Exchange rates – and the management of them – are a major theme of economic news. But it can be all rather confusing. I shall try to spell out in simple terms the main issues, brushing over the nuances. But even so, this post ended up much longer than I intended!
We don’t always need to think about the mechanics of exchange rates, even when they are obviously involved. Take the Maldives or one of the Caribbean Islands which relies on tourism for its income, either in the form of “hard” currency like USD or its local currency. It needs this income in order to be able to import the goods it needs – food, fuel, machinery or whatever. We can just say “the island needs currency to be able to pay for the things it needs”. But that only gets us so far. In order to really understand what is going on around us we need to dive into the whole topic of exchange rates and foreign reserves.
A strong currency
Let’s start off by asking ourselves what we mean when we say a particular currency is “strong” – ie at a high exchange rate compared with other currencies? As a tourist we might think about the “real exchange rate”. That is to say, the exchange rate after you allow for cost of living. If we are travelling from the UK to Thailand, and the exchange rate is £1 = 42 Thai Baht, then we might exchange £15 (the cost of a basic meal in the UK) for 15 x 42 = 630 Baht, but we’ll be pleasantly surprised to find that we can grab a decent meal for only 200 Baht. In this case we are justified in claiming the pound is “strong”. However, for economists it’s more about trade than anything else. If the UK is importing much more from another country than the UK is exporting to it, we can consider that the UK currency is “strong”.
We live in a world of multi-lateral trade, but to fix ideas let’s just consider the trade between the UK (£) and Europe (€). And let’s suppose that trade to and from the continent has been fairly balanced and the currency has been oscillating around 1£ = 1,2€ for some time. But one morning we wake up to find that the pound has strengthened to 1£=2€. The British will then feel on top of the world – all the goods in Europe will seem very cheap to them when expressed in pounds. A computer worth €1000 in Europe used to cost €1000/1,2 = £833 from the UK, but now only costs €1000/2=£500. And making that weekend trip to Paris or Rome would also be more affordable since pounds in their pockets go such much further than before. The result of all this would be for the British to buy lots of cheap European products (either from home, or while on holiday), and British businesses will also import a lot more from the continent. On the other hand, the Europeans will find UK products expensive and will import a smaller volume of goods from us than before.
The forex market
So far so good, but let’s dig a little deeper. What is really happening when a purchase is made in a different currency? Take a look at the following chart (ignore the central banks for the moment!):
Suppose you’re living in the UK and you wish to buy a product advertised on Amazon France for €1000, which for you is £500. Your bank will debit £500 from your £ account and pay Amazon £500. Amazon will then turn to one of the large international banks (or payment processors like PayPal) to exchange this £500 for €1000, which they will then use to pay the supplier in France (who of course wishes to be paid in euro).
These international banks (JP Morgan Chase, Citibank, HSBC, Deutsche Bank, UBS and the rest), together with central banks and other currency traders, are part of what we call the “forex” (foreign exchange) market. Many of these players will maintain their own reserves of the main currencies, and will swap currencies with traders like amazon, and also with each other.
Currency booths like Travelex work in a similar way. Some are independent businesses and others are run by large banks, but they will have their own pile of euros, yen, dollars, pounds and other popular currencies to exchange.
And this is in fact how exchange rates are really determined – by supply and demand for each currency.
If Japanese products are all the rage, everyone will be buying these Japanese products denominated in yen. Consumers around the world will be paying Amazon Japan their euros, pounds and dollars in exchange for yen. Amazon will work with, say, Deutsche Bank to exchange these currencies for yen. As the banks begin to deplete their reserves of yen and accumulate euros, pounds and dollars, they will start to shift the exchange rate in favour of the yen, offering more euros, pounds or dollars (which they have an abundance of) for yen which is getting scarce. Thus over time the popularity of Japanese goods will drive the value of the yen upwards.
An automatically adjusting mechanism!
We can see from the above that the whole system has a tendency to adjust automatically. If the exchange rate is too high (in the sense that money is flowing out of the country, spending on imports), then over time the exchange rate will adjust downwards. Imports will become less affordable and exports will pick up until an equilibrium is reached.
One country (or region) can’t keep supplying or receiving goods for ever…
We have seen from the way exchange rates are set that one country can not continue to supply another country with a one-way flow of goods. Eventually the exchange rate would adjust to balance the pattern of trade.
But this is also common sense. After all, why would one country provide a better quality of life (goods) to another in perpetuity? The mechanism is rather easier to understand in the case of a single currency zone like the USA. If one state continued to buy goods from a neighbouring state, it would eventually run out of money!
Governments manipulate exchange rates
We’ve sketched out above the case of floating exchange rates, whereby they adjust up and down with the ebb and flow of supply and demand from trading partners and consumers. But governments might also step in and influence exchange rates in the short term. They might deem their exchange rate excessively high and detrimental to their exporters, or perhaps they feel it’s on the low side and fueling inflation (because imports are too expensive).
The government might wish therefore to nudge the exchange rate in the right direction. In the extreme, they might even try to fix the exchange rate, or at least ensure that it moves within a narrow band. There are three main ways they can do this.
Let’s focus on the case where the UK government wishes to prop up its own currency.
Method 1: The central bank uses its foreign reserves
The Bank of England uses its foreign reserves (its stockpile of euros, dollars, other foreign currencies and gold) to buy up pounds in the forex market.
Look back up at the chart – this is why the central banks with their foreign reserves are part of the picture.
Where would the Bank of England get these “foreign reserves” in the first place? Well for a start it can buy euros and other currencies in the forex market with pounds (not really a solution here, since this would have the effect of pushing the pound down! – but in the long term the Bank of England has an interest in building up its foreign reserves for a rainy day). Another method would be to sell UK government bonds. When these bonds are issued, some foreign investors will snap them up and pay the government in foreign currencies, and the Bank of England might take these funds as they are without converting them to pounds first.
Method 2: the central bank raises interest rates
This attracts foreign investors who might decide to put their money into UK bank accounts or buy some UK government bonds. This demand for the domestic currency will keep it up.
Nothing is for free though, and the direct cost of doing this for the government is that it will have to keep forking out bigger interest payments in the future. There would also be a negative knock-on effect on the economy hitting demand (let’s not get into that – there are so many moving parts in economics and this is not a text book!).
Method 3: protectionism
Imposing quotas on imports is frowned upon these days, but it’s still common to slap tariffs onto imports so that consumers prefer to buy home-grown products.
Balance of payments crises
Let’s say that the UK government has committed to maintaining the currency at a level which is far too high. The country will be importing a lot (since imports are cheap for them) and exporting little. This leads to a “trade gap”. The currency drains away from the country as people are using their £s to buy products abroad. The international banks are flooded with £s and are drawing on their reserves of other currencies, and this exerts a downward pressure on the pound. To counteract this, the central bank might start to buy up pounds with its cache of foreign currency. But reserves are finite and it will eventually run out! This is known as a “balance of payments crisis”. When this happens, the currency can no longer be supported and the pound will tumble, disrupting trade and triggering inflation as foreign goods in the shops shoot up in price. We don’t hear much about the “balance of payments crises” these days since fixed currencies are out of fashion, but the concept is still important to understand.
Devaluations can also be aggravated by speculation. We should keep in mind that the foreign reserves of central banks are dwarfed by the foreign reserves of the international banks and other actors in the foreign exchange market, including hedge funds and individual speculators. The UK holds roughly $175b in foreign reserves while daily trading volumes in the global forex market are around $7 trillion!! So you can see that a central bank’s attempt to impose an exchange rate in the long run against market forces is doomed to failure. If markets sense that a central bank is struggling to maintain the currency, speculators can swoop in and bet against the currency (as famously occurred in UK’s “black Wednesday” in 1992).
The current account and the financial account
Let’s introduce some useful terms.
The “current account” is all about trade movements. Let’s suppose that the UK pound is very strong compared with the euro. It’s often easier to think about flows of money rather than flows of goods (money is more important since it can buy things in the future):
As the money floods out and we suck in imports, we run a “trade deficit” (you can remember this as a deficit of money) which is bad for our “balance of payments”.
As the money drains out of the UK economy, the exchange rate will also devalue (if it’s left to float freely) until the net trade is zero. This is easy to remember – “d” for trade deficit goes together with “d” for “devaluation”). You can picture this as two water towers – water will flow out of the higher one into the lower one, and as it does so the level of water drops until the two water levels are even again and there is no further flow of water.
Inversely, if money floods into the UK economy, it will pump up the exchange rate.
The current account is all about one-off international payments, like buying a product or a service, or sending foreign aid, or paying wages. It’s money you won’t see again.
On the other hand, “capital transactions” are international investments – eg someone buying a factory abroad, someone buying a share or a bond, issuing a loan, making FDI (foreign direct investments). In all these cases in a few years’ time they can “cash out” and get the money back. These investments might have an important effect in the short term, but they are fickle and impermanent and can be reversed quickly on market sentiment. The central bank spending its foreign reserves or putting up interest rates to attract foreign investors are also examples of “capital transactions”.
In simple terms, we can think of the “balance of payments” alluded to above as made up of the “current account transactions” and “capital transactions”.
Why might the exchange rate appreciate?
Before we turn to our final and most interesting topic, let’s first review what’s been said and list the main reasons why a currency might get stronger (or weaker – just take the opposite points). A currency could appreciate due to:
- trade surplus – if it’s exporting more than its importing then there’s a net demand for the currency propping it up
- high interest rates – attracting foreign money looking for returns, increasing demand for the currency
- the central bank intervening to buy its currency with foreign reserves
And we should also add that an economy that’s doing well is generally an attractive target for investors:
- if the country is politically stable, the economy is growing, there is positive economic news (eg commodity prices are rising and the economy is a net exporter of these commodities), inflation is low, low public debt etc then investors will snap up its assets, and support the currency
Goodies and baddies in international trade
Now we come to the most interesting question of international economics. Let’s cut to the chase with the following striking statement:
A country selling a lot to the rest of the world is viewed negatively.
Why should this be?!
In a world where exchange rates float freely, then trade gaps should self-correct over time. If a country is a net exporter, the demand for its currency would eventually drive the exchange rate up until its goods were no longer competitive. But governments act in their own interests, and tend to intervene – obviously or more subtly.
A country in deficit is in a bad way. It’s losing money. It is receiving goods for the rest of the world which is nice, but it knows this can’t continue indefinitely because it can’t afford it, so there will be a day of reckoning. There are only two market solutions to deal with this balance of payments issue. The first is deflation – slow the economy down, let unemployment rise so that people won’t be able to afford the imports. Not a great answer since besides self-inflicting the misery of unemployment on the population, cuts in investment are no good for its long term competitive position. The second is to let the currency depreciate. This could prime inflation, but in the short run it could help its businesses be more competitive abroad. This will be at the expense of foreign businesses though, since after a devaluation we will find their goods too expensive. This is why deliberate devaluation is known as “exporting unemployment”, or “begger my neighbour”.
The inconvenient fact is that the balance of trade is a zero-sum game. If there are countries in deficit, there must be others in surplus to the same degree. Every country will try to move from deficit to surplus, pushing others downwards. As the economist John Eatwell put it, “the entire international system has a built-in deflationary bias”. And this is why countries in surplus are regarded with suspicion. Deficit countries will say “It’s because of them that we are in deficit, and it’s probably because they are deliberately holding their currency down to remain competitive”.
In the past the world economy relied on a “big spender” to shower the world with cash, a country which could run a permanent deficit, especially by investing or lending money abroad. In the 19th century it was Britain, with its manufacturing and finance. And after the second world war it was the US with its huge foreign investments and Marshall Aid (even if at the time it was running a trade surplus – this has been reversed now). But the world lacks a big spender now, and we are all concerned about our balance of payments.
Two pariahs often accused of manipulating their terms of trade are China and Germany.
China produces cheap products with cheap labour, and has bought up USD with the effect of keeping the Chinese currency artificially low. China now owns trillions of dollars of assets, and runs a huge trade surplus with the US. It has also been purchasing foreign companies. This has the effect of bolstering foreign currencies and keeping the Chinese yuan down. Since these assets are in the form of equities, they ensure a steady stream of income back to the home country, and this weight of interest payments and dividends will be a strain on these foreign economies in the years to come. Trump has previously accused China of currency manipulation to gain trade advantages.
As Peter Birks put it:
“There has been much talk and little action about the unsustainability of the US trade deficit with China. The question will increasingly be asked, what will happen when China wants some of its wealth back? For nearly 30 years it has supplied the US with a higher standard of living than it merits by its own production and its contribution to that higher standard of living is now around $1000 a year for every man, woman and child in the country. For China to cash in that debt, Americans would have to accept a lower standard of living than they merited…”
Trump has recently criticised Germany’s automotive exports to US – “they think we’re stupid and they take advantage of us”. Trump has focussed on Germany’s trade practices and tariffs rather than currency valuation though. He is now advocating higher tariffs on foreign products to bolster US manufacturing.
Understanding exchange rates is damnably difficult. Wouldn’t it be so much easier if the whole world just used the dollar?!