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. 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).
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.
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.
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.
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.
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.
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
Posts
