Despite all of our theories, economists always have trouble explaining exchange rate movements.  What can we say about recent past movements, and also of the future? 

Let’s have a quick look at exchange rate theory. 

Exchange rates are of course the price of one currency relative to another currency.  And like any price, in simple terms, exchange rates are determined by supply and demand.  What are the main factors driving supply and demand?  (There are several types of exchange rates – nominal bilateral, real bilateral, nominal effective and real effective – all of which will be discussed in this article.  See definitions below.) 

First, purchasing power parity theory tells us that if our inflation is higher than our trading partners, we would lose competitiveness – in other words, our real exchange rate would increase.  Thus, the demand for our currency would decline, such that our exchange rate would depreciate sufficiently to compensate for this higher inflation.  Our real exchange rate would return to first base.  Similarly, if our inflation rate is running below that of our trading partners, we would gain competitiveness – in other words, our real exchange rate would decline.  Thus, demand for our currency would increase, and the exchange rate would appreciate, again returning our real exchange rate to first base.

Second, theory would tell us that foreign exchange markets should get nervous if a country’s foreign debt starts rising as a proportion of GDP.  They would be nervous about the “sustainability” of the debt, that is, the capacity to pay the interest on this debt and to ultimately repay this debt.  Where debt is rising unsustainably, the demand for our currency would decline and the exchange rate would depreciate.  This currency depreciation would improve our competitiveness.  Increased exports and lower imports would reduce the current account deficit, and moderate the rise in our foreign debt.

Third, in the short run, when one country might have higher interest rates than others, investors will switch their demand for investments from low interest rate countries to higher interest rate countries.  This is happening right now when interest rates are virtually nothing in the crisis-affected advanced countries, and capital is rushing to emerging economies which have much higher rates of interest.

Fourth, there is the realm of political factors.  Investors are always attracted by the US given its international political and economic power status – also by the fact that the dollar is the world’s main reserve currency.  Especially in times of uncertainty, it is considered to be a safe haven.  These factors always prop up demand for the dollar.  But when people are really worried about the dollar, they switch their demand to gold, which is the last remaining thing that they can run to!

Fifth, foreign exchange markets can also be greatly influenced by psychological factors, often called “animal spirits”.  According to John Maynard Keynes, “Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

Now let’s have a look at movements in some of the world’s major currencies.

US dollar.  The US nominal effective exchange rate was under steady downward pressure in the couple of years leading up to the global financial crisis reflecting concerns about its growing debt and high current account deficit.  Following the Lehman shock in September 2008, the dollar curiously strengthened as part of a crisis-induced flight to safe havens.  It then fell again in light of market concerns about the implications of its stimulus package for the nation’s debt.  As the economy then recovered, the dollar strengthened, only to fall again when there were concerns about a possible ‘double-dip’ recession. 

The dollar has continued its descent in recent months as the US government continues to maintain very low interest rates and stimulate the economy by monetary expansion known as “quantitative easing 2” (“QE2”).  The US real effective exchange rate followed the same trend as the nominal effective exchange rate.

Euro.  The euro nominal effective exchange rate was on a rising trend from the beginning of 2006 until mid-2008.  It suffered a brief collapse at the same time as the dollar’s post-Lehman rise, only to bounce back again. From very late 2009 until mid-2010, the euro crashed under the weight of the Greek financial crisis and financial troubles in some other European countries.  In the past few months, it has bounced back somewhat.

Yen.  From the beginning of 2006 until the Lehman shock, the nominal effective exchange rate of the yen was broadly stable.  Following the Lehman shock, the yen rose sharply and has continued to rise in recent months.  It is the only part of the advanced world to not have a financial crisis, although it has been badly hit by the US and European financial crises.  Purchasing power parity theory suggests that the yen should be continuously appreciating in light of Japan’s many years of deflation.  Over all the years of Japan’s deflation, the cumulative inflation differential that built up vis-à-vis the US is over 40 per cent. 

It also seems that the yen’s strength is in large part a reflection of dollar and euro weakness.  In this way, the yen may function as a ‘default currency’.  This means that investors who want to leave dollars and euros must find somewhere to go to.  They find their way to the yen because there is no solid alternative, especially because the RMB is blocked by the Chinese government’s policy of fixing the exchange rate. 

Although Japan’s public debt is now up to 200 per cent of GDP, markets seem reassured by the fact that over 90 per cent of this debt is held by Japanese residents (mainly banks), rather than foreigners.  The Japanese government has sought to push the yen down recently by intervening in foreign exchange markets by selling yen and buying dollars.  But this seems to have had limited effect as markets believe that the yen should be strong.  It is difficult to lean against the wind.  The yen could however be a case of irrational ‘animal spirits’ in light of Japan’s looming debt problems.   

Renminbi.  For most of its history, the RMB has been pegged to the US dollar at a fixed exchange rate.  For period 1997 to 2005, Chinese government maintained a peg of 8.27 RMB per dollar.  On 21 July 2005, the fixed peg was lifted, and the government managed a gradual revaluation of the RMB against the dollar, in fact 21 per cent over the three year period to 2008.  At the same time, however, the dollar entered into a steep decline against the euro, yen and other currencies which meant that China’s effective exchange rate appreciated much less. 

In July 2008, when the global financial crisis struck, China re-pegged the RMB again as the Chinese government is very concerned with maintaining economic, social and political stability.  Under pressure from the US, on 19 June 2010, the People’s Bank of China announced that it would lift the peg.  But the value of the RMB has risen only a couple of percentage points.  Because China has experienced higher inflation than its trading partners, the value of the real effective exchange rate has risen much more than the nominal effective exchange rate.

Won.  When the Lehman shock struck, Korea suffered a liquidity shortage, as foreign banks repatriated money back to their head offices which were short of finance.  The Koreans (like the Singaporeans who suffered a similar fate) were saved by the Federal Reserve Bank of New York.  While the Korean won bounced back, it remains still below its pre-crisis levels despite the high current account surplus, in part because of intervention by the Bank of Korea.  According to the President of the Asian Development Bank, the won is undervalued, echoing the position of the Japanese government which is concerned that Korean enterprises have stolen a march on the Japanese.

Australian dollar.  The A$ is essentially a “commodity currency”, as Australia is a leading commodity exporter.  Australia is a country which sees its export proceeds go up and down, as commodity demand and prices go up and down with economic cycles.  Not long after the Lehman shock, the A$ crashed amid concerns that the world economy was heading for depression and that commodity prices would fall.  In the event, China and other emerging economies bounced back quickly from the initial crisis, strengthening demand for commodities.  Thus, the Australian dollar also bounced back, although it has been very much stronger against the US dollar than it is on an effective exchange rate basis. 

What future for the world’s major currencies?

Of course, no-one knows which way the world’s major currencies could move, but here is some speculation based on my assessment of “economic fundamentals”.

The major factor influencing the US dollar and the RMB will be the so-called “global imbalances”, namely the large US current account deficit and Chinese current account surplus.  Although these imbalances have fallen back from their pre-crisis levels, they look set to resume an increasing trend for several reasons.  The Chinese are stubbornly sticking to fixing their exchange rate.  While it might appreciate by some 5 per cent a year in the future, this is nothing relative to the size of the imbalances, especially given that Chinese productivity will keep growing.  This means that the US dollar will be under downward pressure in the near term.

However, when the US economy inevitably resumes dynamic growth, confidence will no doubt return to the US dollar, and international investors will likely be happy to invest in the US, despite all its problems.  It is after all the land of Bill Gates, Google, Harvard and Michael Jackson!  In addition, the US government will gradually get its budget deficit more under control and private savings will build up.

As mentioned above, the Chinese RMB will likely experience a steady annual appreciation of 5 per cent or so.  But China is increasingly vulnerable to inflationary pressures, as the government does everything it can to maintain annual economic growth of at least 8 per cent.  This is necessary to maintain employment growth and social stability.  But it is difficult to implement such a policy precisely.  All the signs are that the Chinese government’s 2009 stimulus package has stoked up inflationary pressures, which the government is having difficulty controlling.

In addition, when the Chinese government keeps buying US dollars to keep the exchange rate under control, it sells RMB back to the market in return.  While these RMB can be bought back by selling Chinese government bonds, it is not an easy operation to control.  Further, as the appreciating RMB becomes a one-way bet for speculators, foreign capital will increasingly find its way into China to make profits.  Although China still has strict capital controls, capital flows can always find a way around, such as by leading and lagging trade payments and receipts.  In short, there is a growing buildup of inflationary pressures in China.

The Japanese yen will likely continue to appreciate whilst ever Japan experiences deflation.  When the dollar returns to strength, the yen lose some the strength it enjoyed because of dollar weakness.  Looking out a few years, the yen will however face a “crunch time”.  As the Japanese population continues to age, Japan’s senior citizens will start withdrawing their savings from banks to enjoy their retirement.  This will ultimately mean that Japanese banks will have less money to invest in Japanese Government Bonds, and foreign investors will be necessary fill Japan’s savings gap.  This could lead to a loss of confidence in the yen which could provoke a downward spiral.  As market sentiment turns, Japanese companies could refrain from repatriating to Japan their profits on their overseas operations.  They could switch these profits into dollars, for example!  In sum, looking out a few years, a crash of the yen is most certainly on the cards.

The euro is a complex mix of large surplus countries like Germany and large deficit countries like the Mediterranean countries.  The European economy is unlikely to be a source of great dynamism.  Innovation performance has been weak for a long time.  European countries will be hard hit by population ageing, and declining populations in some cases.  The European Union project will likely muddle through, stumbling from one crisis to the next, in light of the disparate situations and diverging destinies of its member countries.  In short, we should expect neither any spectacular strength nor any great weakness in the euro.

The Korean won should continue to strengthen.  As economies converge towards to the global technological frontier, their exchange rates should naturally strengthen.  A strong currency is a sign of a strong economy.  But Korea’s very rapidly ageing population will gradually catch up with it, and at some point lead to running down of savings and currency weakness.

The Australian dollar, as discussed above, is essentially a commodity currency.  If the large emerging economies like the BRIC (Brazil, Russia, India and China) maintain their strong development, the demand for commodities will remain strong, as will the Australian dollar.  The main shadow on the horizon is the ultimate depletion of Australia’s natural resources which is, thankfully, a long way away.

Will you follow my forecasts?  Be careful.  If I really knew what was going to happen, I would not be sitting here writing this stuff.  I would be out on the markets making a million!

References:

Global Economic Indicators, Federal Reserve bank of New York

http://www.ny.frb.org/research/global_economy/globalindicators.html   

BIS Effective Exchange Rates.  Bank for International Settlements.

http://www.bis.org/statistics/eer/index.htm  

All About...The Foreign Exchange Market in the United States, Federal Reserve Bank of New York

http://www.newyorkfed.org/education/addpub/usfxm/   

John M Keynes, The General Theory of Employment, Interest and Money.

London: Macmillan, 1936, pp. 161-162.

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.

George A. Akerlof and Robert J. Shiller

http://www.amazon.com/Animal-Spirits-Psychology-Economy-Capitalism/dp/0691142335  

South Korea's Won Is Still Undervalued After Gains, ADB Chief Kuroda Says

http://www.bloomberg.com/news/2010-10-26/south-korea-s-won-is-still-undervalued-after-gains-adb-chief-kuroda-says.html  

The new BIS effective exchange rate indices, Marc Klau and San Sau Fung

http://www.bis.org/publ/qtrpdf/r_qt0603e.pdf  

Definitions:

A nominal bilateral exchange rate is simply the value of one currency expressed in terms of another.  For example, the US dollar is currently worth about 80 Japanese yen.

A real bilateral exchange rate is an index calculated from a nominal bilateral exchange rate adjusted for inflation differentials between the two countries.

A nominal effective exchange rate is an index calculated from the weighted average movements of the bilateral exchange rates of a country’s trading partners.

A real effective exchange rate is the same as the nominal effective exchange rate, but adjusted for inflation differentials between the countries.