Category Archives: Exchange Rates

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

US dollar under pressure as the reserve currency.

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
  • n 2018 banks of Germany, France, and the UK held more liabilities in US dollars than in their own domestic currencies.

So why therefore is there pressure on the US dollar as the reserve currency?

The COVID-19 pandemic has closed borders and will inevitably lead to more regionalised trade, migration and money flows which suggests a greater use of local currencies. However China has made its intention clear that the Yuan should become a more universal currency. Some interesting facts:

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

However if the past is anything to go by the US economy has gone through some very turbulent times but the US dollar has remained firm. This suggests that how we perceive the US economy doesn’t seem to relate to the value of its currency.

Source: The Economist – China wants to make the yuan a central-bank favourite
7th May 2020

Why do developing countries like a strong currency?

In the majority of economics textbooks a depreciation of the exchange is beneficial to an economy especially those like developing countries which depend a lot on export revenue.

A fall in the value of the exchange rate will make exports cheaper and so acts as an implicit subsidy to firms that sell abroad. Exposure to world markets also helps companies in the developing world learn and improve.Finished imported products that are still purchased will be more expensive and some of these will count in the country’s consumer price index. Costs of production will be pushed up because the cost of imported raw materials will rise. Domestic firms may also feel less competitive pressure to keep costs and prices low.

A rise in the value of exchange rate will make exports more expensive in terms of foreign currencies, and imports cheaper in terms of the domestic currency. Such a change is likely to result in a fall in demand for domestic products. A higher exchange rate may also reduce inflationary pressure by shifting the aggregate supply curve to the right because of lower costs of imported raw materials. The price of imported finished products would also fall and there would be increased competitive pressure on domestic firms to restrict price rises in order to try to maintain their sales at home and abroad.

It has been traditional for developing countries to try and engineer a weaker currency to make their exports more competitive especially as this revenue is one way in which their economies can start to grow. China and other South East Asian economies adopted this strategy as they went through industrialising their economy. Empirical studies suggest that an undervalued currency boosts growth more in developing rather than developed economies.

Why then is it that some African countries still want to maintain a strong currency? Primary sector exports and overseas aid raises the demand for local currencies making them appreciate. Governments are concerned about a weaker currency as

  • Some are dependent on capital imports to finance infrastructure projects
  • It forces them to spend more income to pay back foreign debts.
  • Pushes up the cost of imported goods, including food, medicine and fuel – mainly impacts the city population who are more likely to complain to politicians.
  • Some companies in developing countries import a lot of their machinery and raw materials – additional cost to their production.
  • A weaker currency does make exports cheaper but this can be nullified by more expensive imports.

However all of this has been overshadowed by COVID-19. The pandemic is increasingly a concern for developing countries which rely heavily on imports to meet their needs of medical supplies essential to combat the virus.

New Zealand primary sector holding up but challenges remain

With countries around the world imposing a lock down for its population the global economy is entering a recessionary phase. Levels of unemployment not seen since the Great Depression of the 1930’s are anticipated – in the US 10 million people now looking for unemployment benefit. With this level of unemployment the demand side of the economy takes a hit and consumers who are worried about job security ‘batten down the hatches’ and start to be a lot more conservative with their spending – only essential items. One significant advantage for New Zealand is the fact that we have large primary sector which allows us not only to feed the population but also export – Fonterra exports 95% of local production to 140 countries. The panic buying that was seen in supermarkets around the country led to a government advertising campaign saying that we have plenty of food (and toilet roll) so no need to stockpile necessities. However this panic buying seems to have eased off and although doing the shop at the supermarket maybe slower than normal, people are getting their food okay – Good Friday tomorrow sees the supermarkets shut so they can restock.

On world markets New Zealand’s major primary export product prices have been declining as a percentage (see graph above) but what is encouraging is that this decline has been from a strong position which is unlike those in other sectors of the global economy. Meat and dairy sales surged prior to coronavirus with sales values rose 7.4% ($649 million), to $9.5 billion in the 2019 December quarter. On the contrary stock markets around the world have taken a significant hit with some declining over 20% but also coming from much weaker positions.

Other factors that help the primary sector

NZ dollar
The 11% decline in the NZD/USD exchange rate gives the primary industry some protection against the fall in global food prices. Remember a decline in the value of the NZD makes our exports cheaper.

Oil prices
The cheaper oil prices have been passed on at the pump and this has reduced costs for the primary sector.

Inelastic good
Food is a necessity good as people need to eat – i.e. very inelastic. Therefore food related products are expected to holdup better than most. Even in the worst of downturns there will still be demand for food.

Restaurants, bars and cafes

With the closure of eating establishments during the lock down the profile of global food demand has changed as people buy more provisions from the supermarket. This has meant that supply chains have had to adjust and reallocate resources to online etc. When the country comes out of the lock down there is a supply issue for firms to get up and running again but let’s not forget the demand side. Will consumer behaviour have changed? Will people still want to go to restaurants and bars as before? One interesting statistic to lookout for will be the activity in these areas.

Not all rosey
Even though the points above suggest that things might not be too bad for the primary sector, one has to be aware of the recent drought conditions in the North Island and parts of the South Island which were classified as a large-scale adverse event by Agriculture Minister Damien O’Connor. Also with Covid-19 and border restrictions there are labour shortages in some industries with up to two-thirds of the workforce coming from overseas, half on Recognised Seasonal Employer (RSE) visas and half backpackers. Further concerns are the transport links into Asia for exports as the airline industry cuts back on international schedules. Important to remember that the vast majority of commercial flights carry cargo.

All that being said I think we are quite lucky to be in New Zealand.

Source: BNZ Rural Wrap – 9th April 2020

Coronavirus – impact on the NZ economy

Below is a link to a very good interview with Corin Dann and Don Brash this morning on National Radio’s ‘Morning Report’. Former Reserve Bank Governor Don Brash says that the major Central Banks need to act together and reduce interest rates to offset the impact of Covid-19. The Central Banks he refers to are: US Fed, Bank of England, Bank of Japan and the European Central Bank. Good discussion of the impact of the NZ dollar on trade and the fact that just the past month in New Zealand, the virus may have cost as much as $300 million in lost exports to China. Worth a listen

National Radio – Don Brash interview

China no longer a manipulator of its currency

Here is a very good explanation from the FT on China’s exchange rate and the fact that the US no longer sees China as a manipulator of its currency – the Renminbi.

  • In May 2019 with the threat of US tariffs on Chinese goods the Renminbi depreciated in value – notice the chart is inverted which means that 1 US$ buys more Renminbi and the value of the currency falls. To look at it another way it takes more Renminbi to buy 1US$. This makes Chinese exports cheaper in the US.
  • In August 2019 when the US came good on their threat to impose tariffs the Renminbi fell below 7 Renminbi / US$ in order to protect its exports to the US. Below 7 Renminbi / US$ is seen as a major threshold – the last time this happened was after the GFC.

How do China authorities intervene to manipulate the Renminbi?

The Renminbi is not a floating exchange rate which it is not determined by supply and demand. The government manages its exchange rate in two ways:

  • Peoples Bank of China (Central Bank) can or sell US$ on the foreign exchange market – this depends on what they wish for the value of the Renminbi against the US dollar
  • People’s Bank of China permits the Renminbi to trade 2 per cent on either side of a daily midpoint set by the. Basically at 9.15am the Peoples Bank of China 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.

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.
  • A material current account surplus of more than 3% of GDP.
  • Persistent one-sided intervention in its currency market.

But in August the Chinese economy was slowing down and the Peoples Bank of China (Central Bank) provided stimulus to the economy which would depreciate the currency anyway. However with more trade talks between the US and China and both agreeing to no more tariffs and phase one of a trade deal, the value of the Renminbi against the dollar starts to appreciate. Although the US has no longer called China a currency manipulator it seems that it didn’t have the grounds to do so. This must be a concern for other trading partners with the US.

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.