a currency

  • A devaluation is good for exports and tourism, but bad for imports.

One speaks of a devaluation when one's own currency loses value compared to the foreign currency. The effects are the exact opposite of what an appreciation entails. Imports are becoming more expensive and exports cheaper.

Here, too, an example should be given for better illustration. Let's go back to the numbers above. If the euro is 1.20 dollars, a product worth 100 euros costs 120 dollars. If parity is reached through a currency devaluation, the goods now cost 100 dollars.

However, the cost of import increases. 100 dollars previously cost 83.33 euros, now 16.67 euros more. For exporters, a devaluation can lead to an increase in sales, whereas for the importer it can lead to a decrease in sales.

Devaluation as an economic policy measure

Economic policy measures to stimulate one's own economy are based precisely on these considerations. Quite a few countries devalued their currencies in times of economic recession in order to restore international competitiveness. Examples are Canada and Finland in the early 1990s, when devaluations occurred as part of economic reforms.

Greece and other euro countries with economic difficulties have taken the measure of devaluation. There are economists who attribute a better economic situation to these countries if they weren't part of the Eurosystem.

There are currently similar discussions in Finland. Some Finns want to recognize that their Swedish neighbor has seen better economic growth since the crisis by the fact that they still have their crown and can pursue a more flexible economic policy.

However, one should not rely solely on the devaluation of the currency alone; it can only be one of many measures. Some economists criticize the one-sided view of some politicians, who see salvation in a devaluation and postpone necessary reforms.

But how can a devaluation be carried out? With this question, one must first make a distinction between the different types of exchange rates.

With a fixed exchange rate, in which the state or the respective central bank simply sets the exchange rate, it is sufficient to simply make the currency cheaper. In all other cases, the central bank must be actively involved in the foreign exchange market.

The cheap money policy

When the central bank lowers the key interest rate so much that it becomes cheaper and cheaper for banks to borrow money from it, it is called the "cheap money policy". The idea behind it has two thrusts.

  1. Firstly, banks should be encouraged internally to grant more loans in order to increase the willingness of companies to invest. In addition, private individuals are to be encouraged to consume more. Both should benefit economic development.
  2. Second, there is an outward thrust. Central bankers hope that such a devaluation of their own currency will increase exports. This idea is now so well established that no one wants a strong currency anymore, that both politicians and central banks in their majority no longer want a strong currency.

inflation

  • Central banks and politicians are aiming for inflation of around 2 percent per year.

In an economic system in which the central banks are not bound by instructions from the government, the central bank itself decides how high the key interest rate is. Their striving for a devaluation of their own currency is based on the goal of not allowing economic stagnation.

According to the dogma followed by all central banks, the earlier specter of inflation has long since lost its horror. A healthy inflation is even seen as a boon to the economy, while deflation is demonized.

The idea behind it is relatively simple: A currency devaluation should force companies to invest their money earlier, since the investment costs more money a year later. These investments secure the sales of other companies (such as the suppliers and subcontractors), which in turn employ more employees in order to be able to cope with the increasing demand.

All of this incentive is lost if money does not lose value or even increases in value as part of deflation. In the latter, the theory goes on, companies put investments on the back burner and hope that they will become even cheaper over time.

Targeted inflation of around 2 percent is intended to prevent this scenario.

Quantitative easing

  • Also called monetary easing. Central banks flood the market with cheap money and want to devalue the currency.

When the central bank massively lowers the key interest rate in order to initiate this development, it puts a lot of money into the economic cycle in a targeted manner. As a result, one's own currency is available en masse on the market, the supply far exceeds the demand on the foreign exchange market and the value of money in relation to other currencies loses value.

This is not an undesirable side effect on the part of the central banks, but a targeted measure, because it hopes in this way to strengthen both exports and domestic consumption.

This process is also known as quantitative easing and can currently also be observed at the European Central Bank (ECB) under the leadership of Mario Draghi.

What role does the key rate play in the devaluation?

  • A high key interest rate usually leads to an appreciation and a lower one to a depreciation of the currency.

Banks get the money from the central banks. You don't get this money for free, you have to borrow it. As always, you don't get anything for free: the banks have to pay the key interest rate set by the ECB as a fee.

If it is high, they hesitate to take it, because in order to make money for themselves, they have to pass it on to consumers at high interest rates. That can be a deterrent, especially when you don't necessarily need the money as a consumer.

Central banks hope to be able to fight high inflation. The FED (Federal Reserve Bank - Central Bank of the USA) briefly raised the key interest rate to 20 percent in 1980 in order to stop inflation in the double-digit percentage range. Since there is not so much money in circulation, the supply drops and the currency is upgraded. That makes exports more expensive.

If the central bank cuts the key interest rate, it hopes that the opposite effect will be achieved.

The foreign exchange market

Foreign currencies are traded here. If the supply exceeds the demand, the currency is devalued. If the demand exceeds the supply, the currency is revalued.

Exchange rate systems at a glance

Fixed exchange rateExchange rate remains stableUntil recently, the Swiss National Bank did everything it could to keep the euro at a constant CHF 1.20.
Flexible exchange rateExchange rates fluctuate and depend on supply and demandThe dollar varies against the euro. The fluctuations are sometimes enormous.
Nominal exchange rateIndicates the price of a currency in a foreign currency1 euro costs $ 1.06
Real exchange rateWorks with representative shopping cartsThe best known is the Big Mac Index, which looks at how expensive each country is.

Revaluations and devaluations in the foreign exchange market

Exchange rate systems play a role in this context. Currencies are traded on the foreign exchange market, where the principle of supply and demand applies.

  • If the supply exceeds the demand, the exchange rate drops. If the demand is greater than the available supply, then the currency sinks: It is devalued by the laws of the market. Major international investors (internationally operating major banks, insurance companies, institutional investors, private small investors) appear as actors here. This basic mode is called a flexible exchange rate system.
  • Sometimes central banks also operate on the foreign exchange market, such as the Swiss National Bank (SNB) recently, which bought up euros in bulk in order to devalue its own currency. She kept the exchange rate of 1 euro equal to 1.20 francs. The goal was clear: exports should not become more expensive and, more important for Switzerland than for Germany, a stay in the Confederation should not become prohibitively expensive for tourists. When the central bank intervenes massively to maintain a fixed exchange rate, it is called a fixed exchange rate system.

Exchange rates: Two types of determination

When it comes to the exchange rate, however, two further distinctions are made, namely between the nominal and the real.

  1. Nominal exchange rate
    The nominal exchange rate describes the price of a currency in a foreign currency. Everyone who goes on vacation and has to exchange money knows this procedure.
  2. Real exchange rate
    On the other hand, the tourist cannot do much with a real exchange rate. Representative shopping baskets are bought from him and they are shown how expensive they are. First of all, this index says little about the absolute equivalent value. First and foremost, you only know how much of the respective currency has to be raised, there are no more comparisons at first. They are only meaningful if you include the duration of the hours in the comparison, how long you have to work for such a basket of goods or if you observe the development over a longer period of time and take into account the changes over time.