Understanding World Currencies and Exchange Rates

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1 Understanding World Currencies and Exchange Rates Contents Currencies Exchange Rates Exchange Rate Movements Interpreting Numerical Exchange Rate Movements How Foreign Exchange Markets Work Why Exchange Rates Move Government Manipulation of Exchange Rates Euro Currency Crises / Collapses Links to Web Sites on Topic 1

2 Currencies For reasons of part of being a country and being able to control/influence an important part of the domestic economy, most countries have their own money When spoken of in the domestic context, this money is referred to as the money supply; when this money supply is traded with other money supplies internationally, the term currency is more often used 2

3 Exchange Rates The rates at which these currencies exchange with other currencies are known as foreign exchange rates, or the short hand of exchange rates The most important exchange rates for currencies are the exchange rates with the US$. In fact this is almost the only exchange rate actually used in actual foreign exchange trading, as the foreign exchange trading process does not typically trade non-$ currencies directly with each other, instead trading the first into dollars and then from dollars into the second. 3

4 Exchange Rates While paling in importance to the exchange rates between US$ and other world currencies, a second exchange rate that is calculated for analysis purposes are so called cross exchange rates, the implicit rate between 2 non-$ currencies. These rates are often used to track competitiveness between 2 non-us countries. Examples of important rate pairs in this regard are: Pound/Euro, Yen/SKWon, Yen/Yuan, Peso/Real, Florint/Zloty, Indian Rupee / Pakistan Rupee 4

5 Exchange Rates A final exchange rate that is used for analysis purposes is a calculated average value, or exchange rate, of one currency against an average of other important currencies. These exchange rates go by various names average, effective, trade-weighted, etc. and have as purpose tracking a countries overall exchange rate competitiveness against a basket of important world currencies. 5

6 Exchange Rate Movements As we all know, currencies move in value against each other, or, their exchange rates change Essentially, other than not changing, there are 2 movements A currency can rise in value against another currency / other currencies A currency can fall in value against another currency / other currencies 6

7 Exchange Rate Movements When the movement is a rise in value, the currency or exchange rate is said to have appreciated against the other currency(ies)..as in the Dollar appreciated against the Yen When the movement is a fall in value, the currency or exchange rate is said to have depreciated against the other currency(ies)..as in the Peso depreciated against the Dollar 7

8 Interpreting Numerical Exchange Rate Movements So we know that exchange rates appreciate and depreciate, but to know how to decide if a particular numerical exchange rate movement is appreciation or depreciation requires another, not trivial step The reason the step is non-trivial is that by foreign exchange trading community conventions, not all exchange rates are expressed same way 8

9 Interpreting Numerical Exchange Rate Movements In particular, there are 2 ways that the most important exchange rates, those with US$, are expressed For nearly all world currencies, the exchange rate is expressed as Numbers of Foreign Currency per US$, as Yen100/$, Mexican Pesos12/$, Indonesian Rupiahs9000/$, Canadian Dollars 1.04/$, etc. But, for 2 world currencies, the Pound and the Euro, the convention is Numbers of $ per Pound or Euro, as in $1.56/Pound and $1.29/Euro 9

10 Interpreting Numerical Exchange Rate Movements So, and not surprisingly, what is appreciation or depreciation differs for the 2 forms of the exchange rates with dollar. For the Numbers of Foreign Currency per Dollar exchange rates most exchange rates when the numerical exchange rate goes up, it means the $ has appreciated and the foreign currency depreciated, with the opposite meaning for the numerical rate going down So when Japanese Yen / Dollar rate goes from 90 to 100 per Dollar, it means Yen has depreciated and Dollar has appreciated from dollar perspective, I get more Yen for a Dollar Dollar is of greater value 10

11 Interpreting Numerical Exchange Rate Movements For the Numbers of Dollars per Foreign Currency exchange rates Pound and Euro when the numerical exchange rate goes up, it means the $ has depreciated and the foreign currency appreciated, with the opposite meaning for the numerical rate going down So when US$ / Euro rate goes from 1.32 to 1.20, it means Dollar has appreciated and Euro depreciated from dollar perspective, it takes fewer Dollars to buy a Euro Dollar is of greater value (and my European trip is cheaper) 11

12 Interpreting Numerical Exchange Rate Movements For cross exchange the same principles apply; when a cross exchange rate goes up/down numerically, it means the currency in numerator of expression has depreciated/ appreciated and the currency in denominator of expression has appreciated/depreciated So, if SKWon/JapanYen rate goes from 10 to 8, would mean won had appreciated, yen had depreciated For average exchange rates, they are always set up such that a higher/lower numerical average exchange rate means on average appreciation/depreciation against other major currencies So if the average exchange rate index value for British pound went from 101 to 105, would mean pound had appreciated 12

13 How Currency Markets Operate While we will soon plan to get to what makes exchange rates move appreciate or depreciate, it will be useful to discuss the mechanics of how currency markets work Currency markets are run by foreign exchange departments of international banks, and specialty foreign exchange trading firms These departments and firms acts as brokers / dealers / intermediaries between the ultimate users of foreign trade exchange 13

14 How Currency Markets Operate These ultimate users of foreign exchange are entities who have operations in more than one currency / country; they need to trade currencies to move their resources from one country to another. Examples of these entities include: exporters and importers, governments, international investors, currency speculators, multinational companies, etc. Each of them frequently or occasionally need to convert value in one currency into value in another currency. 14

15 How Currency Markets Operate To carry out the needed exchange, they will go the foreign exchange trading community and make an offer of the currency they have and a bid for the currency they want, at the price or exchange rate being quoted by the foreign exchange trading community. Because so much foreign exchange trading is going on some say as much as $5 trillion a day it will be almost certain that someone else will be offering the currency they want and bidding for the currency they have, and the exchange is quickly completed. The foreign exchange traders make their money by profiting from small gaps between the bid and offer prices for the currency. 15

16 How Currency Markets Operate This trading of currencies goes on in two types of foreign exchange markets. In the spot market, the one most familiar, the exchange of currencies is made instantly, or, to be exact, settled within 2 days. In the forward market, in some ways the one most important, the contract to exchange the currencies, including the amount and the exchange rate, is made today, but the actual exchange does not occur until a date well into the future specified in the contract. 16

17 How Currency Markets Operate The forward contract is so important because it allows international economic actors to either hedge currency exposure or speculate in currencies, both important activities. Hedgers, especially exporters and importers, use the forward foreign exchange market to lock in an exchange rate at which they can exchange a receipt from or payment to another currency due at some future date, eliminating risk of currency movement. Without the forward foreign exchange market, international trade would cease. 17

18 How Currency Markets Operate Speculators use the forward market to make bets on the future movements of currencies more efficiently than if they had to actually had to buy or sell the currency they thought was going to appreciate or depreciate, respectively. A particularly notable currency speculator who makes great use of the forward market is George Soros The major centers of currency trading in the world are in 3 cities, London, New York, and Tokyo, but with the growing importance of China s economy, Shanghai may get added to the list in 10 years or so. 18

19 Why Exchange Rates Move While it is very difficult to explain exactly why a specific currency moves a specific direction on a specific day, the basic forces are straightforward. Essentially, a currency rises in value, or appreciates, when there is more money trying to get into the country to buy its goods or invest in it, or, less money trying to leave the country to buy foreign goods or invest somewhere else. A currency falls in value, or depreciates, when there is less money trying to get into the country to buy its goods or invest in it, or, more money trying to leave the country to buy foreign goods or invest somewhere else. 19

20 Why Exchange Rates Move Exch Rate App Initial Exch Rate Dep Supply of Domestic Currency Leaving Country This graph is a useful way to illustrate Movement of exchange rates. -- The Supply Curve shows amount of monies wanting to leave country. If they increase appreciates Supply Curve shifts to right and causes currency to depreciate, and vice versa. depreciates -- The Demand Curve shows amount of monies wanting to enter country. If they increase Demand Curve shifts to right and currency Appreciates and vice versa. Demand for Domestic Currency To Get Into Country Domestic Currency Being Traded on FX Markets 20

21 Why Exchange Rates Move There are variety of forces that drive whether more/less money flows into / out of a country. Stability relative to other countries, with relatively more/less internal stability causing money to enter/leave. Inflation relative to other countries, with relatively more/less internal inflation causing money to leave/enter. Productive capabilities relative to other countries, with relatively more/less internal productive capability causing money to enter/leave. 21

22 Why Exchange Rates Move Economic policies relative to other countries, with relatively better/poorer internal economic policies causing money to enter/leave. Interest Rates relative to other countries, with relatively higher/lower internal interest rates causing money to enter/leave. Rates of domestic spending relative to other countries, with relatively more/less internal domestic spending causing money to enter/leave. 22

23 Why Exchange Rates Move Examples Over past 8-9 months, yen has depreciated against the dollar, moving from 85 to dollar to 100 to dollar, as a result of the Japanese government increasing domestic spending and lower interest rates, causing on balance less money to enter Japan and more to leave Over the past several years, the China exchange rate has appreciated against the dollar, going from 8.32 to 6.32 per dollar, as a result of China being a great place from which to export goods and in which to invest, causing large amounts of money to want to enter China. (Of course, as to be discussed next, China s government has prevented the appreciation as much it could have been through currency manipulation) 23

24 Why Exchange Rates Move It also is important to look at what happens when exchange rates do move. Essentially: When an exchange rate appreciates, It makes the country more expensive to the rest of the world and the rest of the world less expensive to the country Increases money going out and lowers money coming in Helps importers and consumers and hurts exporters When an exchange rate depreciates, It makes the country less expensive to the rest of the world and the rest of the world more expensive to the country Lowers money going out and raises money coming in Helps exporters and hurts consumers and importers 24

25 Government Manipulation of Exchange Rates Governments can and do chose from a variety of ways to manage their currencies and exchange rates. The IMF provides the following categories of these ways: Pure float government has no correct exchange rate and takes no action to affect exchange rate (US Dollar) Managed float government has no correct exchange rate but does on occasion take actions to affect speed of exchange rate movements (Japan Yen) 25

26 Government Manipulation of Exchange Rates Peg government chooses and announces a desired exchange rate, and when necessary takes actions to keep that rate (Saudi Arabia Rial) Crawling Peg government chooses, not a specific exchange rate, but a pace of change in the rate, and when necessary takes actions to keep that pace of change (no used much anymore; Turkey a historical example) 26

27 Government Manipulation of Exchange Rates Currency Board like a peg, except the government takes away from itself the ability to change the rate or take actions to hold or not hold it (Hong Kong, Estonia, Bulgaria) Use Some Other Country s Currency, sometimes called dollarization formally declares the money to be used in the country is some other currency (Panama, El Salvador, Ecuador, and the Euro) 27

28 Government Manipulation of Exchange Rates What the government and central bank have to do in case of floating exchange rate is simple very little as they allow the market to set the rate. In the case of a peg, however, a process must be followed First, a currency, or group of currencies, that is to be pegged against must be chosen Second, the desired rate must be set and announced Third, the amount the actual rate will be allowed to deviate from the desired rate, called flucuation bands, must be set Fourth, then actual exchange rate reaches upper or lower flucuation bands, actions, called intervention must be taken 28

29 Government Manipulation of Exchange Rates The nature of intervention is as follows. If the actual exchange rate is trying to rise in value / appreciate, the central bank will use its domestic money supply to buy up foreign exchange to keep exchange rate from appreciating. This is called undervaluing exchange rate As a result, the exchange rate will not appreciate and the central bank will accumulate foreign exchange rate reserves; China is best example of this. The primary reason for doing this is to maintain export competitiveness As the country has unlimited supply of its own money, this action can be carried out indefinitely 29

30 Government Manipulation of Exchange Rates If the actual exchange rate is trying to fall in value / depreciate, the central bank will use its foreign exchange reserves to buy up domestic currency to keep exchange rate from depreciating. This is called overvaluing exchange rate As a result, the exchange rate will not depreciate but the central bank will lose foreign exchange rate reserves; countries that eventually have a currency crisis Mexico, East Asia, etc. are best examples of this. The primary reason for doing this is to provide stability of exchange rate (often backfires) and political purposes As the country does not have unlimited supply of foreign exchange reserves, this action generally leads to problems 30

31 Euro Over the course of the 1990s and early part of last decade, a sub-set of the EU countries created a common currency known as the Euro The purpose of the Euro was to reduce foreign exchange costs of trading within the EU and to create a competitor currency to the dollar The steps to creating, and now expanding, Euro are: Before joining, match economic polices, especially money supply, inflation, budget balances Decide on the exchange rate that will be used to go into the Euro Join and replace the original national currency with the Euro in effect dollarize with the Euro Give up the ability to use changes in domestic money supply and changes in exchange rate as tools to solve economic problems 31

32 Euro While the Euro has in general benefitted the member countries, it also, because of the nature of what it entailed, was a major part of the cause and difficulty in solving the ongoing European financial crisis, as follows. On the Cause side, when countries were allowed into Euro, a perception was created that they had good economic policies, so countries like Greece, Italy, etc., could borrow money as easily as Germany But, as we have seen, these countries did not have good economic policies, so they were allowed to overborrow When the overborrowing was realized, huge amounts of money left, collapsing their economies On the Solution side, if Greece, Italy, etc. were not in Euro, they could have expanded their domestic currency and/or depreciated their exchange rate as means of reducing the collapse, but, since they were in Euro, could not And so, the crisis has lingered and lingered and.. 32

33 Currency Collapse Our final topic, and a useful comparison to Euro crisis, is currency collapse A currency collapse is defined a large, rapid depreciation of a country s exchange rate, say 30-40% or more in less than 2-3 months Examples include: Mexico in 1994, East Asia in 1997, Russia in 1998, Turkey in 2001, Argentina in 2002, Iceland in 2008, to cite a few 33

34 Currency Collapse A currency collapse generally follows following pattern. Country has a pegged exchange rate Because of good economic policies / circumstances, foreign money is flowing in Policies / circumstances turn negative (instability, excess inflation, business-unfriendly policies ) Foreign money flows reverse Downward (depreciation) pressure is placed on exchange rate 34

35 Currency Collapse Central bank, because of peg, defends the exchange rate by buying local currency (that the foreign investors are selling to get out) with foreign exchange reserves Exchange rate remains same, but reserves fall Reserves eventually near zero, the central bank has to stop intervening, and the currency collapses leading also to a fairly severe domestic economic recession The IMF comes in and assists the country to stabilize the currency, albeit at a much lower level The presence of the IMF, the lower value for the currency and its impact on competitiveness, and better circumstances and policies, the latter that the IMF demands, arrest the economic deterioration and put the economy back on an upward trend 35

36 Links to Websites Foreign Exchange Market arket Exchange Rates 36

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