What is a J curve?
A J-curve is a trend line that shows an initial loss immediately followed by a dramatic gain. In a graph, this activity model would take the form of a capital “J”.
The effect of the J-curve is often cited in economics to describe, for example, how a country’s trade balance initially worsens following a currency devaluation, then quickly recovers and exceeds finally his previous performances.
J-curves are observed in other fields, notably medicine and political science. In each case, it represents an initial loss followed by a significant gain at a level that exceeds the starting point.
Understanding the J curve
The J curve is useful for demonstrating the effects of an event or action over a defined period of time. In other words, it shows that things will get worse before they get better.
Key points to remember
- A J-curve illustrates a trend that begins with a sharp decline and is followed by a dramatic increase.
- The trend line ends with an improvement from the starting point.
- In economics, the J-curve shows how a depreciation of the currency causes a serious aggravation of a trade imbalance followed by a substantial improvement.
In economics, it is often used to observe the effects of a weaker currency on trade balances. The diagram is as follows:
- Immediately after the devaluation of a country’s currency, imports become more expensive and exports become cheaper, which creates a worsening of the trade deficit (or at least a smaller trade surplus).
- Shortly after, the country’s export sales volume began to increase steadily, thanks to their relatively cheap prices.
- At the same time, consumers at home are starting to buy more local products because they are relatively affordable compared to imports.
- Over time, the trade balance between the nation and its partners rebounds and even exceeds the periods prior to the devaluation.
The devaluation of the national currency had an immediate negative effect due to an inevitable delay in meeting increased demand for the country’s products.
When a country’s currency appreciates, note economists, an inverted J curve can occur. The country’s exports suddenly become more expensive for the importing countries. If other countries can meet the demand for a lower price, the stronger currency will reduce its export competitiveness. Local consumers can also turn to imports as they have become more competitive with local products.
The J curve in Private Equity
The term J curve is used to describe the typical trajectory of investments made by a private equity firm.
The J curve is a visual representation of the simple fact that sometimes things will get worse before they get better.
Private equity firms have a different route to profitability than public companies or the funds that invest in them.
Their portfolios, by design, are made up of companies whose performance was poor when they were purchased. The company then spends significant sums to reorganize the business before transforming it into a renewed business.
This means an initial drop in performance followed, at least theoretically, by a sharp improvement in performance.