FX & Imperialism

What affects the exchange rate of a country’s currency? The answer depends on where that country stands in the world economy. Not simply because an exchange rate is the value of one currency versus another, so that you must weigh up two or more countries. It is mainly because the capitalist world economy acts both as a force that bears down upon everyone and because the most powerful countries within the system also have the most influence over how this works. Exchange rate theories ignore this latter point and this prevents an understanding of imperialism today.[1]

1. FX and the law of value

Some countries may link their national currency to that of an important trading bloc, as does Denmark and some peripheral EU countries to the euro. Others may closely tie their national currency to the currency in which their major exports and imports are priced, as in the case of Saudi Arabia and Hong Kong with the US dollar. Still others may decide to join a regional currency union, or some such arrangement, in order to limit the degree to which fluctuations in currency values might destabilise their international trade and also their domestic economies. Such policies will change the ways in which pressures from the world exert themselves, but they will not get rid of those pressures.

For example, a country whose exchange rate has been fixed against another still finds itself vulnerable economically if it becomes uncompetitive in the world market. It would face less demand for its goods and services, rising unemployment and also less ability to sell its bonds or equities to capitalist investors unless the yields were made more attractive. Among other things, this is what happened to Greece, despite Greece remaining a euro member country, and this has also become evident in some other euro countries.

This is not to say that a country can easily escape from these pressures by devaluing its currency. Every policy decision has its related cost, although some costs will be worse than others. The point is that every country is still potentially at the mercy of the market, with moves in currency values being only one means by which the market’s judgement is transmitted.

Here is the breakdown of trading in the global FX market by currency, showing the top 10 currencies. That trading amounted to $6.6 trillion daily in April 2019, according to the latest survey from the Bank for International Settlements released in September. Note that since a currency transaction involves two currencies, the sum of all the percentages would be 200%, not 100%:

Currency	2019 % share
US dollar	88
Euro	32
Japanese yen	17
UK sterling	13
Australian dollar	7
Canadian dollar	5
Swiss franc	5
Chinese renminbi	4
Hong Kong dollar	4
New Zealand dollar	2

As one might expect, the rich ‘Anglo-American’ countries dominate global currency trading. The euro is less than half as important as the US dollar, despite being the currency of 19 countries. Even the New Zealand dollar is traded more than the Indian rupee and nearly twice as much as the Brazilian real. Below, I examine how the structure of the imperialist world economy finds its reflection in the foreign exchange market, looking first at theories of how exchange rates are determined.

2. Exchange rate theories

Economists have many theories for exchange rates, but the feature they all have in common is that they ignore the structure of the world economy! They might take into account a country’s average price level or rate of inflation compared to others, its productivity growth, its balance of international payments, or the yield on financial assets as ways in which to determine the ‘fair value’ of its currency against others. While it is reasonable to include such things in the analysis, what is missing in these approaches is that they tend to use the same set of variables for each country. Different countries are distinguished by the importance a particular variable might have, with little attention paid to how a country’s status in the world economy can be decisive.

‘Purchasing power parity’ (PPP) is probably the simplest theory of explaining what the underlying value of a currency should be. It is not the favourite theory, but is a constituent part of many others. The basic idea is that the price of a typical good should be the same in two countries, after allowing for differences in taxation, transport costs, etc. If that good costs $1.20 in the US and €1.00 in a euro country, then the PPP value of the euro is $1.20. Then, if the euro is worth $1.30 or $1.10, the euro is either over-valued or under-valued, respectively.

Of course, there is no such thing as a typical good, and a wide variety of goods and services also have to be taken into account. Typically, the PPP approach uses a base year as a suitable starting point for the two (or more) economies, and then looks at the rates of inflation in average price levels since then. For example, if prices have risen in the US by 10% over the past few years but have not changed in the euro countries, then the implied level of the US dollar in the market should be 10% lower versus the euro to compensate for this. If the dollar’s value in the foreign exchange market does not fall, then its ‘real exchange rate’ will have risen, implying a loss of US competitiveness.

One problem with PPP analysis is what index of prices to use: consumer prices, producer prices, or a deflator reflecting the whole of GDP? Excluding certain items or not? Different indices will give different results.

More importantly, the PPP approach does not easily allow for changes in product quality, or new, successful products brought into the international market. Nor does it take account of the impact on exchange rates of changes in world commodity prices. In the latter case, for example, if oil prices rise from $50 per barrel to $100, then significant oil exporting countries will see a sharp rise in their export revenues. These things can justify a rise in the ‘real exchange rate’ of a currency and make it sustainable, whereas PPP analysis rests on the view that the real exchange rate of a currency should stay unchanged.

PPP analysis is used mainly as a guide to currency values based on inflation trends. It will tend to have more validity when the inflation rate in one country is dramatically above those in others, signalling that the value of the currency should fall in the market. This has recently been the case in Venezuela and Argentina.

Other theories of exchange rates broaden out the economic analysis to take account of factors not directly related to the trade in goods. This is just as well, since the influences on an exchange rate go well beyond that. However, these are commonly ‘equilibrium’ exchange rate theories, and usually they try to find an exchange rate for a currency that is compatible with a range of macro-economic targets. This attempt raises more questions than it answers.

Such targets may be a current account balance (including goods and services trade, and income receipts and payments) that is seen as sustainable over the long-term, underlying flows on the financial accounts (direct investment, portfolio investments, etc), and reasonable levels of domestic employment. Good luck with trying to figure out what those numbers should be!

This ‘equilibrium’ approach also tends to sanitise what happens in reality. Partly because it is based on a view that there is some stable, equilibrium level for all the variables that could potentially be achieved, when the global capitalist market is forever disrupting the best-laid plans. Also because some equilibriums are more equal than others, and there is no explanation given for this.

3. Balance of payments and the US dollar market

Take the US dollar, for example. There are some important features of the US international balance of payments that the equilibrium theories may attempt to count but will not delve into.

A country’s balance of payments covers all the transactions between it and foreign residents. This includes not simply exports and imports of goods and services, but also flows of profits, interest and dividends to and from the country, investment in foreign portfolio assets (equities and bonds), foreign buying of domestic portfolio assets, and direct investment and banking flows, among other things.

At first sight, such transactions appear to reflect the supply of and demand for US dollars in the foreign exchange market. For example, if US exports of goods in one month amounted to $150bn and US imports of goods were $200bn, there would be a deficit of $50bn on this part of the accounts, giving a net supply of dollars into the market that would exert downward pressure on its exchange rate (leaving aside the other items for the moment).[2] But this is not what happens. Instead, the way in which transactions take place is conditioned by the structure of the world market.

The dominant role of the US means not only that almost 100% of US exports are priced in US dollars, so that its exporters receive their domestic currency when they sell to other countries. Over 90% of US imports are also priced in terms of US dollars, so companies exporting to the US receive dollars, rather than euros, Japanese yen, Chinese renminbi, etc. In principle, the latter could then sell these dollars and buy euros, etc, so putting the dollar’s exchange rate under pressure. But in practice they will keep a dollar-based bank account for most of the funds.

This is because the US dollar is used for the contract pricing of much international trade, from oil and other commodities to aerospace, engineering and technology supplies, and their dollar accounts will be used for their own imports of dollar-priced goods. The result is that the US trade deficit does not lead to a comparable net sale of US dollars.

So the prominent position of the US dollar in the global market makes the dollar’s exchange rate far less vulnerable to a big US deficit than is the case for other currencies. This was a simple example from the trade account part of the balance of payments. It gets more complicated when looking at the flows of investment income and finance, but the same factors apply: the power relationships in the world economy.

4. Investment income, finance and FX pressures

‘Fundamental equilibrium’ FX theories project that a country with rising net foreign liabilities (as implied by persistent current account deficits) will find its exchange rate declining in value. Mainstream economic theory also has the view that rates of return should equalise across all kinds of investment, so it expects that a country with growing net liabilities on its foreign investment position will find that its net investment income will fall into deficit. This is because it will pay more on the rising value of assets that foreigners hold in the country than it receives on the relatively declining value of assets that it holds in other countries. Let’s see how these projections (do not) work for the US dollar.

The US has had a current account deficit in every year since the early 1990s, and this has been reflected in a rising value of net liabilities to the rest of the world.[3] By the end of 2018, the US foreign liabilities were a staggering $9.6 trillion more than the foreign assets held by US residents – this was up from a deficit of a ‘mere’ $1 trillion in 1999. Yet, despite this, the US still had a huge net investment income in 2018 of $267bn in 2018! It received $1078m of income on its assets of $23.7 trillion, but paid out just $811m on its far greater liabilities of $33.3 trillion.[4] Also, the US Fed’s broad index of the US dollar’s nominal value versus other currencies rose by 15% from January 2006 to July 2019, and was also 6% higher in inflation-adjusted terms. [5] What is going on?

Two related points account for this apparent anomaly: there are different types of asset and liability, and the investment returns on each also tend to be different, contrary to much economic theory. On so-called ‘foreign direct investment’ (FDI), where an investor has 10% of more of a foreign company’s equity, the returns tend to be highest. On ‘portfolio investments’, which includes money allocated by asset managers, pension funds, insurance companies, etc, into foreign equities and bonds, the returns are usually lower than on FDI. Returns are usually lowest of all on money market investments, including loans and deposits. Such returns will vary with economic conditions, but this pattern has been true for the major countries in the past several decades, particularly with the fall of money market interest rates to historically low levels.

Guess what? US foreign assets are concentrated in the higher-yielding FDI and equity assets. These accounted for two-thirds of US foreign assets at end-2018. Meanwhile, over half of US foreign liabilities (the investment foreigners have in the US) are concentrated in the lower-yielding US debt and money market instruments. That is how the US earns more on less, while foreigners earn much less on much more, giving the US that net investment income of $267bn.

A big reason behind this favourable outcome for the US is not that foreigners are a bit stupid and satisfied with low yields, while the US is a centre of shrewd capitalist investors who make well-judged forays into the rest of the world economy. Instead it is a reflection of US global power.

The US government can often force weaker countries to accept US investment on favourable terms, and the volume of US wealth puts its capitalists in a strong position to take advantage of any weakness elsewhere. Another benefit for the US comes from one consequence of the role of the US dollar mentioned before. Foreign central banks, as well as foreign companies doing international business, are in effect obliged to hold reserves of US dollar funds to manage their economic risks and guard against any financial mishap. These are funds held as US Treasury and agency securities, US dollar deposits and other items that give a low return.[6]

5. What about the rest?

The US pattern of privilege and relative insulation from changes in currency values does not apply to other countries to the same degree, and especially not to countries far lower in the world pecking order. For example, many so-called ‘emerging market’ economies often borrow funds from investors that are denominated in US dollars or another major currency. If the exchange rate of their own currency falls, that can greatly increase the value of their debts, apart from raising the cost of their imports.

These latter countries also find that the flows of international investment into their financial markets tend to be fickle and destabilising. If a country becomes a favoured investment location, billions will flow in to buy companies, bonds and property – boosting prices, because the scale of such flows will overwhelm the relatively small domestic financial markets. Then, when the favourable sentiment turns sour, investors move on to the next big thing, or conditions in world financial markets worsen, the flows can easily reverse and prompt a collapse.

They also have little access to longer-term, more secure funding, or to the far less volatile inflows that come from foreign central bank investments. The US dollar accounts for around 60% of central bank foreign exchange reserves that totalled $11.7 trillion in mid-2019. The euro’s share is next in line, though much smaller at 20%, and the currencies of Japan, the UK, China, Canada and Australia trail far behind the euro.

Being one of the big boys helps in FX markets, as in all the others. In contrast to the leeway given to the US, which occasionally shuts down its own government operations and more frequently strikes out in the world with unilateral policies, weaker countries in the global pecking order can barely put a foot wrong before they find it stamped on.

6. Market analysis pragmatism

The failure of economic theories to get to grips with the reality of the imperialist world market leads FX market participants – dealers, speculators, investors, advisers – to sideline those theories. Not because they want to analyse imperialism, but because they want to find something that works. So they adopt a range of pragmatic tools with which to try and judge the likely pressures on exchange rates.

Chart or ‘technical’ analysis is one method, where previous patterns of price moves are used to assess potential trigger points and trends in the FX market. That is an endorsement of the view that ‘the market is always right’, even if it has just completely changed its mind! A problem for technical analysis is that ‘key’ price levels expected to trigger a sharp price move, if broken, are usually well known. The result is that other market speculators buy or sell a currency to force prices through such levels. These days, automatic trading systems do a lot of this, commonly reversing position when a price level has been broken to gain a small profit. In this way, they also, as a by-product, undermine the validity of the signals they have depended upon!

The huge scale of the international currency markets – trading some $6.6 trillion per day in 2019 – helps endorse the pragmatic approach. After all, if many companies are buying/selling currencies to manage their business, including hedging against adverse FX moves, if asset managers, investment companies, hedge funds and banks are forever shifting funds into different markets, then it is unlikely that a simple model will work for currency valuation, or, more importantly, to judge currency risk. This can lead to the use of what one might call brainless correlation analysis.

Here, the job is to find another market price, anything, that seems to have a relationship to the changing level of one currency versus another. It could be the price of gold or oil, futures market expectations for changes in interest rates, z-scores of implied option volatility or market positioning data held by banks or by trading exchanges. It does not really matter much whether there is an identifiable causal relationship between the things being correlated. If it looks like the US dollar, the euro, sterling, etc, goes up or down when the implied volatility on the S&P 500 equity index goes down or up, then that’s good enough, just as long as the relationship holds for a while and gives some kind of lead on the forthcoming move in currency values.

When fully dressed up statistically, these correlations are often part of a set of FX market signals used by market participants. Wherever possible, if only to avoid embarrassment, some kind of market causation is usually inferred. No analyst would admit to using the price of lean hog futures on the Chicago Mercantile Exchange to judge the next move in the Norwegian krone versus the euro, even if there happened to be a decent correlation between the two.

7. Hidden FX hedging

At the risk of complicating further a discussion of what might seem to some as already a little arcane, I will turn to FX hedging. Basically, this means doing deals in the FX markets that reduce or eliminate the currency risk that is faced. It may look like a subsidiary aspect of the FX market, but hedging can play a big role in driving currency values up or down, often for reasons not evident to market observers.

All bigger companies tend to hedge their risk in currency markets, in other words to protect themselves against adverse moves in currency values for the things they need to buy or sell. For example, if a euro-based company knows it will receive $100m in three months’ time, then it will face a loss if the exchange rate of the US dollar falls against the euro. So it may decide to insure itself against the dollar’s fall. The most common way is for the company to do a deal to sell the $100m in the FX forward market at a fixed price for three months’ time.

If it does this, then there are two potential costs. Firstly, the dollar may actually rise in value, not fall, so the company has missed out on a higher euro value for its future revenues. However, if it does nothing, then it is just gambling the dollar will rise or at least not fall, and the whole point of the hedging exercise is to eliminate risk. Secondly, the FX forward deal will usually be done at an exchange rate that is different from the prevailing ‘spot’ rate of the currency.

The way it works is that if three-month US deposit rates are higher than the deposit rate on the base currency – the euro, Japanese, yen, sterling, etc – then the forward value of the dollar will be lower by the same degree. If three-month US deposit rates are lower, then the forward value of the dollar is correspondingly higher than the spot rate. If that were not the case, then there would be an arbitrage gap, and dealers would buy and sell the dollars in the spot and forward markets to bring about the required relationship between the spot rate and the forward rate. Nevertheless, although the two rates would be different, the forward value of the dollar would be fixed, thus eliminating risk.

8. Dollar-yen hedging

Taking the example of the US dollar versus the Japanese yen, the FX market prices work as follows. If US 3-month interest rates are 2.0%, Japanese yen 3-month rates are minus 0.1%, and the US-dollar is worth 107.0 yen in the spot market, then the 3-month forward value of the dollar would be lower than 107.0 to offset the higher US interest rate. The interest rate gap is 2.1% per annum in favour of the US dollar, but the term is only for three months, so the forward value of the US dollar would be roughly 0.5% (a quarter of 2.1%) less than the spot value, or close to 106.4.[7] So, if the Japanese company sells dollars in the forward market, it will lose roughly 0.5% compared to prevailing exchange rates in the spot market. However, it will have eliminated the risk to its finances that the dollar will fall even further.

That 0.5% (or 2.1% annualised) number is the cost of hedging currency risk for three months. It rises and falls with the degree to which the US dollar interest rate is above the Japanese yen interest rate. If the two deposit rates were equal, then the cost of hedging would be close to zero; if Japanese rates were above US rates, then there would be a forward currency gain compared to the spot rate for the Japanese company in hedging its dollar risk.

In Japan’s case, its close to zero or even negative interest rates for many years has meant that there has almost always been a positive cost of hedging. Yet, when the premium of US rates over Japan’s falls to very low levels, this reduces that cost and can encourage its corporates and investors to increase their hedging activity as the expense of eliminating currency risk is reduced. Equally, if US interest rates rise versus Japan’s, then the cost of hedging will also rise and this will tend to reduce the amount of hedging that is done.

Admittedly, this can all appear like an obscure FX market technicality. But it becomes an important driver of foreign exchange moves when the amounts concerned are not just the odd $100m, and instead are measured in the tens, even hundreds of billions of dollars.

Consider the example of Japan’s life insurance companies. They have hundreds of billions of dollars in foreign bond and equity investments, funded by their insurance premiums, and the returns on their investments are used to pay out on policies. Principally, they invest in bonds, to gain a regular income from coupons and interest payments, and the many years of low interest rates in Japan have led them to seek better returns in foreign securities. While their domestic policies pay out in terms of Japanese yen, the income and the asset value of their foreign investments is in US dollars, euros, sterling, etc. So they are exposed to a lot of foreign exchange risk.

How much risk can be illustrated by the largest Japanese life insurer, Nippon Life. The company has invested huge sums in foreign securities, mainly bonds. At the end of March 2019, it held a total of ¥14.2 trillion in foreign bonds, nearly $130bn, about 60% of which were in US dollars, nearly 30% in euros and near 10% in sterling. Its policy is to hedge the currency risk on these bond assets, but not fully. (Foreign equity holdings are far smaller, as for other life insurance companies, and tend not to be hedged) How much hedging depends both upon its expectations for currency markets and the cost of hedging, with the latest data showing that roughly 60% of Nippon Life’s currency risk on foreign bonds is hedged.

Other Japanese life insurance companies have similar policies, although their hedging ratios will differ. In total, the foreign bond holdings of the lifers probably amount to some $300bn, perhaps more.

Now consider what happens in currency markets when hedging activity changes. Just taking the Japanese life insurers, and excluding other investment companies whose activities will also have an impact, there could be a very big amount of foreign currency buying or selling.

If the average hedge ratio was 50% on $200bn of US dollar bond holdings, then the lifers will have done forward selling of the US dollar of roughly $100bn for the next three months. However, when it is time to renew the hedge, the cost of hedging may have risen a lot (higher US deposit interest rates versus Japan), so they decide only to hedge 25%. The net effect would be to buy $50bn in the FX market and so boost the dollar’s value versus the Japanese yen.

Alternatively, if the cost of hedging fell a lot (with the US Fed cutting interest rates), the hedge ratio may rise to 75%. Then they would sell another $50bn in the FX market. It might even rise to 100%, when they would sell an extra $100bn, pressuring the dollar’s value lower. This latter move was one factor in the US dollar’s collapse versus the Japanese yen from 2008 to 2011, from around 100-110 down to 75-80, as the US Fed cut interest rates towards 0.25% and also came close to pushing the cost of hedging down to zero.

These large-scale US dollar buying or selling actions would be driven by the cost of hedging. They would be independent of whatever the average Japanese life insurance company thought of Donald Trump, the US Fed or US political developments!

Mutatis mutandis, similar pressures in the FX market will follow from European asset managers adjusting their hedge ratios on US investments, or US asset managers doing the same for their European investments, and so forth. Note that the FX hedging decision is separate from the decision to buy or sell the underlying asset (usually applying only to bonds), and that lots of dollars, etc, may be sold, even if the asset manager maintains its dollar, etc, bond holdings.

That’s enough on FX hedging.

9. FX markets express economic power

The privileged position of the US stands out in global FX markets, from US companies facing far less currency risk than others, to the country receiving low cost financing for its consumption and military adventures. However, these are not things that any US politician has seen fit to recognise; it is an outlook not confined to Trump and friends. Instead the powerful position of the US is taken as a given, and one that they will fight to sustain, with pressures on other countries to open up their markets and submit to the imperial law of value.

As the example of FX hedging shows, moves in currency markets may have little to do with the standard assessment of trade balances. Instead, the full panoply of wealth, investment and financial dealing also has to be taken into account. In particular, a country is a player in these markets if it belongs to the rich club that dominates the international flows of funds. If it does not, then it has to wait in the wings and seek to gain access to the funds available by showing the requisite degree of obeisance to the major capitalist powers.

Tony Norfield, 7 October 2019

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[1] My bona fides for discussing the FX market are the more than 20 years I spent analysing financial markets, including more than 10 when I was global head of FX research at a major European bank. During that time I constructed a number of models for the FX market, or participated in their development, paying attention to the many and varied theories available.

[2] This example also ignores that payments for the goods generally do not occur at the same time as the actual imports and exports are despatched and delivered.

[3] There is not a one-to-one relationship, however, because the value of assets and of liabilities changes with changes in financial market prices and the value of the US dollar versus other currencies.

[4] These asset-liability figures exclude financial derivatives.

[5] See https://www.federalreserve.gov/releases/h10/summary/jrxwtfbc_nm.htm

[6] To some extent, a number of countries have become aware of this and have diversified their foreign asset holdings from low-yielding debt securities into equities, property and other assets by setting up ‘sovereign wealth funds’, etc, that are separate from central bank FX reserves.

[7] This example is only approximate, to indicate the size of the difference between spot and forward FX values. In the market, the bid-offer spread, day count, form of interest rate, etc, also have to be taken into account.