J curve

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The term J-curve is used in several different fields to refer to a variety of unrelated J-shaped diagrams where a curve initially falls, but then rises to higher than the starting point.

Contents 1 Private equity 2 Balance of trade model 3 Country status model 4 Medicine 5 Political science (Model of revolutions) 6 References

[edit] Private equity

In private equity, the J curve is used to illustrate the historical tendency of private equity funds to deliver negative returns in early years and investment gains in the outlying years as the portfolios of companies mature.^[1][2]

In the early years of the fund, a number of factors contribute to negative returns including management fees, investment costs and under-performing investments that are identified early and written down. Over time the fund will begin to experience unrealized gains followed eventually by events in which gains are realized (e.g., IPOs, mergers and acquisitions, leveraged recapitalizations).^[3]

Historically, the J-Curve effect has been more pronounced in the US, where private equity firms tend to carry their investments at the lower of market value or investment cost and have been more aggressive in writing down investments than in writing up investments. As a result, the carrying value of any investment that is underperforming will be written down but the carrying value of investments that are performing well tend to be recognized only when there is some kind of event that forces the private equity firm to mark up the investment.^[4]

The steeper the J curve, the quicker cash is returned to investors. A private equity firm that can make quick returns to investors provides investors with the opportunity to reinvest that cash elsewhere. Of course, with a tightening of credit markets, private equity firms have found it harder to sell businesses they previously invested in. Proceeds to investors have reduced. J curves have flattened dramatically. This leaves investors with less cash flow to invest elsewhere. For example, in other private equity firms. The implications for private equity could well be severe. Being unable to sell businesses to generate proceeds and fees means some in the industry have predicted consolidation amongst private equity firms.^[5]

[edit] Balance of trade model

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In economics, the 'J curve' refers to the trend of a country’s trade balance following a devaluation or depreciation. A higher exchange rate initially means imports are more expensive, or equivalently exports sell for less foreign currency, making the current account worse (a bigger deficit or smaller surplus). After a while, though, the volume of exports will start to rise because of their lower more competitive prices to foreign buyers, and domestic consumers will buy fewer of the costlier imports. Eventually, the trade balance should improve on what it was before the devaluation. If there is a currency revaluation or appreciation there may be an inverted J-curve.

Following the depreciation or devaluation of the currency, the volume of imports and exports will remain level due in part to pre-existing contracts for imported goods that have to be honoured. However, the depreciation will cause the price of imports to rise and the price of exports to fall. Therefore, total spending on imports will subsequently increase and total spending on exports will decrease. It is this that causes the worsening of the current account.

Moreover, in the short run, demand for the more expensive imports remain price inelastic. This is due to time lags in the consumer's search for acceptable, cheaper alternatives. As a result, the quantity demanded for imports remain the same, although consumers are now paying a higher price for it. Ceteris paribus, a worsening of the current account, and hence the balance of payments, is to be expected in the short run.

Over the longer term a depreciation in the exchange rate can have the desired effect of improving the current account balance. Demand for exports picks up and domestic consumers will switch their expenditure to domestic products and away from expensive imported goods and services. Equally, many foreign consumers may switch to purchasing cheaper imported products instead of their own domestically produced goods and services.

Empirical investigations of the J-curve have sometimes focused on the the effect of exchange rate changes on the trade ratio, i.e. exports divided by imports, rather than the trade balance, exports minus imports. Unlike the trade balance, the trade ratio can be logged regardles of whether a trade deficit or trade surplus exists.^[6]

[edit] Country status model

Another 'J-Curve' refers to the correlation between stability and openness. This theory was suggested initially by the author Ian Bremmer, in his book The J Curve: A New Way to Understand Why Nations Rise and Fall.

The x-axis of the political J-Curve graph measures the 'openness' of the economy in question and the y-axis measures the stability of that same state. It suggests that those states that are 'closed'/undemocratic/unfree (such as the Communist dictatorships of China and Cuba) are very stable; however, as one progresses right, along the x-axis, it is evident that stability (for relatively short period of time in the lengthy life of nations) decreases, creating a dip in the graph, until beginning to pick up again as the 'openness' of a state increases; at the other end of the graph to closed states are the open states of the West, such as the United States of America or the United Kingdom. Thus, a J-shaped curve is formed.

States can travel both forward (right) and backwards (left) along this J-curve, and so stability and openness are never secure. The J is steeper on the left hand side, as it is easier for a leader in a failed state to create stability by closing the country than to build a civil society and establish accountable institutions; the curve is higher on the far right than left because states that prevail in opening their societies (Eastern Europe, for example) ultimately become more stable than authoritarian regimes.

Bremmer's entire curve can shift up or down depending on economic resources available to the government in question. So Saudi Arabia's relative stability at every point along the curve rises or falls depending on the price of oil; China's curve analogously depends on the country's economic growth.

[edit] Medicine

In medicine, the 'J-curve' refers to a graph in which the x-axis measures either of two treatable symptoms (blood pressure or blood cholesterol level) while the y-axis measures the chance that a patient will develop cardiovascular disease (CVD). It is well known that high blood pressure or high cholesterol levels increase a patient's risk. What is less well known is that plots of large populations against CVD mortality often takes the shape of a J curve which indicates that patients with very low blood pressure and/or low cholesterol levels are also at increased risk.^[7]

[edit] Political science (Model of revolutions)

In political science, the 'J-curve' is part of a model developed by James Chowning Davies to explain political revolutions. Davies asserts that revolutions are a subjective response to a sudden reversal in fortunes after a long period of economic growth, which is known as relative deprivation. Relative deprivation theory claims that frustrated expectations help overcome the collective action problem, which in this case may breed revolt. Frustrated expectations could result from several factors, including growing levels of inequality within a country, which may mean those who are increasingly poor relative to the rich are getting less than they expected, or a period of sustained economic development, lifting general expectations, followed by a crisis.

This model is often applied to explain social unrest and efforts by governments to contain this unrest. This is referred to as the Davies' J-Curve, because economic development followed by a depression would be modeled as an upside down and slightly skewed J.

[edit] References