- The crux of the forex market revolves around trade and capital flows, as these elements significantly influence both economies and companies operating within them.
- This article delves into the profound impact of currency spot prices and illustrates a hypothetical yet realistic scenario that has left its mark on the Japanese economy.
PREPARING THE SCENE WITH THE JAPAN’S CURRENCY
To fully comprehend this narrative, it is essential to delve into the historical context of the USD/JPY pair, tracing its origins back to the 1970s and the troubling period of stagflation.
To combat stagflation, Paul Volcker took bold measures in the United States, raising interest rates to unprecedented levels in an attempt to curb the rampant inflation that plagued the economy during that time. These remarkably high interest rates triggered a surge in demand for the US Dollar, fueled by the carry trade and the significant interest rate disparity between the USD and JPY.
Between its low point in 1978 and its peak in 1982, the USD/JPY pair experienced an impressive 56% surge. The pair eventually cooled off as the impact of Volcker's policies began to manifest in the US. However, from March 1984 to February 1985, the bulls regained control, driving the USD/JPY pair to reach a high of 262.80 in 1985. It was around this time that the Plaza Accord came into play, an agreement among the G5 nations to manipulate exchange rates with the intention of depreciating the US Dollar.
Consequently, the strength of the Japanese Yen started to become evident, setting the stage for significant shifts in the exchange rate dynamics.
Let's now examine a hypothetical model based on price data from 1998 to 2008, a period when the USD/JPY exchange rate experienced substantial depreciation. However, it is essential to note that the issues surrounding Japan's economic challenges and the exchange rate fluctuations date back well before the mentioned 1998 period.
A PRACTICAL (BUT IMAGINARY CASE) OF CURRENCY VALUES IN MOTION
In 1998, a Japanese automobile manufacturer crafted a car, investing approximately ¥2,800,000 in production ($20,000). However, there was no concern whatsoever as they planned to retail the vehicle for $30,000, ensuring a splendid profit of $10,000 for each car sold.
Considering the USDJPY exchange rate at approximately ¥140.00 in 1995, let's examine the overall cost and sale of one of these cars:
Production Cost: ¥2,800,000
Equivalent Production Cost in USD: $20,000
Selling Price: $30,000
Profit per Car: $10,000
In 1998, the exchange rate was approximately ¥140.00 per 1 dollar, resulting in a production cost of ¥2,800,000 for the car. Nevertheless, selling it for $30,000 or ¥4,200,000 provided a satisfying profit of ¥1,400,000 or $10,000. A 50% profit margin seemed ideal back then, and the auto-manufacturer was content.
However, the landscape has dramatically shifted since then. The world has undergone immense transformations, altering the auto-industry's dynamics and leaving our manufacturer with new challenges to confront.
JUST 13 YEARS AFTER, THAT CURRENCY RATIO ON USDJPY HAD DROPPED BELOW 80.
The appreciation of the yen has a profound impact on the auto-manufacturer's cost structure and revenue, leading to a significant profit margin loss. As the yen strengthens, the company's costs remain unchanged at ¥2,800,000, but the sales revenue drops to ¥2,400,000 due to the fixed pricing in the US market. Consequently, the profit margin of 50% disappears, resulting in a loss of 400,000 yen per car sold.
In response to this financial challenge, the auto-manufacturer faces a few unfavorable options. They can choose to raise the car's price in the US market to mitigate losses, but this may deter customers and harm their market share compared to competitors. Alternatively, they might resort to cost-cutting measures, which often involve laying off workers or hiring fewer employees. Such actions adversely impact the overall economy by increasing unemployment and reducing pay raises, leading to lower inflation and raising uncertainty about the future economic outlook.
Overall, the auto-manufacturer finds itself in a difficult situation, as it grapples with the repercussions of a stronger currency that unexpectedly disrupted its profitability.
THE REPONSE:
In response to the challenging economic environment with an expensive yen, Japan takes action to devalue its currency. The primary objective is to boost exports and make their goods more competitive in international markets. By depreciating the yen, Japanese products become cheaper for foreign consumers, potentially leading to increased demand and higher profits for Japanese exporters.
For instance, consider our hypothetical auto-manufacturer in Japan. They managed to survive the expensive yen environment by optimizing their production costs, bringing it down to 2,300,000 yen per car. Although this allowed them to stay afloat, their profit margins were still minimal, at only 100,000 yen per car.
However, when the Bank of Japan intervenes to weaken the yen, they may take steps to influence the currency's exchange rate, such as selling yen in the foreign exchange market or implementing monetary policies that lower interest rates. As a result, the USDJPY exchange rate rises to 100.00, indicating that one US dollar is now equivalent to 100 Japanese yen.
This currency devaluation now presents a significant opportunity for our auto-manufacturer. With the cheaper yen, their products become more affordable for foreign buyers. Assuming the production cost remains at 2,300,000 yen per car, when selling a car in USD, they will effectively receive 23,000 USD per car (2,300,000 yen ÷ 100 yen/USD). This translates to a substantial increase in profit margins since they were previously only making 100,000 yen per car.
Our auto-manufacturer is experiencing a remarkable turnaround amid challenging times, as they continue to produce cars at a cost of 2,300,000 yen. However, the recent shift in the USDJPY exchange rate to 100.00 has unexpectedly brought them a windfall, yielding 3,000,000 yen for every car sold – resulting in a remarkable profit of 700,000 yen per unit.
This newfound profitability opens up exciting possibilities for the company, allowing them to reinvest in advanced equipment. As a consequence, other manufacturers in Japan will benefit from increased equipment purchases, fostering greater profitability and prompting a surge in hiring. The auto-manufacturer can now leverage its improved profit margin to offer more competitive prices, potentially outpacing its German and American competitors.
Subsequently, the company will need to expand its workforce to meet rising demands, leading to a surge in employment opportunities. As the demand for skilled workers grows in both equipment and auto-manufacturing sectors, wages will inevitably increase.
This interconnected process sets in motion a powerful chain reaction of economic growth within the economy, and all this transformation was triggered by a simple change in the exchange rate.
The allure of weaker currency prices makes exporting all the more attractive, and for economies reliant on exports, the potential for substantial growth becomes evident when their currencies become more affordable.
This represents the core essence of the forex market, shaped by the interplay of trade and capital flows. Such dynamics are often overlooked as our globalized economy is so interconnected that the ripple effects of one major economy's actions can reverberate across the globe.
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