Tariffs And Currency Devaluation, In A Nutshell

If you are new to investing and just entered the financial markets, you may have heard of the terms ‘tariffs’ for a while now and most recently, ‘currency devaluation’. As if investing is a difficult animal to deal with, adding in all these macroeconomic mumbo-jumbo may have sent your head further spinning.

Well, like it or not, you will need to have some idea of what these terms mean in your fundamental analysis (at the Economic Conditions level according to The Bedokian Portfolio¹), but to make things digestible for you, I will explain them in easy-to-understand analogies. Let us use a setting where there are only three countries in the world; Country A, Country B and Country C.

Tariffs

Country A and Country C both produce a widely used consumer product called gizmo. The cost of producing a gizmo in Country A was about (let’s be currency neutral here) $6, while in Country C the production cost was $3 each. Gizmo sellers in Country A, seeing the cheaper production cost in Country C, began to import gizmos from the latter. Even with (assumed) transportation costs of $1, the total cost of getting a gizmo from Country C was just $4, cheaper than the $6 produced at Country A itself. Gizmo manufacturers in Country C were happy since someone was buying from them, and gizmo sellers in Country A were happy, too, as their costs were down by $2 per gizmo.

Soon, gizmo manufacturers in Country A began to see their orders decline, and they cannot compete with Country C’s gizmo cost due to their own inherent production costs. As a result, many gizmo factories closed down and unemployment rose. The government of Country A then saw this unemployment as an issue and began to take steps in protecting their own gizmo production sector. They then imposed a 50% tariff on imported gizmos from Country C. With this tariff, the cost of a gizmo from Country C was the same as the ones from Country A (150% of $4 = $6), thus providing a so-called level playing field.

Such an act was seen as protectionist because the government of Country A wanted to protect its own gizmo manufacturers (and jobs). Also, consumers in Country A would have the opportunity cost of getting a lower priced gizmo due to the cheaper production cost in Country C.

It is not the end of the story yet. We shall now add in another character in the whole picture; Enter Country B, which had no tariffs imposed on by Country A. Enterprising middlemen in Country B would just buy the gizmo from Country C at $4 each (including $1 transportation), then sell them the Country A at $6 apiece (with transport), thus earning $1 per gizmo in the trade ($6 sell price - $4 cost - $1 transportation to Country A = $1). For gizmo sellers in Country A, now their cost is the same, regardless of where they got their gizmos.

Currency Devaluation

Let us use Country A and Country C again, this time we will assign a currency to each of them, namely A$ and C$ respectively, and an exchange rate of A$1 is to C$4. Assuming all things equal, Country C’s central bank decided to devalue their currency to A$1 is to C$5.

There could be a few reasons why a country would want to devalue its currency. One of the main reasons was to make its exports relatively cheaper. If a gizmo costs C$4 to manufacture in Country C, with the A$1:C$4 rate, an importer in Country A could get it at A$1 (sans transportation costs). But with the A$1:C$5 rate, the importer could get 1.25 gizmos for that same A$1. Multiply that on a large scale, it meant the importer could get 25% more gizmos for the same amount of A$ paid. So if Country B produced gizmos but at 1.1 gizmos per A$1, the importer at Country A would prefer to get it from Country C, thus Country B lost out its gizmo exporting business to Country C.

However, from the other side, it meant that imports from Country A into Country C were seen as more expensive. A A$1 gizmo imported from Country A would cost C$5 for Country C buyers instead of the pre-devaluation amount of C$4.

In The Real World

Hope the above analogies gave you a better understanding of tariffs and currency devaluation. Translating that knowledge into the real world, you could see how the countries that are involved in the trade war are using the above macroeconomic policies and tools.

Frankly, we do not know how this trade war will pan out, as both the United States and China are not showing signs of backing down for now. If this is going to be a protracted affair, then look out for the “middleman” regions/countries as highlighted in the last paragraph of the Tariffs section. Also, I had mentioned some other opportunities in my previous post here.

Reference

If you are interested to know more about economics, you can start off with Economics for Dummies (Flynn, Sean. 3^rdedition. 2018. John Wiley & Sons. ISBN 978-1-119-47638-2) and Economics 101 (Mill, Alfred. 2016. Adams Media. ISBN 978-1-440-59340-6).

Happy National Day!

1 – The Bedokian Portfolio, p89-90