Category Archives: Exchange Rates

Commodity Currency – Aussie dollar overvalued.

Below is a video from the FT that I showed my A2 class this morning. The significance of it is the Australian dollar and how its value is strongly linked to iron ore prices. Recent growth in China has exceeded expectations and this has led to a rebound in commodity prices especially iron ore. The belief is the AUS$ is higher than the equilibrium level suggests and that this rate will not be sustainable. There are two reasons for this:

  1. Commodity prices have accelerated which has led to more demand for AUS$ which might not be sustained.
  2. Higher relative interest rates has made the AUS$ strong as ‘hot money’ has been attracted in the country. The Reserve Bank of Australia (central bank) has recently cut the cash rate (interest rates) to 1.75% and there is talk of a further cut this year.

A Level Revision – Fixed, Dirty Float Exchange Rate Systems

For many years after the Second World War most countries operated a system of fixed exchange rates. The external value of a currency was fixed in terms of the US$ and the value of the US$ itself was fixed in terms of gold. In effect, therefore, the values of the currencies were fixed in terms of gold. The ‘fixed’ rate was not absolutely rigid. The value of a currency was allowed to vary within a narrow band of 1 or 2% on each side of the ‘fixed’ rate or parity. For example, if the value of the NZ$ were fixed at NZ$1 = US$0.50, a permitted deviation of 2% would allow it to vary between NZ$1 = US$0.51 and NZ$1 = US$0.49. These limits are often described as ‘the ceiling’ and ‘the floor’. Central banks were responsible for maintaining the values of their currencies within the prescribed bands. They are able to do this by acting as buyers or sellers of the currency in the foreign exchange market. For this purpose each central bank must have a fund containing supplies of the home currency and foreign currencies.

The way in which the Reserve Bank of New Zealand can use its funds of currencies to influence the exchange rate can be explained by making use of the diagram below. Let us assume that the value of the NZ$ has been fixed at A and, initially, the market is in equilibrium at this exchange rate. The permitted band of fluctuation is PP1 and the value of the pound must be held within these limits. A large increase in imports now causes an increase in the supply of NZ$’s in the foreign exchange market. The supply curve moves from SS to S1S1 causing a surplus of NZ$’s at the ‘fixed’ rate (A). If no intervention takes place, the external value of the
NZ$ will fall to B which is below the permitted ‘floor’.

The Reserve Bank will be obliged to enter the market and buy NZ$. In doing so that will shift the demand curve to the right and raise the value of the NZ$ until it is once again within agreed limits. In the diagram below intervention by the Reserve Bank of NZ has raised the exchange rate to C.

Managed ER

When the Reserve Bank of New Zealand is buying NZ$’s, it will be using up its reserves of foreign currencies; when buying NZ$’s it exchanges foreign currencies for NZ$’s. ‘Supporting the NZ dollar’, that is, increasing the demand for NZ$’s, therefore leads to a fall in the nation’s foreign currency reserves. In the opposite situation where an increased demand for NZ$’s tends to lift the value of the NZ$ above the permitted ‘ceiling’, the central bank will hold down its value by selling NZ$’s. This will increase the supply of NZ$’s and lower the exchange rate. When the Reserve Bank is selling NZ$’s it will be increasing its holdings of foreign currencies.

The main argument for a fixed exchange rate is the same as that against a floating rate. A fixed rate removes a major cause for uncertainty in international transactions. Traders can quote prices which will be accepted with some degree of confidence; buyers know that they will not be affected by movements in the exchange rate. The risks associated with international trade are lessened and this should encourage more trade between nations and more international borrowing and lending.

New Zealand inflation not expected to hit 2% until March 2018

Today Graeme Wheeler the RBNZ governor announced at 0.25% cut in the OCR – now 2.25%. He listed the following reasons for the cut:

  • Significant fall in inflationary expectations. The RBNZ has forecast that inflation will only reach 0.5% by September this year and 2% in March 2018. Since the GFC in 2008 weak inflation has been prevalent in the world economy and with the collapse in oil prices it has got weaker in the second half of last year.
  • Globally there is also decline in core inflation – a measure of inflation that excludes certain items that face volatile price movements. Therefore there is little or no imported inflation to talk about. A depreciation of the $NZ could mean an increase in the price of imports but would make New Zealand exports more price competitive – something that Graeme Wheeler is keen on given the weakness of New Zealand export prices.
  • A decline in the global outlook – interest rate cuts in Japan, EU and the UK accompanied by weaker growth in China. See graph below of Central Bank rates.

Surprisingly enough he said that the lower Fonterra milk payout was not a major factor in the bank’s decision as it was just a reflection of weaker global demand. Graeme Wheeler did suggest that one more rate cut might be on the cards – ‘monetary policy will continue to be accommodative’

CB rates

History of the Renminbi

Below is a very good video from the FT which outlines the growth of the Chinese currency – the Renminbi (RMB). It includes some excellent graphics including the value of the currency against the US$ from 2005 – 2015 (see graphic below)

  • 1948 – RMB was put into circulation by the Communist party
  • 1997 – RMB was pegged to the US$
  • 2005 – Peg was removed
  • 2009 – China allowed approved companies to settle trade payments with non-Chinese customers using the RMB
  • 2015 – 20% of China foreign trade is settled in RMB compared to 3% in 2010
  • 2015 – RMB the 5th most traded currency although it is a long way behind US$ and €

The Chinese authorities want to have the RMB included in the basket of currencies that make up the IMF’s special drawing rights. This would mean an official endorsement of the RMB as a reserve currency. However one of the conditions of the IMF of being a reserve currency is that it must be freely tradable. Although the Chinese government is reducing its interventionist approach it is not yet ready to give market forces complete free rein over its exchange rate.

Renmimbi

China – Economic uncertainty in 2016

China’s outlook in 2016 looks to be more complicated than ever. Consider the following:

1. The data out of China is difficult to measure and the economy remains soft like 2015

2. The Chinese authorities are unlikely to support any further credit stimulus as the corporate sector is already one of the highest leveraged in the world – see graph. However they have allowed the Yuan to devalue (1.5% this year so far) in order to help the export market

3. China’s foreign reserves have decreased significantly as locals and foreign investors take money out of China – the Yuan would have fallen further is it wasn’t for foreign exchange intervention.

4. Investors are wanting to exit the stockmarket – 12% down in 2016. This figure would have been higher if authorities didn’t curb the trading and buying of stocks. Although the stockmarket is down 40% from its mid 2015 high it is basically unchanged from a year ago.

The Chinese economy needs more stimulus and that the currency and stockmarket should fall further – a lower currency would also support growth. On a positive side low Government debt and vast foreign exchange reserves are the ammunition to tackle the downside economic risks.

Source: NAB – Australian Markets Weekly – 11th January 2016

China Corporate debt

 

AS and A2 Macroeconomics: Internal and External Balances

In explaining the differences between internal and external balances I came across an old textbook that I used at University – Economics by David Begg. It was described as ‘The Student’s Bible” by BBC Radio 4 and I certainly do refer back to it quite regularly. Part 4 on macroeconomics has an informative diagram that shows the impact of booms and recessions on the internal and external balances.

Internal Balance – when Aggregate Demand equals Aggregate Supply (potential output). And there is full employment in the labour market. With sluggish wage and price adjustment, lower AD causes a recession. Only when AD returns to potential output is internal balance restored.

External Balance – this refers to the Current Account balance. The country is neither underspending nor overspending its foreign income. For a floating exchange rate, the total balance of payments is always zero. Since the balance of payments is the sum of the current, capital, and financial accounts, saying the current account is in balance then also implies that the sum of the capital and financial accounts are in balance.

In the diagram right the point of internal and external balance is the intersection of the two axes, with neither boom nor slump, and with neither a current account surplus nor a deficit.

The top left-hand quadrant shows a combination of a domestic slump and a current account surplus. This can be caused by a rise in desired savings or by an adoption of a tight fiscal policy and monetary policy. These reduce AD which cause both a domestic slump and a reduction in imports.

The bottom left-hand corner shows a higher real exchange rate, which makes exports less competitive, reduces export demand and raises import demand. The fall in net exports induces both a current account deficit and lower AD, leading to a domestic slump.

In a downturn a more expansionary fiscal and monetary policy can hasten the return to full employment eg. Quantitative easing, tax cuts, lower interest rates. However one could say that today it doesn’t seem to be that effective.

Winners and losers from China currency depreciation

On Thursday last week the Chinese authorities cut the reference rate for Yuan against the US$. This cut was the third is as many days and the central bank of China put the yuan’s central parity rate at 6.4010 yuan for US$1, the China Foreign Exchange Trade System said, a drop of 1.11% from the previous day’s 6.3306. The currency can only trade 2 percent above or below the yuan’s central parity rate. Still, the visible hand of the state isn’t going to disappear completely.

Winners with a cheaper yuan
1. Chinese exporters are more competitive abroad.
2. Foreign consumers of Chinese products – imported products are more affordable.
3. China’s case for becoming a reserve currency could be bolstered by letting markets determine the exchange rate.

Losers
1. Chinese companies that have debt denominated in dollars, or buy things in dollars
like Chinese airlines, or other businesses that rely on imported oil.
2. Companies that compete with Chinese firms – including those in neighboring countries.
3. Companies that depend on exports to China – like the makers of luxury goods and mining companies.
4. Anyone worried about weak inflation in the U.S. or Europe

Yuan deprec

Source: New York Times

Nigeria defend their currency by banning toothpick imports

TothpicksStill on the theme of defending exchange rates and Africa, the Central Bank of Nigeria (CBN) is desperate to defend its currency (the naira) as it has been hit hard by the dramatic fall in the price oil, Nigeria’s main export. Over the last year the naira has fallen by approximately 20% against the US dollar. Instead of letting the currency depreciate the CBN are trying to defend it by blocking imports and therefore decreasing the supply of naira on the foreign exchange market. Foreign reserves have fallen by about 20% and can only cover about 6 months of imports. The CBN is not issuing any foreign reserves for a range of imports that include: Indian incense; wire rods; rice; tined fish and believe it or not toothpicks. They are also not issuing foreign currency for the importation of private jets – I wonder who would import them?

It is usual for central bankers to protect their currencies when they are concerned about inflation or they allow them to depreciate to make exports prices more competitive and imports more expensive. However, it seems that Nigeria wants an uncompetitive exchange rate and higher inflation.
Source: The Economist

Low interest rates but not the case in Uganda?

Major central banks around the world have maintain interest rates at record low levels since the global financial crisis in 2008. However, yesterday the Bank of Ugandan (Central Bank) increased its benchmark interest rate by 150 basis points to 14.5% in order to protect the currency and ease inflationary pressure. However interest rates did reach 23% in January 2012. The Bank of Uganda has intervened in the foreign exchange market to the extent that foreign reserves have decreased in the last year by 17% to US$2.8 billion but have been forced to increase interest rates as an alternative. Uganda is Africa’s biggest exporter of coffee with a current inflation rate of 4.9%. How some developed countries would love to have a bit of inflation.

BOU interest rates

Source: Trading Economics