The J-Curve is an important concept when discussing both private equity and trde defecits, and has slightly different implications in each context. In private equity, the J-Curve shows an investor’s net cash position over time, beginning positive, dropping as contributions to the fund are made, then (hopefully) rising as the fund’s investments pay off. When discussing a nation’s trade balance, J-Curve describes what happens to the balance of trade following a major devaluation of that nation’s currency. Upon devaluation, the nation’s imports will drop as foreign goods become relatively more expensive, while exports will begin to rise due to foreign currencies’ strength relative to the domestic currency. The resulting changes to the balance of trade form a J-Curve.
Q. So, we’ve talked about the J-curve in private equity: an investor keeps putting new dollars in for a good while before he sees any return. But now we’re hearing about J-curves in connection with Greece… so how does this buzzword work?
A. The question is: What happens to the Greek economy if it leaves the Euro and goes back to the Drachma? Of course, that’s effectively a huge devaluation of its currency, maybe 50% or even more. That would make imports more expensive and exports cheaper. So, what happens to its deficits? A very popular theory is that it will form a J pattern, getting worse and first and then turning around.
Q. Like Argentina, right? It’s economy contracted badly right after it devalued, but subsequently stormed back.
A. That’s the argument. And the shorthand explanation for why it’s a J instead of straight line up is that imports get much more expensive immediately, but it may take a while for the cheaper exports to catch on in foreign countries, so the short term impact is that deficits get worse. That’s the bottom of the J.
Q. Well, we don’t dumb it down here on Money Moves! So what’s the more complete explanation?
A. The impact of the devaluation really depends on what you’re importing and exporting, and the price elasticity of those things. Imagine that the locals must still buy imports, say food; and nobody cares about the country’s exports at any price. Then, of course, the devaluation might make things worse, not better!
Q. So, how’s it look for Greece?
A. Some people say Greece doesn’t have any exports, so the Argentina analogy is off base. But in reality its exports as a % of GDP are greater now than Argentina’s was when it devalued. The difference is Greece doesn’t export a lot of goods: they “export” services, like shipping and tourism. So for anyone expecting classical formulas to predict what’s going to happen here, I have one caution: you have to remember that there’s no J in the Greek alphabet.