Category Archives: Exchange Rates

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

Don’t cry for me Argentina – collapsing peso and 40% interest rates

To avoid a run on the peso the Argentinian Central Bank has increased interest rates from 27.5% on 27th April to 40% on 4th May. Argentina’s peso has lost 20% of its value against the US dollar since the start of the year making it the worst performing emerging-market currency.
The problems began in January when the central bank wanted to ease interest rates by increasing the inflation target from 12% to 15% – the government were concerned that the high interest rates were having a detrimental effect on economic growth. However when the Central Bank eased interest rates by 0.75% expectations about inflation started to rise and then investors began to question what the Argentinian Central Bank and Government were trying to achieve with economic policy.

In order to prop up the peso the Argentinian Central Bank sold $4.3bn of its dollar reserves over 5 days and it raised interest rates by 6%. But the peso lost 7.8% of its value during trading on 3rd May so inevitably came an interest hike to 40%. However if inflation figures continue to disappoint the peso will continue its downward slide.

Interest rates are set to continue at high levels and if the central bank cuts rates too early they run the risk of a rerun of the crisis. Fitch (credit rating agency) recently downgraded their outlook for Argentina from positive to stable citing high inflation and economic instability.

But high interest rates are damaging to an economy. By increasing the borrowing costs you make it very difficult for business grow and the economy slows with the threat of a recession and higher unemployment. The key for Argentina will be to keep rates high just long enough to inspire confidence that policymakers have halted the currency run, but not so long that the increase drains the economy.

Big Mac Index January 2018 – Worksheet

The Big Mac index was invented by The Economist 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 and answer the questions that follow. It makes for a good discussion of PPP amongst countries

The Big Mac Index – January 2018

* Estimated figures

1. Complete the table above. In which country was their actual exchange rate on January 2018 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

b) 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. Differences in the prices of hamburgers could exist in the real world for a number of reasons. Suggest one reason relating to a) supply and b) demand which could lead to apparent deviations from equilibrium exchange rate values.

Venezuela’s hyperinflation and collapsing currency

I have blogged in the past about the ongoing problems in Venezuela of hyperinflation, food shortages and social unrest. One of the consequences of hyperinflation is the loss of confidence in its economy which leads to an outflow of money and a lack of foreign investment. The result of these events is the fall in the Venezuelan currency – the bolívar. One way of monitoring its decline is the use of The Economist’s Big Mac index – it is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad – the video explains PPP and shows how undervalued / overvalued an exchange rate is relative to a Big Mac exchange rate.

According to the Big Mac index the price of Big Mac in
Caracas = 145,000 bolívars
USA = US$5.28

Purchasing Power Parity
Purchasing power parity (PPP) is when an amount of money in one country can be exchanged for a quantity of foreign currency, and the two amounts will buy identical baskets of products in both countries. So if we take the above example the PPP exchange rate is:

145,000 bolívars ÷ US$5.28 = 27,462 bolívars

However the Big Mac index seems to underestimate the slide in the Venezuelan currency as the black market is estimated to be around 260,000 bolívars. A US based website called DolarToday provides black market exchange rates that are updated daily for Venezuelans who cannot exchange currencies with the Venezuelan government for the dwindling supply of the US dollar. According to DolarToday, the estimated exchange rate is 230,228.36 VEF/USD in Venezuela’s free market as of 21 February 2018, which makes it the least valued circulating currency in the world – see graph from Wikipedia. Notice the reduced time for the bolívar to lose 90% of its value.

The company bases its computed exchange rates of the Venezuelan bolívar to the Euro or the United States dollar from the fees on trades in Cúcuta, Colombia, a city near the border of Venezuela. Currently, with no other reliable source other than the black market exchange rates, these rates are used by Reuters, CNBC, and several media news agencies and networks.

Therefore traders in Caracas check the DolarToday rate before presenting the bill to their customers. But local goods have no reference price and don’t keep up with the collapsing value of money – a monthly mobile phone tariff is 38,000 bolivars = 15 cents and a haircut is 25 cents. The minimum wage has increased regularly and it now stands at 800,000 bolívar = less than US$4 at the black market exchange rate.

If wages were perfectly indexed, it would serve only to speed up inflation. But their slow and uneven adjustment means the pain of hyperinflation is shared haphazardly. As Juan Perón of Argentina supposedly said, if prices take the lift, wages cannot take the stairs.

Sources:
The Economist – Hyperinflation in Venezuela – January 27th 2018
Wikipedia – Venezuelan bolívar