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The currencies issues and the volatilities in foreign exchange rates
The currencies issues:
A current issue which impacts on all financial decisions is the volatilities in foreign exchange rates,
especially that of the US dollar, Euro , Yen and the Chinese RMB. Each of these currencies is under going
changes in their values and for the US dollar, Euro and Yen even possibly their traditionally dominant
status as reserve currencies. On the other-hand, the Chinese RMB is emerging as an international
currency and may eventually become one of the main reserve currencies. It is worthwhile to examine
the factors and issues which are affecting their exchange rates and their status as reserve currencies.
The Current Currencies Problems and Issues:
Theoretically the factors which determine exchange rate are the following:
i) Relative inflation rates
ii) Relative national income growth rates
iii) Relative interest rates
iv) Exchange rate expectations
v) Central bank intervention
i) The EU is a union of un-equals and the PIIGS countries are causing stress and concerns about the exchange rate of Euro and the major currencies
ii) Private sector: Spain, Ireland and Greece went on a private sector pending
iii) EU has a monetary policy which is the direct opposite of the US .European countries are practicing a policy of austerity i.e. very severe cuts in their fiscal and budgets.
iv) The PIIGS have national debt to GDP ratios which well over a 100% and their banking systems are under great strain
v) Greece was the first country which required a bailout by the ECB and IMF.
vi) This was followed by Portugal, which resulted in a change in the government and a possible bailout as well.
vii) Ireland was the next to need help to salvage the major Irish banks.
viii) There are some forecasters who think that there is a possibility that EU may suffer some kind of a break-up.
ix) Strong on the core but very weak at the periphery and the gap is widening.
x) Political realities in rescue programs especially Germany and France who are the “givers” and the periphery, the receivers.
xi) The Euro is the most credible rival to the US$, It’s status is poised to expend provided the euro successfully overcome sovereign debt crisis currently faced by some member countries and can avoid moral hazards problems associated with bailouts within the European union. Currently, it appears that it is the main alternative to the US dollar.
xii) Latest increase in interest by ECB has triggered a massive dive in the euro rate which has resulted in the exchange rate of euro going in the opposite direction to standard theory. Why? Basically it has increased the debt burden of the PIIGS countries by making the eventual payments of interest or borrowing costs higher. This assumes that there are still lenders. This increase in interest rate has also triggered a contagion effect. Now the crisis appears to have spread to Italy and Spain. The crisis is now on a scale especially Spain where the EFSF may not even be enough to solve the problem. The euro against the US$ is currently at its lowest.
Greece: latest rescue
i) A second bailout in addition to the May bailout of 110b.by EU and IMF.
Extra 109b of Government sources 50b. by private sector bond holders
ii) Maturity of existing bonds extended to 15 years instead of 7.5 years
iii) Interest rates reduced to 3.5 % from 4.5 – 5.8%.
iv) Bankers voluntarily swap Greek bonds for longer term maturities .EU acknowledging that the swap schemes may lead to Greece being declared in selective default. However, EU stood ready to protect Greek banks from fall out by providing credit guarantees if needed to ensure that they can still obtain liquidity from ECB.
4 options will be offered to private sector creditor taking part in the scheme
a) 3 offers to exchange Greek government bonds
b) 1 offer to roll over into a 30 years maturity
v) IIF ( Institute of International Finance-400 members)’s comment
a) Reduce Greek debt from 340b by 13.5b
b) Expect 90% to take up
vi) Rescue Fund, EFSF :
a) Will be allowed to buy back bonds from the secondary market if the ECB deems it necessary to fight the crisis
b) Give states precautionary credit lines before they are shut put of credit markets
c) Lend governments money to recapitalize banks
d) EFSF also to prevent Spain and Italy from being shut out of markets to prevent contagion
Financial markets appear reasonably happy as they see a longer term approach to the crisis rather than a stop gap measure. EU appears to be sending the right signals. Greek debt reduced by 24% from 150%.
vii) The 440billion euro EFSF is too small. The bond vigilantes broadly agree that EFSF need two trillion Euros to forestall a twin crisis in Italy and Spain. This may create political problems for France and Germany.
viii) Total rescue bill so far by ECB-
a) 365 Bil Euros in official loans to Greece, Portugal, Ireland
b) 96 Bil Euros in bonds buying
c) Creation of the 440 Bil. EFSF
Many economists believe the only way out of the Euro zone crisis in the long term may be a closer integration of fiscal policy e.g. a Euro zone guarantee for countries bonds or issuance of a joint Euro zone bond to finance all countries. Germany does not agree to this.
ix) Last bulwark of euro may be tottering
The euro zone face a real risk of recession because of a volatile mix of factors: slower global demand, tighter credit from banks, repeated austerity efforts, high commodity prices and over-valued euro and higher interest rates from the ECB.A sudden slow down in the two countries that make up half of the bloc’s gross domestic product could also have major political ramifications, narrowing room for manoeuvre for both Merkal and Sarkozy as they try to fight the crisis. Germany’s GDP growth was a merge 0.1% in the second quarter. How long can it be a “transfer” union if these two countries GDP growth drops?
Italy: August 14
i) A painful mix of tax increases and spending cuts to meet ECB’s demands on shoring up Italy’s strained public finances
ii) Austerity package cuts of 20 billion euro for next year and 25.5 billion the following year to bring the budget back to balance in 2013
iii) Special levy on incomes above 90,000 to higher taxes on income from financial investments and cuts in cost of government
iv) ECB demanded a accelerated deficit cuts from Italy as a condition for buying its bonds on the market after a sell-off sent Italian borrowing costs soaring and threatened to put the euro-zone’s debt crisis on a new unmanageable plane
Current situation: Talk of the issue of a Euro bond which means that these bonds are guaranteed by all 17 member euro countries.
i) Core countries will suffer the most as their credit rating will drop resulting in increased costs for their individual debt
ii) Core countries may be politically affected- “transfer union”
The US Dollar
i) A monetary policy of “pumping” money into the economy to assist economic recovery.
ii) The US budget is operating at an unprecedented level of deficits. It has practically reached the limit approved by Congress. The 2 party political system is a political risk as they are finding it hard to agree on how limit of the deficit is to be solved.
iii) Interest rates in the US at a very low level. This helps to keep the exchange rate of the dollar low.
iv) S&P for the first time has cut US outlook to “negative” citing a “material risk” that policy makers may not reach agreement on a plan to trim its large budget deficit. This should put the dollar under further pressure. Take note that the dollar is already at or near record lows against the major currencies. The IMF reinforced S&P’s warning by admonishing the US for not having any credible plan to bring its huge budget deficit down.
v) There is a question mark over Fed’s decision to print more money to revive economy.
vi) The latest “quantitative easing” by the Fed, dubbed the QE2 will create US$600 bilion in greenback cash like magic. Latest is that QE will continue as the US recovery is still struggling
vii) US had been accused of devaluing the dollar through QEs to ensure that it’s export are relatively cheaper.
viii) Despite of all these negative factors why is the rest of the world still believe in the US dollar and in assets denominated in US dollar?
a) The US still enjoy a safe-haven status compared to the simmering unrest in the middle east an the devastating effect of the tsunami in Japan
b) The Greek bond yields shows up the risk of the unresolved sovereign debt crisis in the eurozone (Bail outs, Greece, Ireland and now Portugal bailout package of 78 bil euros)
c) Emerging markets are tightening monetary policies
d) High oil prices are giving the oil rich countries and trade balance countries huge reserves. Since there few or almost no alternatives that they can channel their savings but the US
e) There is an optimistic view that the US dollar has reached about its lowest, is well supported and should rebound soon. The US economy is seen to be recovering.
3 pillars which give it the most favoured- currency status
i) the depth of US dollar-denominated debt securities
ii) the dollar is the world’s safe haven
iii) the dollar benefits from a dearth of alternatives
Financial Stability Oversight Council (FSOC)- proposed new rules
i) regulations for firms whose failure may endanger the financial system
ii) enhanced capital requirements
iii) annual Fed stress tests
The US$ isn’t going anywhere. It is not about to be replaced anytime soon. The only dangers areas:
i) reckless US mismanagement giving rise to chronic inflation or deflation if the exit of QE2 is not handled properly
ii) the second round of QE is not well handled and
iii) US Budget deficits run out of control.
iv) The US lawmakers are seeking a path to increasing the debt limit US$ 14.3 trillion and to cut at least US$1 trillion from the long term deficit before an August 2 deadline.
v) A short term default by the US on its debt because of technical links may have catastrophic legal consequences.
Present situation in the US:
vi) Slow growth
vii) Unemployment still a major problem
viii) Domestic demand still lagging
ix) QE 2 coming to an end
x) Biggest problem is that the sovereign debt ceiling of US$ 14.3 trillion has been reached and it can only be increased if Congress approves. It has become a “political” issue for the 2012 election.
xi) S&P has cut the AAA to AA+
xii) If the sovereign debt ceiling is not increased, US will default and many believe that the systemic risk and financial crisis will be even greater that of 2007.
Deal August 2,2011
a) The immediate impact is to raise the debt limit by $400 billion, giving the Treasury what it needs to avoid exceeding the current $14.3 trillion cap. An additional $500 billion increase will be available, subject to disapproval by Congress.
b) In exchange, spending is to be cut by $917 billion over a decade from Cabinet-level agencies and the thousands of federal programs they administer.
c) The bill’s second phase begins with the creation of the special committee of lawmakers. Depending on its success in recommending savings that Congress ratifies by Christmas, the nation’s borrowing authority will rise by $2.1 trillion or as much as $2.5 trillion.
i) Is only a step forward, not a solution
ii) Needs a plan to reduce the deficits by no less than $4 trillion in the next decade
iii) Plan needs :
a) cut wasteful spending in the defense
b) address the unsustainable growth of our entitlement programme
c) reform the tax code
d) cannot avoid the big “ticket” items –Medicare, Medicaid, Social Security solvency and Tax reform
e) restore Americans’ faith in the political system
f) The “Super- Committee” of 6 Democrats and 6 Republicans has failed to agree on deficit reductions setting in motion automatic cuts by US$1.2 trillion over 10 years. The cuts are designed to be split evenly between domestic and military programmes. The US president has said that he will veto any bill to repeal the agreement.
xiii) Downgrade and impact:
a) Treasuries more risks leads higher interest rates. Linkages to all other rates
b) Possible recession- inflation, higher costs. Less jobs
c) US problems could get worse, higher costs of debt may have to borrow more, further downgrade
d) Eroding reserve status
The Japanese Yen
i) Effects of the earthquake and tsunami. Too strong a Yen as Japanese firms are selling their foreign investments to bring back funds to rebuild. Unusual increased in demand for Yen caused too strong an appreciation. This may hamper the recovery which in turn will affect global economic conditions
ii) This resulted in unusual support from the major central banks of major countries to bring the exchange rate of the Yen to a reasonable level.
iii) Depending on the rate of recovery of the economy
Given the problems of the US$ and the Euro, there is a move to the Yen and the exchange rate vis a vis US$ and Euro is at a high. This is not because the Yen is intrinsically strong but the dollar and euro are weak
iv) BOJ going alone to intervene in the exchange market to maintain the Yen at a rate which does not adversely affect her exports.BOJ is continuing with the policy of intervention to maintain the Yen at an “appropriate “ level
The Chinese Yuan (Renminbi)
i) Issue of under-valuation – PBC intervention
ii) A controlled slow appreciation, possible a 5% increase this year
iii) A high growth rate and high inflation
iv) Wider Yuan use in trade with China. There a number of bilateral currency agreements between China and a number of countries e.g. Malaysia
v) The gradual internationalization of the Yuan
vi) Differential in interest rates between China (high) and the US (low).This leads to massive capital inflow leading to appreciation of Yuan
vii) Expectation as a significant factor
viii) (PBC)People’s Bank of China is considering setting up a fund (intervention fund) that will direct foreign exchange in the market so that the central bank does not increase base money. This is to prevent the Yuan from rising too fast and too far. China’s central bank has been an avid buyer of dollars generated by China’s exports.
ix) “ Hot” money impact
b) RMB’s internationalization and eventually a reserve currency?
Internationalization: An international currency is used and held beyond the issuing country’s borders and plays the role of unit of account, medium of exchange and store of value for residents and non-residents alike.
a) Progressing without too much notice
Advantages to China:
ai) Elimination of exchange risks to which Chinese firms are exposed
aii) Greater funding efficiency for Chinese financial institutions thus strengthening their competitiveness in global financial markets
aiii) A boost to China’s trade with its neighbours owing to the reduction in transaction costs
aiv) Less need for China to hold US dollar assets and risk capital losses on the country’s foreign exchange reserves
av) Eventual status as one of the world’s reserve currencies which would provide China more freedom to maneuver in domestic and international economic policy
Chinese officials believe that China’s internationalization is a way for China to set its own agenda without being overly constrained by external conditions beyond its control.
c) Progress made in the use of the RMB as a settlement currency:
i) Issuance of RMB denominated bonds
ii) Currency swap agreements with foreign central banks
iii) RMB deposits in Hong Kong is growing exponentially
iv) Incentives have been provided to encourage enterprises to use RMB to settle transactions
v) China has formalized rules allowing foreign firms to use Yuan raised overseas to make investments in the country as part of the moves to internationalize its currency. A trial scheme would permit overseas companies to use Chinese currency raised offshore to set up companies, make acquisitions, increase stakes in subsidiaries and provide loans, the China Business News said, citing a Central bank statement.
vi) Most analysts believe that it is inevitable that the Renmimbi will be a reserve currency in the not too distant future and the foreign reserves of countries will compose of US dollar, Euro, Yen and Renmimbi, (some gold). The question is whether it can over take the US dollar as the top currency?
Professor Martin Reldstein, Harvard.:
China will allow the Renminbi to rise substantially against the dollar if they want to raise its overall global value in order to decrease China’s portfolio risk and rein in inflationary pressure.
In the past 12 months, the Renminbi strengthened by 6% *against the dollar, its reference currency. A more rapid increase of the Renminbi dollar exchange would shrink China’s exports and increase its imports. It would also allow other Asian countries to let their currencies rise or expand their exports at the expense of Chinese producers. Why might the Chinese authorities deliberately allow the Renminbi to rise more rapidly?
2 fundamental reasons.
i) Reduce its portfolio risks
ii) Containing domestic inflation
Reduce its portfolio risks:
The authorities concern about the risks implied by its portfolio of foreign securities. China’s existing portfolio of US$ 3 trillion worth of dollar bonds and other foreign securities exposes it to two risks:
i) Inflation in the US and Europe: Inflation in the US or Europe would reduce the purchasing value of the dollar bonds or euro bonds. The Chinese would still have as many dollars or Euros but those dollars or Euros would buy fewer goods on the world market
ii) Rapid devaluation of the dollar relative to the euro and other currencies. Even if there were no increase in inflation rates, a sharp fall in the dollar’s value to the Euro and other foreign currencies would reduce its purchasing power. The Chinese can reasonably worry about that after seeing the dollar fall about 10% relative to the Euro in the past year and substantially more against other currencies.
iii) The only way to reduce those risks is to reduce the amount of foreign currency securities that it owns. But China cannot reduce its volume of such bonds while it is running a large current-account surplus. During the past 12 months China had a current-account surplus of nearly US$300 bil, which must be added to China’s existing holdings of foreign securities
Containing domestic inflation:
i) A stronger Renminbi lowers the cost to Chinese consumers and imported goods as expressed in Renminbi. A barrel of oil might still cost US$90, but a 10% increase in the Renminbi dollar exchange rate reduces the Renminbi price by 10%.
ii) Reducing the costs of imports is significant because China imports a wide range of consumer goods, equipment and raw materials. China’s total annual imports amount to roughly US$1.4 trillion or nearly 40% of GDP
iii) A stronger Renminbi would also reduce demand pressure more broadly and more effectively than the current policy of raising interest rates. This will be even more important in the future as China carries out its plan its increase domestic spending especially spending by households
iv) Chinese consumer prices rose about 6.5% over the past year while US CPI rose only 3.5%. The three percentage point difference implies that the “real inflation adjusted Renminbi dollar exchange rate rose (% over the past year (i.e. 6%*nominal appreciation plus the 3% inflation difference)
v) The dollar is likely to continue falling relative to the Euro and other currencies over the next several years. As a result, the Chinese will be able to allow the Renminbi to rise substantially against the dollar if they want to raise its overall global value in order to decrease China’s portfolio risk and rein inflation pressure
Nov.22,2011 China plans new currency pairs for Yuan trading
China’s ( China Foreign Exchange Trade System –CFETS) domestic foreign exchange market launch trading of the Yuan against the Australian and Canadian dollars. The Yuan is currently traded onshore against the dollar, euro, pound sterling, yen, Hong Kong dollar, ringgit and ruble. This is another step to internalize the Yuan
Nov.23, 2011 China doubles HK Yuan Swaps
China’s central bank doubled the size of a currency swap with Hong Kong to 400 billion Yuan (US$63b), a move aimed at giving the financial centre a bigger relief valve to cope with rising demand for trade settlement in the currency. The expansion will boost confidence that Beijing intends to internationalize the Yuan