Category Archives: Exchange Rates

The Pound, the Exchange Rate Mechanism (ERM) and George Soros pockets $1bn

Teaching  exchange rates with my AS Level class and couldn’t get away from the events in Britain on the 16th September 1992 – known as Black Wednesday. On this day the British government were forced to pull the pound from the European Exchange Rate Mechanism (ERM). The video below explains the drama that unfolded very well.

Background

The Exchange Rate Mechanism (ERM) was the central part of the European Monetary System (EMS) and its purpose was to provide a zone of monetary stability – the ERM was like an imaginary rope (see below), preventing the value of currencies from soaring too high or falling too low in relation to one another.

It consisted of a currency band with a ‘Ceiling’ and a ‘Floor’ through which currencies cannot (or should not) pass and a central line to which they should aspire. The idea is to achieve the mutual benefits of stabel currencies by mutual assistance in difficult times. Participating countries were permitted a variation of +/- 2.25% although the Italian Lira and the Spanish Peseta had a 6% band because of their volatility. When this margin is reached the two central banks concerned must intervene to keep within the permitted variation. The UK persistently refused to join the ERM, but under political pressure from other members agreed to join “when the time is right”. The Chancellor decided that this time had come in the middle of October 1990. The UK pound was given a 6% variation

Black Wednesday

Although it stood apart from European currencies, the British pound had shadowed the German mark (DM) in the period leading up to the 1990s. Unfortunately, Britain at the time had low interest rates and high inflation and they entered the ERM with the express desire to keep its currency above 2.7 DM to the pound. This was fundamentally unsound because Britain’s inflation rate was many times that of Germany’s.

Compounding the underlying problems inherent in the pound’s inclusion into the ERM was the economic strain of reunification that Germany found itself under, which put pressure on the mark as the core currency for the ERM. Speculators began to eye the ERM and wondered how long fixed exchange rates could fight natural market forces. Britain upped its interest rates to 15% (5% in one day) to attract people to the pound, but speculators, George Soros among them, began heavy shorting* of the currency. Spotting the writing on the wall, by leveraging the value of his fund, George Soros was able to take a $10 billion short position on the pound, which earned him US$1 billion. This trade is considered one of the greatest trades of all time.

* In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to that third party. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than it received on selling them. Wikipedia.

Impact of an appreciating currency

Currently looking at exchange rates with my AS class. Below is a mindmap showing the causes and effects of a rise in the value of a currency. Also looks at how a rise in the currency may reduce inflationary pressure. Good for revision purposes when dealing with exchange rates and trade. Also gives a structure for essay questions / long answers in CIE and NCEA respectively.

Adapted from CIE A Level Revision by Susan Grant.

US dollar – journey to reserve currency status and where to from here?

From CNBC – a short history of how the US dollar became the reserve currency and could that status be under threat. The main points from the video are:

  • how investors rush to buy US$ during crisis times
  • the history behind the gold standard
  • 88% of foreign exchange transactions are done in US$
  • Could other currencies threaten the US$ as the global reserve currency?
  • Central banks have added the Chinese Yuan as part of its reserves.
  • European autonomy is being mooted so that they are independent of payment channels in the US$
  • Holdings of of US$ reserves in the global banking system – see image below

Dollar vs Renminbi for reserve currency status

In doing most introductory courses in economics you will have come across the four functions of money which are:

  • Medium of exchange
  • Unit of Account
  • Store of Value
  • Means of deferred payment

Since the Bretton Woods Agreement in 1944 the US dollar was nominated as the world’s reserve currency and ranks highly compared to other currencies in the above functions. As a medium of exchange the US dollar is very prevalent:

  • 60% of the world’s currency reserves are in US dollars
  • 50% of cross-border interbank claims
  • After the GFC, purchases of the US dollar increased significantly – store of value.
  • Around 90% of forex trading involves the US dollar
  • Approximately 40% of the world’s debt is issued in dollars
  • In 2018 banks of Germany, France, and the UK held more liabilities in US dollars than in their own domestic currencies.

Is the Yuan challenging the US dollar for reserve currency status?
In 2015 Chinese authorities were keen on the currency going global and the following points would indicate this.

  • Deposits in renminbi = 1trn renminbi = US$144bn
  • Yuan transactions have grown in Taiwan, Singapore, Hong Kong and London.
  • Investment by Chinese firms into Belt and Road project = US$3.75bn which was in the renminbi
  • China settles 15% of its foreign trade in renminbi
  • France settles 20% of its trade with China in renminbi
  • 2018 – Shanghai sock market launched yuan-denominated oil futures.
  • The IMF suggest that the ‘yuan bloc’ accounts for 30% of Global GDP – the US$ = 40%

However as reported by the FT – see video below – the goal of reserve currency status was made more complex by the decision to maintain a loose peg to the US dollar. This means that the value of the renminbi would follow the non-specific value of the US dollar. So when the US dollar appreciated so did the renminbi and with a higher exchange rate Chinese exports became more expensive. This led the People’s Bank of China to intervene and devalue the currency by approximately 2% in 2015 – a weaker currency makes exports cheaper.

How do the Peoples Bank of China set the Yuan’s value?
Basically at 9.15am the Peoples Bank of China (Central Bank) and the SAFE (State Administration for Foreign Exchange) issues a circular to all the trading banks stating that this is the exchange of the renminbi to the US$ for today.

However this panicked investors who off-loaded their renminbi assets and sent its value downward. The reaction of China was to impose strict capital controls to stabilise the currency. But since the end of 2015 there has been a Chinese foreign exchange policy with the market forces of supply and demand being more prevalent. Nevertheless, there is still a long way to go before the renminbi is a freely floating exchange rate and the benefits that come with it.

Is China still influencing the value of the yuan?

I have blogged quite a bit on this topic and refer back to a very good video clip from PBS Newshour on how the Chinese authorities influenced the value of the yuan back in 2010.

Basically at 9.15am the Peoples Bank of China (Central Bank) and the SAFE (State Administration for Foreign Exchange) issues a circular to all the trading banks stating that this is the exchange of the Renminbi to the US$ for today. When companies sell goods overseas the US$ etc that they acquire are then exchanged for Renminbi with the Central Bank – therefore the Central Bank accumulates significant amounts of US$.

Today it could be said that China has done well economically relative to other countries largely due to its large trade surplus. However one would think that with a large trade surplus the yuan would increase in value as there is a greater demand for the currency in order to buy China’s exports. This raises the question as to whether China has been manipulated its currency in order to maintain its competitive edge in the export market.

  • When a country’s currency is getting too strong the governments/central banks sells its own currency and buys foreign currency – usually US$.
  • When a country’s currency is getting too weak the governments/central banks sells its foreign currency – usually US$- and buys its own currency.

For two decades until mid-2014 China’s prodigious accumulation of foreign-exchange reserves was the clear by-product of actions to restrain the yuan, as the central bank bought up cash flowing into the country. A sharp drop in reserves in 2015-16 was evidence of its intervention on the other side, propping up the yuan when investors rushed out. Since then, China’s reserves have been uncannily steady. This year they have risen by just 1%. Taken at face value, the central bank seems to have refrained from intervening. That is certainly what it wants to convey, regularly describing supply and demand for the yuan as “basically balanced”.
Source: The Economist – “Caveat victor” – October 31st 2020

With the surge in China’s trade surplus the yuan has remained fairly stable and with this you would expect that there would be an increase in foreign exchange reserves with Chinese authorities buying foreign exchange with yuan.

A couple reasons why this may not be the case:

  • Commercial banks foreign assets have increased by US$125bn since April. The commercial banks are state owned so it is plausible that the government has used them as a substitute. Adding these foreign reserves to the offical figures suggests invention to keep the yuan at an artificially lower rate. There is the possibility that the central bank has special trading accounts at the state banks. Also exporters have wanted to keep their US$ as they are worried that the disharmony with the US could damage the yuan.
  • The central bank made it cheaper to short the yuan in forward trades – shorting a currency means that the trader believes that the currency will go down compared to another currency.
  • Chinese officials want the yuan to be volatile but within a narrow range in order to convince other countries that they are not intervening whilst persuading people in the market that they will intervene if necessary.

Caught between a rock and a hard place

The Peoples Bank of China (PBOC) are trying to protect domestic producers by keeping a weak yuan so to make Chinese products attractive to overseas buyers. At the same time they are trying to prevent domestic capital from flowing too quickly out of China to stronger currencies. However a longer term scenario is that China would like the yuan to be more prevalent as a currency in the global market. The yuan currently accounts for approximately 2% of global foreign exchange reserves, although by 2030 it is estimated that it will account for 5% to 10% of global foreign exchange reserve assets.

Source: The Economist – “Caveat victor” – October 31st 2020

OCR – LSAP – FLP = New Zealand’s Monetary Policy Toolkit

Below is a useful flow diagram from the ANZ bank which adds Large Scale Asset Purchases (LSAP) and Funding for Lending Programme (FLP) to the Official Cash Rate (OCR – Base Rate)

LSAP – this is the buying of up $100 billion of government bonds – quantitative easing
FLP – this gives banks cheap lending based on the Official Cash Rate – could be about $28 billion based on take up
OCR – wholesale interest rate currently at 0.25%. Commercial banks borrow at 0.5% above OCR and can save at the Reserve Bank of New Zealand (RBNZ) at 1% below OCR.

With FLP and more LSAP this will mean lower lending rates and deposit rates. This should provide more stimulus in the economy and allay fears of future funding constraints making banks more confident about lending. Add to this a third stimulus – an OCR of 0.25%. The flow chart shows the impact that these three stimulus policies have on a variety of variables including – exchange rates – inflation -unemployment – consumer spending – investment – GDP. Very useful for a class discussion on the monetary policy mechanism.

AS Level Revision – Floating Exchange Rates

Being doing a Cambridge revision course this week and this is an area that I covered today. Below is a useful graphic explaining how the demand for exports impacts the currency of the importer and exporter – US$ and Euro.

In theory, an advantage of a floating exchange rate is that it will automatically correct any tendency for the balance of payments to move into surplus or deficit.The following sequence of events shows how this automatic correction is supposed to work.

• Assume the NZ balance of payments is initially in equilibrium.
• Assume now that export values remain unchanged, but an increased demand for $ tends to move the NZ B of P into a deficit.
• This increased demand for imports will increase the supply of dollars in the foreign exchange market.
• The external value of the dollar will fall and this will make exports cheaper and imports dearer.
• The changes in the relative prices of exports and imports will increase the volume of exports and reduce the volume of imports and the B of P will be brought back into equilibrium.

In practice it may not work out like this because the supplies of exports and imports may be slow to adjust to the price changes. For example, if the prices of exports fall, it may take considerable time before the increased quantities demanded can be supplied. There are also problems associated with the elasticities of demand for exports and imports. A 10% fall in the prices of exports will not increase the amount of foreign currency earned unless the quantities demanded increase by more than 10%. A further problem is that a depreciation of the pound increases import prices and, since New Zealand imports a large amount of raw materials and manufactures, this has the effect of raising the cost of living and the costs of production in many industries.

A disadvantage of the system of floating exchange rates is the fact that greatly increases the risks and uncertainties in international trade.

For example, an Auckland manufacturer of cotton cloth may be quoted a firm US$ price by his American supplier, payment due, say, in 3 months. He will still not be certain of the costs of his cotton because he does not know what the US$-NZ$ exchange rate will be when he comes to make payment.

If he is quoted US$500 for a bale of cotton and the exchange rate stands at:
NZ$1 = US$0.56, a bale of cotton will cost him NZ$892.86.

If, however, by the time he comes to make payment, the exchange rate has moved to:
NZ$1 = US$0.53, a bale of cotton will cost him NZ$943.40.

Speculators remove some of this uncertainty by operating a forward exchange market where they guarantee to supply foreign currency at some future date at a price agreed now. A perfectly free market in foreign currency is not likely to be found in the real world. Even when currencies are said to be floating, governments tend to intervene in the market to smooth out undesirable fluctuations. The central bank (Reserve Bank in NZ) is responsible for this type of intervention and the way it operates is explained in the next section.

Advantages of a Strong Dollar

• A high NZ$ leads to lower import prices – this boosts the real living standards of consumers at least in the short run – for example an increase in the real purchasing power of NZ residents when traveling overseas
• When the NZ$ is strong, it is cheaper to import raw materials, components and capital inputs – good news for businesses that rely on imported components or who are wishing to increase their investment of new technology from overseas countries. A fall in import prices has the effect of causing an outward shift in the short run aggregate supply curve
• A strong exchange rate helps to control inflation because domestic producers face stiffer international competition from cheaper imports and will look to cut their costs accordingly. Cheaper prices of imported foodstuffs and beverages will also have a negative effect on the rate of consumer price inflation.

Disadvantages of a Strong Dollar

• Cheaper imports leads to rising import penetration and a larger trade deficit e.g. the increasing deficit in goods in the NZ balance of payments in 2011
• Exporters lose price competitiveness and market share – this can damage profits and employment in some sectors. Manufacturing industry suffered a steep recession in 2011 partly because of the continued strength of the NZ$, leading to many job losses and a sharp contraction in real capital investment spending and the lowest profit margins in manufacturing industry for over a decade
• If exports fall, this has a negative impact on economic growth. Some regions of the economy are affected by this more than others. The rural areas are affected by a strong dollar in that our produce becomes more expensive to overseas buyers.

GDP comparison between countries and Big Mac Index worksheet

Here is something that I use with my Year 12 & 13 Economics students when looking at the comparison between nominal GDP and PPP – NCEA Level 3 Growth external and CIE A2 Unit 4. I have found the worksheet that follows useful for students to workout the price of a Big Mac in US dollars in each country, the Big Mac exchange rate and compare it with the actual exchange. The table below gives the Nominal GDP in various countries expressed in US dollars. If you convert the value of GDP in local currency into one common currency (US$) it gives you a false idea of many countries’ economic status. The cost of different goods and services can vary widely – countries like China and India have much lower costs for most consumer items compared to more developed countries like the US and Germany. Therefore to make a more accurate comparison economists tend to use the purchasing power parity (PPP). This is a simple calculation where a base currency is chosen (usually US$) and a basket of goods and services is chosen. They are then compared to the value of the same items in another country using traditional exchange rates. However it is not as simple as that as countries use a wide variety of goods and services that are not the same or not as popular in certain countries.

Countries by Nominal GDP US$ – October 2019 (ranking is on Nominal GDP)

IMF’s World Economic Outlook Database, October 2019

*New Zealand’s GDP in NZ$ is approximately – NZ$ 314 billion (March 2020)

The Economist came up with the Big Mac index in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries. Here is something that I put together using the the Big Mac index from The Economist website. Students have to complete the table below.

The Big Mac Index – July 2020

  1. Complete the table above. In which country was their actual exchange rate on July 2020 closest to their Big Mac exchange rate?
  2. Which country’s currency is suggested by your calculations above as being
    a) the most undervalued against the dollar, and the most overvalued against the dollar?
  3. What factors could have an influence on exchange rate values on a given date as shown in the table above.
  4. In which country was their actual exchange rate on July 2020 closest to their Big Mac exchange rate?

You can check your answers and other countries Big Mac Index by going to The Economist’s website – click below:

https://www.economist.com/news/2020/07/15/the-big-mac-index