Table 10.4 External debt, 2007
Net foreign assets
Rather than being debtors, many countries, including some industrial countries and oil exporters, have accumulated stocks of assets in other countries. The figures tend to understate the true position because of under-declaration and book values that are way out of line with market values.
The stock, however, may not be of any help for offsetting any current-account deficits. Residents may have no wish to repatriate their assets, especially if the current-account deficit is a signal of fundamental economic problems.
Chapter 11
Exchange rates
Devaluation ... would be a lunatic self-destroying operation.
Harold Wilson in 1963; in 1967 he devalued the pound.
Exchange rates are nothing more than the price of one currency in terms of another. They are determined mainly by supply and demand, which reflect trade and other international payments, and, much more important, volatile capital flows which are constantly shifting around the world in search of the best expected investment returns. The prime indicator of market pressures on a currency is the figure for total currency flows in the balance of payments account (see Chapter 10). Other important influences are relative interest rates and yields (Chapter 12) and inflation (Chapter 13).
A history of exchange rates
The easiest way to understand exchange rates and their influence on the balance of payments is to review previous experiences.
The gold standard
Before 1914 exchange rates were fixed in terms of gold, trade was mainly in physical goods and capital flows were limited. A country which developed a deficit on its current account would first consume its reserves of foreign currencies. Then it would have to pay for the imports by shipping gold. The transfer of gold would reduce the money supply in the deficit country and boost it elsewhere, since currencies were then backed by convertibility into gold.
In the deficit country the contracting money supply would tend to depress output and prices. Else where the expanding money supply would boost output and inflation. The deficit country could then only afford to import a lower quantity of dearer foreign goods. The surplus countries could import a higher quantity of the deficit country’s cheaper goods. Thus the current account would automatically return to equilibrium.
That was the theory. It seemed to work in practice until the system got out of balance in the 1920s. The gold standard was temporarily suspended during the first world war. Countries experienced rapid and varying rates of inflation and exports were grossly underpriced or overpriced when the gold standard was reintroduced at pre-war rates. Large current-account surpluses and deficits developed. The gold standard fell from favour and was abandoned almost universally by the early 1930s.
The 1930s
There were widespread experiments with fixed and floating exchange rates during the 1930s. Almost every country tried to alleviate the unemployment of the Depression by limiting imports and boosting exports with measures such as import duties, quotas and exchange-rate devaluation or depreciation. It may seem obvious, but world exports cannot rise if world imports fall. The international payments system fell further into disrepute.
Adjustable pegs
An international conference was convened in America at Bretton Woods, New Hampshire, in June 1944. Participants agreed to form the IMF and World Bank to promote international monetary cooperation and the major currencies were fixed in relation to the dollar. Fluctuations were limited to 1% in either direction, although larger revaluations and devaluations were allowed with IMF permission. In addition, the American government agreed to buy gold on demand at $35 an ounce, which left only the dollar on a gold standard.
Floating rates
The Bretton Woods system broke down in the 1970s. Persistent American deficits had led to an international excess of dollars and American gold reserves came under pressure. In August 1971 the Americans suspended the convertibility of the dollar, imposed a 10% surcharge on imports and took other measures aimed at eliminating its balance of payments deficit. The major currencies were allowed to float, some within constraints imposed by exchange controls (dirty floats).
Fixed rates with some flexibility were reintroduced in December 1971 following a meeting of the IMF Group of Ten at the Smithsonian Institution in Washington (the “Smithsonian agreement”). However, sterling was floated “temporarily”in June 1972 and by the following year all major currencies were floating or subject to managed floats. Despite bouts of extreme turbulence, most major currencies have remained floating ever since. The exceptions are EU currencies. Several of these spent the 1980s and most of the 1990s linked to one another in the exchange-rate mechanism of the European monetary system. At the start of 1999, 11 countries fixed their exchange rates irrevocably and joined a single European currency, the euro. Greece joined on January 1st 2001. Slovenia, Cyprus, Malta and Slovakia followed in 2007–09. The euro floats freely against other currencies.
Nominal exchange rates
Measures: Price of one currency in terms of another.
Significance: Influences external trade, capital flows, and so on.
Presented as: Units of one currency for one unit of another.
Focus on: Trends.
Yardstick: Annual movements of more than a few per cent in either direction can be destabilising.
Released: Minute-by-minute.
Jargon
An exchange rate indicates how many units of one currency can be purchased with a single unit of another. For example, a rate of ¥100 against the dollar indicates that one dollar buys 100 yen: $1 = ¥100.
Stronger and weaker
If the rate changes from $1 = ¥100 to $1 = ¥200 the dollar has risen or strengthened by 100% against the yen (it will buy 100% more yen). The yen has fallen or weakened against the dollar, but not by 100% or it would be worthless. It has moved from ¥100 = $1 to ¥100 = $0.50, a fall of 50%.
When currencies get stronger or weaker, they are said to have appreciated or depreciated if they are floating-rate currencies or to have been revalued or devalued if their rates are fixed by the central bank.
Spot rates
Rates for immediate settlement are spot rates.
Forward rates and futures
Exchange rates fixed today for settlement on a given future date reflect nothing more than spot exchange rates and interest rate differentials.
For example, if a bank agrees to buy dollars in exchange for yen in one month, essentially it borrows the dollars today, converts them into yen, and places the yen in the money markets to earn interest for one month. At the end of the month the bank hands over the yen, takes the dollars and uses them to repay the dollar loan. Nobody takes an exchange-rate risk.
Moreover, arbitrage ensures that forward rates, futures and options move in line.
Forward exchange rates and futures should not therefore be regarded as explicit indicators of expected exchange rates.
Exchanging blows
Our Big Mac index shows the Chinese yuan is still undervalued
Recent renewed American calls for China to revalue its currency have so far fallen on deaf ears. China has rejected accusations that America’s huge trade deficit with it is caused largely by an artificially weak yuan, which has been pegged to the dollar since July 2008. Economists point out that an appreciation of the yen did little to help reduce America’s trade deficit with Japan in the 1980s. But the yuan is unquestionably undervalued. Our Big Mac index, based on the theory of purchasing-power parity, in which exchange rates should equalise the price of a basket of goods across countries, suggests that the yuan is 49% below its fair-value benchmark with the dollar.
Big Mac index
*At market exchange rate on March 16th Weighted average of member countries Average of four cities
Sources: McDonald's; The Economist
The Economist, March 17th 2010
What determines exchange rates
There
is no neat explanation for what determines exchange rates. The two main theories are based on purchasing power and asset markets (investment portfolios).
Purchasing power parity (PPP)
The traditional approach to exchange rates says that they move to keep international purchasing power in line (parity). If American inflation is 6% and Canadian inflation is 4%, the American dollar will fall by 2% to maintain PPP. With floating exchange rates this would happen automatically. If ex change rates are fixed, demand pressures will instead equalise inflation in the two countries.
Another version of this, favoured by some economists, is to define purchasing power parity as the exchange rate which equates the prices of a basket of goods and services in two countries. In the long term, it is argued, currencies should move towards their PPP. The Economist has a simpler approach with its Big Mac index.
Portfolio balance
The port folio approach suggests that exchange rates move to balance total returns (interest plus expected exchange-rate movements). If yen deposits pay 6% and dollar deposits pay 8%, investors will buy dollars for the higher return until the exchange rate has been pushed up so far that the dollar is expected to depreciate by 2%. The expected return from the dollar will then exactly match the expected return from the yen.
Overshooting
The best guess is that exchange rates are determined by PPP in the long run, but that this is overridden in the short term by portfolio pressures. These tend to cause currencies to overshoot PPP equilibrium.
Who determines exchange rates
Clearly there is a complex interaction between exchange rates and various economic and financial variables, many of which are outside domestic control (they are determined exogenously). Central banks can either try to control these variables in order to fix their exchange rate, or leave the exchange rate to the markets.
In fact, of the 150 or so IMF members’ currencies in 1990, less than one-sixth were freely floating, including those of Australia, Canada, Japan, New Zealand and America. Of the remaining currencies, 32 had managed floats or limited flexibility, while around 25 were pegged to the dollar, 14 to the French franc, five to other single currencies and 50 to the SDR (see page 160) or other baskets of currencies. By 2008, however, 40 of the world’s 180-odd IMF members had independently floating currencies and a further 44 had managed floats.
Monetary policy
All economic policies affect exchange rates, although changes in interest rates have probably the most direct and visible influence. The exchange rate is thus the broadest indicator of monetary policy.
Table 11.1 Exchange rates
Intervention
Central banks frequently intervene in the currency markets. They buy or sell their currency in order to alter the balance of supply and demand and move the exchange rate. This is essentially a short-term smoothing activity since they can buy one currency only if they have another to sell. (See Reserves, page 151.)
Effects of exchange-rate movements
The most immediate effect of a weaker currency is higher domestic inflation owing to dearer imports. At the same time, exports priced in foreign currencies and inflows of rents, interest, profits and dividends generate more income in domestic-currency terms. Thus the trade and current-account balances deteriorate.
Later, after perhaps as much as 12–18 months, relative price movements cause a shift from imports to domestic production and exports. This boosts GDP and the trade and current accounts improve. (Their deterioration followed by improvement is known as the J-curve effect.) However, higher inflation caused by a weaker currency can wipe out any current account improvement within a number of years.
Capital account
With regard to the capital account of the balance of payments, a weaker currency makes inward investment look more attractive. In foreign-currency terms outlays are lower and returns are higher, but this may not be enough to attract investors if the currency weakened because of unfavourable domestic economic conditions.
Special drawing rights (SDRs)
Measures: The value of a basket of four major currencies, see Table 11.2.
Significance: Stable international currency and reserves asset.
Presented as: Absolute value per unit of currency.
Focus on: Market rate against any currency.
Yardstick: Average: SDR1 = $1.18 in the 1980s, $1.40 in the 1990s and $1.43 in 2000–2008.
Released: Several times daily.
Overview
The SDR (special drawing right) has some of the characteristics of a world currency. It was introduced by the IMF in 1970 to boost world liquidity after the ratio of world reserves to imports had fallen by half since the 1950s. Through book-keeping entries, the Fund allocated SDRs to member countries in proportion to their quotas (see below). Countries in need of foreign currency may obtain them from other central banks in exchange for SDRs.
11.1 Exchange rates
Source: IMF
Advantages
The SDR is stable. It is used for accounting purposes by the IMF and even some multinational corporations. Commercial banks accept deposits and make loans in SDRs, and it is used to price some international transactions.
Disadvantages
Since the SDR is an average of four currencies it is less valuable than the strongest and is among the first to go when reserves are sold off. Developing countries argue that it would help their liquidity if they had more SDRs, but the quota system ensures that the rich industrial countries have most of them.
Value
SDRs were first allocated in 1970 equal to 1/35 of an ounce of gold, or exactly $1 ($1.0857 after the dollar was devalued in 1971). When the dollar came off the gold standard the SDR was fixed from 1974 in terms of a basket of 16 currencies. This proved too unwieldy and in 1981 the basket was slimmed to five major currencies with weights broadly reflecting their importance in international trade. With the creation of the euro in 1999, the number of currencies was reduced to four (see Table 11.2). The next review is due in 2010.
Table 11.2 Currencies in the SDR %
Table 11.3 SDR exchange rates Currency units per SDR, end of period
Since 1981 the IMF has paid the full market rate of interest on the SDR, based on a weighted average of rates paid by the individual constituents.
Quotas
The IMF allocates to each member country a quota which reflects the country’s importance in world trade and payments. The size of the quota determines voting powers, subscriptions in gold and currencies, borrowing powers and SDR allocations.
Any member with balance of payments difficulties may swap its SDRs for reserve currencies at IMF-designated central banks. It can also use its own currency to buy (draw) foreign currency from the Fund’s pool. The first chunk of currencies (the reserve tranche), amounting to 25% of the member’s quota, may be taken unconditionally. Four additional credit tranches each worth another 25% of the quota may be taken under progressively tougher terms and conditions. When these options are used up there are other borrowing facilities available. The IMF also arranges standby credits in times of severe strain on a currency.
EMU, ecu, ERM and euro
Measures: The euro became the single currency of 11 EU countries on January 1st 1999. By January 1st 2009 there were 16 members.
Significance: Reserve asset, international currency and basis of the European exchange-rate mechanism. Now in circulation in the form of notes and coins.
Presented as: Dollars per euro; yen per euro; (British) pence per euro.
Focus on: Rate against other currencies, especially the dollar.
Yardstick: The euro began life at around $1.17 to the euro. By late 2000 it was trading at just over $0.82 but at the end of 2004 it was $1.36. In 2010 it stood at around $1.20.
Released: Continuously.
Overview
A timetable and criteria for the creation of a single currency as part of economic and monetary union (EMU) was agreed by the EU at Maastr
icht in 1991. The programme built on the exchange rate mechanism (ERM) and the European currency unit (ecu), which was replaced by the euro.
The ecu
Introduced on March 13th 1979, the ecu superseded the European unit of account (EUA). While the EUA was no more than a common unit for book-keeping purposes, the ecu was a reserve asset and a currency in its own right used for commercial transactions and bond issues.
The ecu was based on a basket of EC currencies weighted according to the relative size of GDP and trade volume.
The ERM
Before the creation of the euro, the ERM linked most of the EU’s national currencies, including all those who adopted the single currency. Britain and Italy withdrew in September 1992. The Italians later rejoined.
Each ERM currency had a fixed central rate against the ecu. From these rates a “parity grid” of cross-rates between each pair of currencies was calculated. In most countries, central banks were required to keep their own currencies within 2.25% of all other cross-parities. For some countries, however, the limit was 6%, and was raised to 15% after the near-collapse of the ERM in mid-1993.
When the euro was created on January 1st 1999, the ERM was superseded by a new arrangement, ERM2. Countries that wanted to join the euro were expected to be members of ERM2 before acceding. Two of the four EU countries that were not members of the euro, Denmark and Greece, were members of ERM2. The British pound and Swedish krona float freely against other currencies.
In ERM2, central rates are defined against the euro, rather than the ecu, and the maximum divergence permitted from the cross-parities is 15%. However, the Danes negotiated a narrower band of 2.25%.
The euro
The December 1995 EU summit in Madrid confirmed the intention to introduce a single European currency, to be known as the euro, on January 1st 1999.
Guide to Economic Indicators Page 14
