What’s it: J-curve is a graph shaped like a letter “J.” It is a two-dimensional graphic representation to show the relationship between two variables.
The curve is popular in international trade and private equity funds. In this case, the x-axis represents time, and the y-axis represents net returns, net cash flows, or trade balance.
J-curve in private equity
J-curve illustrates the trend of return or net cash flow of private equity funds over time. Private equity returns negative in the early years because cash outflows are more significant than cash inflows. It may take some time.
Then, in the following period, the cash inflow started to improve. Returns begin to increase as the investment fund lives, starting to become a more mature portfolio.
Several reasons explain why private equity net cash flows were negative in the early years. The first is significant upfront costs, including investment costs, management fees, and costs related to investment portfolio risk. At the same time, the portfolio yet generated sufficient returns to cover these costs.
Factors affecting returns
How significant negative cash flows are and how long it takes for private equity to achieve positive returns depends on the following factors:
- Significance of initial costs. Setting up private equity is expensive. It requires several high costs, such as legal fees, accounting, taxes, and management fees. On the other hand, the initial return on investment is often insufficient. Since the allocation and diversification of investment are gradual, it does not immediately result in a massive cash inflow.
- Failure rate and amount of transaction loss. Some of the initial investments may be successful, but some fail. Private equity typically takes longer to generate a positive total return on its portfolio. When the initial failure rate is low, the cash inflow should be positive faster.
- Investment and divestment timing. The curve gets steeper when the fund managers invest capital more quickly. That way, the investment yields immediate returns. And they can reinvest it elsewhere.
J-curve in international trade
J-curve shows you the effect of currency devaluation or depreciation on the trade balance in a country. In addition to the concepts of exchange rates and trade balance, to learn it, you also need to understand the concept of elasticity of demand, especially about the effect of time on the elasticity of demand.
You can also use this concept to study the effect of currency revaluation or appreciation on the trade balance. Revaluation has the opposite effect of devaluation. Thus, it produces an inverted J-curve.
How the J curve works in international trade
Devaluation makes the domestic currency exchange rate weaker relative to foreign currencies. Take Indonesia, for example. Assume the government devalues the rupiah exchange rate from IDR14,000/USD to IDR15,000/USD.
Rupiah devaluation weakens its purchasing power against the US dollar. On the other hand, for Americans, the US dollar is more valuable when exchanging it for rupiah. By exchanging 1 US dollar, they get IDR15,000, more than before, which was IDR14,000.
Devaluation makes Indonesian products more affordable for Americans. Because the US dollar’s purchasing power is stronger, Americans see Indonesian products to be cheaper. Say, Indonesian exporters do not raise their prices and keep selling at IDR28,000 per unit. Previously, Americans had to spend USD2 to buy 1 unit. However, due to the devaluation, they spent fewer dollars, namely USD1.87.
On the other hand, devaluation makes the price of American products more expensive for Indonesian buyers. For a USD1 dollar product, they have to pay IDR15,000, which is higher than the previous IDR14,000.
Initially, Indonesia’s trade deficit will worsen after the devaluation. The effect of the increased price of imported products is more significant than the decrease in import volume. Likewise, the fall in prices for export products did not immediately stimulate volume more significantly.
Long story short, at the initial devaluation, export and import demands are inelastic. For example, when prices change by 7.1% due to devaluation, the volume of demand for exports and imports changes only by less than 7.1%. As a result, changes in prices have a more significant impact on the trade balance value than changes in demand volume. It makes the trade deficit increase.
The widening trade deficit is temporary because devaluation ultimately affects the export volume and import volume more significantly. Like the elasticity concept, demand is inelastic in the short run because buyers find it difficult to change their habits in a short time in response to price changes. It then becomes more elastic in the longer run.
Export volume will increase by a percentage higher than the percentage decline in the exported product’s price. Buyers in the United States see Indonesian products as more attractive than local products, prompting them to increase demand.
Likewise, the percentage decrease in import volume will be more significant than the percentage increase in product prices. Indonesian consumers will buy less imported products and switch to more affordable products from local markets.
As a result, devaluation causes the deficit to decrease in the long run and leads to a surplus.