Chapter 7: Foreign Exchange and International Financial Markets

1. Chapter 7: Foreign Exchange and International Financial Markets

2. Lesson Outline • “Basic Facts” about Foreign Exchange Markets • Supply & demand as drivers of foreign exchange (forex) rates • Fixed versus flexible exchange rate regimes • The “mechanics” of how each regime functions • Benefits and drawbacks of each • Relative production costs and forex rates • Nations cannot be net exporters in everything, but foreign exchange rates find a level at which some exports can take place

3. Lesson Outline • International Fisher Effect - inflation and real, nominal interest rates • Globalization of Currency Markets • Applying Today’s Material to Understanding the Prospects of Nations - various effects of appreciation and depreciation of national currencies - ties between economic development, exchange rates, and trade and investment flows

4. “Basic Facts” about Forex Markets • About $1.2 trillion per day in transactions • US $ is most heavily traded, as oil must be paid for in US $. Others which are important include the Japanese yen, the UK pound, the Swiss Franc, and the Euro. • Banks do most of the trading (about 80%) and it’s mostly done over bank phone lines. Trading goes on 24 hours per day.

5. “Basic Facts” about Forex Markets • Currency trading is very lightly regulated, especially compared to stock & bond markets. • Countries tend to find it *very* difficult to control exchange rates.   • Why do currencies change in value? • Short term: speculation • Long term: economic fundamentals

6. “Basic Facts” about Forex Markets • Traders like to invest in countries with steady economic growth, low inflation, high interest rates, a trading surplus, and low budget deficits. • Winners in the marketplace are the currency trading desks of banks, while central banks trying to prop up the value of their currency are the losers.

7. Supply and Demand as DriversOf Forex Rates • Foreign exchange markets can be thought of as “pass through” markets”. That is, people “pass through” foreign exchange markets to buy or sell goods, services, or assets denominated in currencies other than their own. • This means that to understand why foreign exchange rates vary, you need to understand what drives international trade and investment flows. You also need to know how national governments and central banks can influence foreign exchange markets.

8. Supply and Demand as DriversOf Forex Rates • See Figure 7.1, 7.2, and 7.3 on pages 189 and 190 to trace the "pass-through" effect of demand for Japanese products on the price of the Japanese yen.

9. Fixed versus FlexibleExchange Rate Regimes • The mechanics of how each regime works: • Flexible exchange rates are determined wholly by supply and demand, as described in the diagrams given in the previous section. • To maintain a fixed exchange rate, a nation’s central bank acts as a “guarantor”, publicly announcing it will buy or sell its own currency at a set price.

10. Fixed versus FlexibleExchange Rate Regimes • The mechanics of how each regime works: • In the short run, central banks can use their own currency and its foreign currency reserves to intervene in foreign exchange markets. • In the long run, persistent and significant differences in the supply and demand for a currency would overwhelm the ability of the relevant central bank to intervene. In the long run, there needs to be a close balance between the supply and demand of a currency for fixed exchange rates to be sustainable.

11. Fixed versus FlexibleExchange Rate Regimes • The mechanics of how each regime works: • To maintain fixed exchange rates over the long term, nations need to be willing to adjust their domestic money supply to roughly match the inflation rate of other nations. • (also see notes on the International Fisher Effect, later in this lesson)

12. Fixed versus FlexibleExchange Rate Regimes • Benefits and Drawbacks of Each Regime: • Flexible exchange rates cannot be “broken” by external shocks or internal policy dilemmas. Also, neither governmental nor central bank intervention is likely to lead to serious distortions in currency value that can eventually lead to sharp currency revaluations and all the associated problems.

13. Fixed versus FlexibleExchange Rate Regimes • Benefits and Drawbacks of Each Regime: • As well, national governments have more freedom to look only at their own internal concerns, whereas under fixed exchange rates a lot of policy-related autonomy is given away, especially concerning monetary policy. • However, flexible exchange rates lead to substantial uncertainty regarding international transactions and also about where to locate plants and factories.

14. Fixed versus FlexibleExchange Rate Regimes • Benefits and Drawbacks of Each Regime: • Fixed exchange rates reduce the riskiness of international transactions. Reducing uncertainty about foreign exchange rates tends to increase the flow of international trade and investment, which is believed to help increase overall economic growth.

15. Fixed versus FlexibleExchange Rate Regimes • Benefits and Drawbacks of Each Regime: • They can also be an anti-inflationary tool, a way of disciplining governments which have a tendency to overspend and print money to pay their bills.

16. Fixed versus FlexibleExchange Rate Regimes • Benefits and Drawbacks of Each Regime: • However, when external shocks occur or when imbalances in inflation rates or economic growth rates are persistent over time, fixed exchange rate regimes can fall apart. And, sudden, large currency revaluations which often occur after a fixed exchange rate regime fails can have sharply negative consequences.

17. Fixed versus FlexibleExchange Rate Regimes • Benefits and Drawbacks of Each Regime: • Also, nations seeking to maintain a fixed exchange rate give up a lot of policy autonomy. • In addition, if they are pegging their currency to a currency that floats (ie: the US dollar), then their exchange rate in terms of currencies other than the US $ will be driven by whatever drives changes in the US dollar, rather than by what is happening in their own country.

18. Fixed versus FlexibleExchange Rate Regimes • Benefits and Drawbacks of Each Regime: • This “disconnect” between national conditions and the value of a nation’s currency can cause problems, as outlined in the article on the Argentinean currency board.

19. Relative Production Costsand Foreign Exchange Rates • Nations cannot be net exporters in everything because foreign exchange rates find a “level” at which nations will be net exporters in some goods and net importers in other goods. • This occurs because there is a “rebound” effect from a substantial currency appreciation or depreciation.

20. Relative Production Costsand Foreign Exchange Rates • For example, when a currency depreciates substantially, land and workers in that country become substantially less expensive to employ in terms of other currencies. • This change in relative production costs tends to pull in overseas investment for some national industries and to tip the competitive balance in favor of some national industries which were formerly not competitive in world markets. • see article on Russian timber

21. Relative Production Costsand Foreign Exchange Rates • If a currency continues to appreciate further and further due to strong demand for goods produced in that country, formerly competitive national industries will no longer be as strong on a global scale. Industries which are net exporters may become net importers. • These newly beleaguered industries will, in turn, often receive less inward foreign direct investment, will be likely to invest more in production facilities abroad, and the nation’s current account balance will be under pressure to shift further towards or into a deficit. All of these responses to a currency appreciation put downward pressure on the value of a currency in the long term.

22. The International Fisher Effect • The International Fisher Effect (IFE) explains why interest rates vary across nations by explaining the link between interest rates and inflation. Because inflation rates differ across nations, interest rates also differ, according to the IFE. • The IFE equation is: nominal interest rate = real interest rate + inflation

23. The International Fisher Effect • There is also evidence suggesting that real interest rates vary across nations. The larger and deeper are internal debt and equity markets and the greater the certainty about future inflation and interest rates, the smaller the “real” rate of return (sans inflation) lenders may be willing to accept.

24. Globalization of Currency Markets • Regarding the globalization of currency markets, covered-interest arbitrage links together interest rates and both spot and forward currency rates. By the terms of the International Fisher Effect, national inflation rates, national interest rates, and both spot and forward foreign exchange rates are therefore all linked together. • (Note that the above is the main reason why under fixed exchange rates national autonomy over monetary policy is severely reduced)

25. Globalization of Currency Markets • 2-way and 3-way arbitrage in currency markets links currency markets together across different nations. • Essentially, the presence around the world of foreign exchange trading sites, together with the activities of arbitrageurs, has brought about a global market for currencies both in spot and forward currency markets.

26. Applying Today’s Material to Understanding the Prospects of Nations • The effects of currency revaluation • Currency depreciation puts upward pressure on inflation and interest rates and drives down living standards. Debt denominated in foreign currencies becomes more expensive to service. Portfolio investors who believe a nation’s currency will depreciate will often shun that country. Goods produced in that nation become cheaper on world markets. The overall effect on national economic growth needs to be examined on a case by case basis.

27. Applying Today’s Material to Understanding the Prospects of Nations • As the article on the Indonesian firm suggests, the overhang from a sudden, sharp currency devaluation takes a while to disappear, especially if that country and its firms are carrying a lot of debt denominated in foreign currencies. • Comparing the articles on Russian timber and on the Indonesian firm struggling with its dollar denominated debts helps underscore the complicated effects of currency devaluation.

28. Applying Today’s Material to Understanding the Prospects of Nations • Currency appreciation has the opposite effect. Again, the overall effect on national economic growth varies on a case by case basis.

29. Applying Today’s Material to Understanding the Prospects of Nations • Economic development, exchange rates, and trade and investment flows • The article “Newly Muscular Euro Hurts Some” highlights the possibly beneficial effects on overall economic growth of currency devaluation, as it suggests that the weakness of the Euro may have added 0.5% to the economic growth rate of the Euro-area members.

30. Applying Today’s Material to Understanding the Prospects of Nations • Economic development, exchange rates, and trade and investment flows • With the weak Euro, the lower cost for Euro-area exports around the world added to EU economic growth, the article is implying.

31. Applying Today’s Material to Understanding the Prospects of Nations • Economic development, exchange rates, and trade and investment flows • Given a higher economic growth rate brought about in part by the Euro's slide in value through much of last year, the Euro area may now begin to attract more inward foreign direct investment, and keep more investment capital at home, which should in turn spur an increase in asset values and investment.

32. Applying Today’s Material to Understanding the Prospects of Nations • Economic development, exchange rates, and trade and investment flows • This in turn may help EU economic growth expand faster than it otherwise would have and may also help the Euro maintain over even further increase its value in the near to medium term.

33. Applying Today’s Material to Understanding the Prospects of Nations • Economic development, exchange rates, and trade and investment flows • However, the Euro’s slide was not all good news. It also put upward pressure on inflation and gave rise to civil disorder when oil prices shot upwards. Sectors dependent on oil to carry on their business were hit very hard by the Euro’s slide.