Category Archives: Exchange Rates

AS Revision – TWI and Floating Exchange Rates

Been doing some revision courses and today we looked at the TWI and floating exchange rates. The exchange rate measures the external value of the NZ$ in terms of how much of another currency it can buy. For example – how many pounds, US dollars or Euros you can buy with NZ$1000. The daily value is determined in the foreign exchange markets (FOREX) where billions of $s of currencies are traded every hour.

A large percentage of the dealing in currencies is purely speculative, that is to say, people trading dollars, yen, euros and sterling seeking to make a profit (or capital gain) from small fluctuations in currency values.

Trade Weighted Index (T.W.I.)

An index that measures the value of $NZ in relationship to a group (or “basket”) of other currencies. The currencies included are from NZ’s major export markets i.e. Australia, USA, Japan, Euro area, UK. – $A, $US, ¥, €, £. Each of the currencies included in the TWI is “weighted” according to how important exports to that country are (= % of total exports)

From the TWI we can see if the $NZ has appreciated or depreciated against our major trading partners currencies overall.

Free, Fluctuating, or Floating Exchange Rates
In a free market the rate of exchange is determined by the market forces of supply and demand. Where these conditions apply the exchange rate is said to free, fluctuating or floating. Therefore the following have a great impact on the rate of exchange in a free market:

An increase in the demand for the $NZ will result from more people wanting get or buy $NZ.

  • Increase in the value of exports
  • Increase in tourists traveling to NZ
  • Increase in foreign investment in NZ (buying assets / companies / depositing savings)
  • Increase in NZer’s taking out loans overseas

An increase in the supply for the $NZ will result from more people wanting get or buy other currencies (as they have to supply $NZ to the market to get the other currencies)

  • Increase in the value of imports
  • Increase in NZer’s travelling to other countries
  • Increase in NZ investment overseas
  • Increase in NZer’s repaying loans made overseas

Other Factors Effecting $NZ with a Floating Exchange Rate

  • Relative Inflation Rates e.g. if NZ’s inflation rate is higher than other countries then the price NZ’s exports will become relatively more expensive and NZ will lose competitiveness and exports will fall.
  • Income of countries NZ trades with e.g. Australia is in a recession – NZ exports
  • Tastes and Preferences e.g. world news, current events, fashion, trends, popularity effecting NZ’s exports e.g. Sept 11th and an increase in tourists to NZ
  • Access to Overseas Market e.g. trade restrictions (protectionist policies e.g. tariff, quotas and regulations) placed on NZ exports by other countries governments.
  • Relative Interest Rates e.g. if interest rates in NZ are higher than in other countries, then this will attract people to save in NZ banks, creating demand for the $NZ.

Argentina – will capital controls work?

Last week Argentina imposed currency controls on business to prevent money leaving the economy after the Argentinian Peso lost over 25% of its value since elections last month – see graphic. The central bank now require that:

  • exporters to repatriate earnings within 5 to 15 days
  • businesses will need permission to repatriate profits abroad or buy US dollars
  • residents are restricted to foreign exchange purchase of US$10,000 and non-residents US$1,000

With a track record of hyperinflation and financial crises, Argentinians are quick to sell their Pesos for US$ to maintain store value – with inflation and turmoil in an economy the local currency has less purchasing power. It is important for the Argentina government to restrict the demand for US$ and improve its ability to pay its significant debt – US$101bn. Capital controls have the aim of protecting the stability of the Peso and savers.

Will it work?

Although capital controls do stabilise the currency in a panic situation, they will only work in the long-term if they are used to confront the underlying macroeconomic problems in the economy itself. However, with Argentina’s inflationary issues coupled with fiscal deficits, capital controls are a band aid solution to the macroeconomic problems. Below is a very good video from the FT giving a background to the problems in Argentina.

China: currency manipulator or market forces?

A good summary from the FT – see video below. The Renminbi is permitted to trade 2 per cent on either side of a daily midpoint set by the People’s Bank of China (PBOC). This suggests that the PBOC still has significant control of the renminbi. 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$. It is then permitted to trade 2 per cent on either side of the midpoint rate. The midpoint set by the PBOC on Monday of Rmb 6.9225 was the lowest since December, when trade tensions were last at fever pitch. The PBOC blamed the tariffs and trade protectionist measures on Chinese goods as the reason why the exchange rate has depreciated.

But is China a currency manipulator? According to the US Treasury a country is a currency manipulator when it does the following 3 things

  • A significant bilateral trade surplus with the US.(Check! China’s got that.)
  • A material current account surplus of more than 3% of GDP.(China does not have that.)
  • Persistent one-sided intervention in its currency market.(China’s move on Monday doesn’t fit this bill, so no.)

But isn’t downward pressure on the Renminbi just part of the what happens to a currency when its economy starts to slow and it’s selling fewer exports.

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

Sources: FT and Business Insider

How George Soros almost broke the Bank of England and pocketed $1bn

Today I was 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 realtion 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.

Is it time to ‘short’ the Aussie dollar

Although I wrote recently on Australia avoiding the ‘resource curse’ this video from the FT suggests otherwise and that the Aussie Dollar in 2019 is going to be volatile. The slowing down of the Chinese economy accompanied by a trade dispute with the US has meant lower demand for the Aussie Dollar. Imports of commodities, especially iron-ore, have slowed as China recorded significant reduction in exports and imports in December last year – see graph below:

A lot will depend in the US Fed and its interest rate stance and whether with weaker inflationary pressure and a slowing economy there could be a drop in rates which would help the Aussie Dollar. The cother concern is the exposure that commercial banks have in the mortgage market. Housing has long been a favoured investment option in Australia and with the housing market slowing banks could be left exposed with defaults on mortgages. So is it time to dump the Aussie Dollar?

Falling exchange rate – causes and effects.

Aussie kick the resource curse

I have mentioned the ‘resource curse’ in many postings since starting this blog. It affects economies like in sub-Sahara Africa and Australia which have a lot of natural resources – energy and minerals. The curse comes in two forms:

  • With high revenues from the sale of a resource, governments try and seek to control the assets and use the money to maintain a political monopoly.
  • This is where you find that from the sale of your important natural resource there is greater demand for your currency which in turn pushes up its value. This makes other exports less competitive so that when the natural resource runs out the economy has no other good/service to fall back on.

The Australian economy did well at the height of the commodity boom in 2013 with iron ore, copper etc earning companies and the economy significant amounts of money. Investment in this area amounted to 9% of GDP in the same year with new mines, gas fields and infrastructure to cope with the increasing demand. But the collapse in commodity prices didn’t have the effect that suggest the resource curse. Countries like Venezuela – oil, Chile – copper, Nigeria – oil etc. have gone through turbulent times as commodity prices fall. Australia though has come through this period quite well for the following reasons:

  • falling investment in the mining sector has allowed the central bank to lower interest rates allowing other sectors, previously shut out, cheaper access to investment funds
  • the falling exchange rate – AUS$ lost 40% in value against US$ between 2011 – 2015 – made other elastic exports more competitive and this was particularly apparent in the tourism, education and construction sectors.
  • Tourism – spending by tourists increased by 43% from 2012 and amounted to AUS$21bn in the year ending March 2018.
  • Education – overseas student numbers increased from 300,000 in 2013 to 540,000 in 2018. Each year they contribute AUS$40bn.
  • Construction – firms have completed projects worth AUS$29bn in the 4th quarter of 2017 which compares with AUS$20bn in the 1st quarter of 2012. The Foreign Investment Board approved AUS$72bn worth of residential-property purchases in 2016, up from AUS$20bn in 2011.

Australia GDP Annual Growth Rate – 2010-2018

Source: Trading Economics

So despite the end of the resources boom the Australian economy’s GDP per annum hasn’t fallen below 2.4% – see GDP graph. Furthermore, Australia ranks as the 14th largest economy on the globe but ranks 7th regarding the volume of foreign investment and this ranking has risen despite the end of the resources boom. Prudent fiscal measures and a sound monetary policy have also played their part in a resilient Aussie economy.

Brexit and New Zealand’s trade with the UK and the EU

The impact of Brexit on New Zealand depends on what kind of exit agreements are reached between the UK and the European Union. The published provisional deal includes a transition period which runs until the end of 2020. During this time, existing trade conditions for third parties (such as New Zealand) will continue. Below are tables showing the trade relationship between New Zealand and both the EU and the UK. The benefits of two way trade with the EU outweigh those of the UK – US$23,273m against that of the US$5,640m

March 2018 – New Zealand’s total trade balance was a surplus of $4.0 billion in the year – this surplus is up $1.3 billion from the trade surplus in the year ended March 2017.
Total exports of goods and services were $78.0 billion, while total imports were $73.9 billion.

China ($15.3 billion) and Australia ($13.9 billion) were the top export destinations.
The European Union ($13.4 billion) and Australia ($12.1 billion) were the top import sources.

Dairy products and logs to China were New Zealand’s top two export commodities by destination, earning $4.0 billion and $2.6 billion, respectively. This was followed closely by spending by visitors from the European Union ($2.2 billion) and Australia ($2.1 billion).

New Zealand’s negotiations

New Zealand is in negotiations with the UK over a FTA. According to New Zealand Foreign Affairs and Trade NZ wants the following from a FTA:

  • Removing tariffs and other barriers that restrict the free flow of goods between our two countries
  • Making it easier for traders of all sizes to do business in the UK, including services exporters
    Strengthening  cooperation and dialogue with the UK in a variety of trade and economic fields
  • Reflecting our goals including progress on gender equality,  indigenous rights,  climate change, and improved environmental outcomes.
  • Some key areas in which we will be seeking even closer cooperation with the UK under the FTA include:
  • High quality primary sector and goods access to the UK’s market, such as for meat, mechanical machinery and equipment, fruit, pharmaceuticals, forestry, dairy and wine
  • Helpful conditions for investment and services providers who operate between the two countries
  • Commitments on progressive trade issues including environmental and labour protections, indigenous rights and gender equality.

Sources:

  • Parliamentary Library Monthly Economic Review – December 2018.
  • New Zealand Foreign Affairs and Trade. 

https://www.mfat.govt.nz/en/about-us/work-with-us/vacancies/

 

 

Turkey’s economy – stuffed

Inflation at 25%, Central Bank interest rates at 24%, Lira down 30% in value since the start of the year. What hope is there for the Turkish economy?

Wages and salaries haven’t kept pace with inflation and the reduction in demand has led to higher unemployment. There is pressure on the central bank to keep interest rates to avoid the lira collapsing. However this makes it expensive for businesses to borrow money and thereby reducing investment and ultimately growth.

No pain no gain – there is no alternative for Turkey other than undertaking painful and unpopular economic reforms. Remember what Reagan said in the 1980’s “If not now, when? If not us, who?”  He was referring to the stagflation conditions in the US economy at the time and how spending your way out of a recession, which had been the previous administration’s policy, didn’t work.

In order to the economy back on track things will need to get worse but President Erdogan has the time on his hands as there is neither parliamentary nor presidential elections in the next five years. This longer period should allow him the time to make painful adjustments without the pressure of elections which usually mean more short-term policies for political gain. Beyond stabilising the lira, which helped to ease the dollar-debt burden weighing on the country’s banks and corporate sectors, the 24 per cent interest rate level the central bank imposed also brought about a long-overdue economic adjustment. A cut in interest rates discourage net inflows of investment from foreigners and the resulting depreciation would accelerate the concerns about financial stability and deteriorating business and consumer confidence. Below is a mind map as to why a rise in the exchange rate maybe useful in reducing inflation.

Why dearer oil impacts developing economies more.

It wasn’t long ago that $100 for a barrel of oil was the norm but with the advent of the shale market the production increased which depressed prices. It was felt that the flexibility of large scale shale production from the USA could act as a stabiliser to global oil prices.

Oil shocks – supply or demand?

Oil shocks are not all the same. They tend to be associated with supply issues caused by conflict or OPEC reducing daily production targets. In the case of an increase in global growth there is the demand side for oil which increases the price. However this doesn’t have a great effect as in such cases the rising cost of imported oil is offset by the increasing export revenue. However today’s increase has a bit of both:

Demand – global consumption has increased as the advanced economies recover after the GFC especially China
Supply – supply constraints in Venezuela from the economic crisis. Also tighter American sanctions on Iran and OPEC producers are not increasing supply with the higher price.

Higher oil prices do squeeze household budgets and therefore reduce demand. Lower prices are expected to act as a stimulus to consumer spending but it can also have negative effects on the petroleum industries.

Emerging economies the impact of higher oil prices

Oil importing emerging economies are badly impacted by higher oil prices:

  • Terms of trade deteriorate as the price of their imports rise relative to their exports
  • Exports pay for fewer imports = importers’ current-account deficits widen.
  • Normally this leads to a depreciation a a country’s currency which makes exports cheaper and imports more expensive.

However this is not the case today. World trade is slowing and with it manufacturing orders therefore higher oil prices make the current account worse which in turn depreciates the exchange rate. For emerging economies who have borrowed from other countries or organisations a weaker exchange rate intensifies the burden of dollar-denominated debt. Companies in emerging economies have borrowed large amounts of money being spurred on by very low interest rates but they earn income in the domestic currency but owe in dollars – a weaker exchange rate means they have to spend more of their local currency to pay off their debt. Therefore indebted borrowers feel the financial squeeze and may reduce investment and layoff workers.

Another problem for emerging economies, as well as higher oil prices, is that central banks are looking to tighten monetary policy (interest rates) with the chance of higher inflation.

Source: The Economist – Crude Awaking – September 29th 2018