Explaining Changes in Exchange Rates Looking at Exchange Rate Changes Under Different Exchange Rate Regimes

Exchange Rate Regimes Today Current exchange rate regimes fall along a spectrum as represented by a national government’s involvement in affecting (managing) the exchange rate for their currency. No Involvement by Government Very Active Involvement by Government Market forces are Determining Exchange rate Government is Pegging or Managing the Exchange rate

Exchange Rate Regimes Today No Involvement by Government Very Active Involvement by Government Market forces are Determining Exchange rate Government is Pegging or Managing the Exchange rate Managed Rate (“Dirty Float”) Regime Pegged Rate Regime Floating Rate Regime

Classification of Exchange Rate Regimes Floating Currency Regime: No (or minimal) government involvement (i.e., intervention) in foreign exchange markets. See Appendix 1 and Appendix 2 for a discussion of central bank intervention. Market forces, i.e., demand and supply, determine foreign exchange rates (prices). Financial institutions (global banks, investment firms), multinational firms, speculators (hedge funds), exporters, importers, etc.

Classification of Exchange Rate Regimes Managed Currency (“dirty float”) Regime: High degree of intervention of government in foreign exchange market. Currency is managed in relation to a key currency or to a basket of currencies. Purpose: to offset “undesirable” market forces and produce “desirable” exchange rate. Sometimes done on a daily basis, other times as market conditions warrant. Usually done because exchange rate is seen as important to the national economy (e.g., export sector or the price of critical imports).

Classification of Exchange Rate Regimes Pegged Currency Regime Ultimate management by governments as they set a fixed rate for their currency by directly linking (pegging) their currency’s rate to another currency. Occurs when governments are reluctant to let market forces determine rate. Exchange rate seen as essential to country’s economic development and or trade relationships. Unstable rate associated with potentially unstable domestic financial and economic situation. Impact on inflation (cost of imports) or business activity (exports) or foreign direct investment.

Examples of Currencies by Regime Floating Rate Currencies: U.S. dollar (1973), Canadian dollar (1970), Euro (1999), British pound (1973), yen (1973), Australian dollar (1985), New Zealand dollar (1985), Thai baht (1997), South Korean Won (1997), Argentina Peso (2002), Malaysian ringgit (2005). Managed Rate Currencies: Singapore dollar, Egyptian pound, Israel shekel, Indian rupee, Chinese Yuan (since July 2005) Pegged Rate Currencies (to the U.S. dollar or market basket) Hong Kong dollar, since 1983 (7.8KGD = 1USD), Saudi Arabia riyal (3.75SAR = 1USD), Oman rial (0.385OMR = 1USD)

Simplified Model of Floating Exchange Rates (Market Determined Rates) The market “equilibrium” spot exchange rate at any point in time can be represented by the point at which the demand for and supply of a particular foreign currency produces a market clearing price, or: Supply (of a certain FX) Price Demand (for a certain FX) Quantity of FX

Simplified Model: Strengthening FX Any situation that increases the demand (d to d’) for a given currency will exert upward pressure on that currency’s spot exchange rate (price). Any situation that decreases the supply (s to s’) of a given currency will exert upward pressure on that currency’s spot exchange rate (price). s s’ s p p d d’ d q q

Simplified Model: Weakening FX Any situation that decreases the demand (d to d’) for a given currency will exert downward pressure on that currency’s spot exchange rate (price). Any situation that increases the supply (s to s’) of a given currency will exert downward pressure on that currency’s spot exchange rate (price). s s s’ p p d’ d d q q

Factors That Affect the Equilibrium Exchange Rate: Floating Rate Regime Relative rates of (short-term) interest. Affects the demand for financial assets (high interest rate currencies). Carry trade strategies affect the supply of currencies (low interest rate currencies) and the demand for currencies (high interest rate currencies) Relative rates of inflation. Affects the demand for real (goods) and financial assets; hence the demand for and supply of currencies Relative economic growth rates. Affects longer term investment flows in real capital assets (FDI) and financial assets (stocks and bonds). Relative political and economic risk. Markets prefer less riskier assets and less risky countries. Safe Haven phenomenon.

Issues of Floating Currencies Floating rate regimes present the greatest ongoing risk for global firms. Why? Since it is difficult to predict changes in demand and supply, it then becomes: Difficult to predict their long term trends (and changes in trends) and shorter term movements. What are the implications of long term trend change for global companies? They complicate the longer term FDI location decision (impact on costs and revenues in home currency). Where should you set up your production facilities? International capital budgeting decision.

Issues of Floating Currencies Data also show that these currencies are potentially very volatile over the short term (e.g., day to day basis). These currencies are subject to large percentage changes over the short run resulting from demand and supply swings. Especially now that governments are staying out of the market. Complicates doing business on an ongoing basis for: Exporters, importers, global asset managers, global commercial banks, overseas sales and manufacturing subsidiaries. What will be the costs and returns associated with different markets and different investments? Thus, global firms need to pay close attention to their floating currency exposures and utilize appropriate risk management tools.

Volatility of British Pound (a Floating Currency)

Managed Currencies (Dirty Float) Under this regime, governments manage their currency to offset (i.e., counteract) market forces. They do this when market demand factors or supply factors are seen as creating undesirable exchange rate moves. Exchange rate management may occur on a daily basis (e.g., China) or only when governments feel conditions warrant. Management involves either intervention action (buying or selling currencies) or interest rate adjustments (to make the currency more or less attractive). See Appendix 3 for a discussion of these two approaches to managing a currency

Who Manages and Why? Today, currency management is likely to be done by the developing and emerging countries of the world. Recall, the major countries have stopped managing their currencies. Why do developing and emerging countries still manage? What is the potential issue of weak currency for them? Concern of the Government is that the price of imported goods will rise; may cause (or intensify) domestic inflation. What is the potential issue of a strong currency? Concern of Government is that its exports will become too costly overseas and they may lose overseas market share. In addition, the slow down exports may reduce domestic economic growth and result in higher unemployment.

Managed Currencies Over the long term, managed currencies are somewhat risky for global firms, but not as risky as floating currencies. Reason: since these currency moves are being “managed” their trend moves are generally likely to be more gradual than the currencies under floating rate regimes. However, these currencies are still subject to trend moves and trend changes (similar to floating rate currencies). So, global companies need to assess currency exposures and risk, over the intermediate term and long term. Trend changes will affect their FDI positions and longer term export and import situations

Managed Currencies Over the short term, these currencies are not likely to be as volatile as floating currencies. Reason: Government management is aimed at countering short term volatility (more so than trends or trend changes). Thus daily and weekly changes are not potentially as great as with floating rate currencies. Thus, there is some risk here, but not potentially as great as with a floating rate regime. Potential issue: If governments are managing their currencies within ranges which markets feel are inappropriate, these currencies may come under attack. Successful attacks can quickly alter a currency’s exchange rate. Example: British pound was managed in the ERM until a speculative attack drove it out in 1992.

Volatility of Singapore Dollar (a Managed Currency)

Volatility of Chinese Yuan (a Managed Currency)

Pegged Currency Regimes: Ultimate Currency Management Under a pegged currency regime, governments link their national currency to a key international currency (usually the U.S. dollar or some combination of currencies). Why do governments peg their currencies? A peg is seen as a necessary condition to promote confidence in the currency and in the country and promoting economic growth. May encourage foreign direct investment and long term capital inflows. Hong Kong’s rational behind its decision (in 1983) to peg. Or by pegging the currency at an undervalued currency this may support the country’s export sector. China’s rational for its early peg which overvalued the USD. However, there are potential costs to governments in holding a peg.

Potential Costs to Holding a Peg If market forces push a pegged currency above its peg (i.e., the currency becomes “too strong” or “overvalued”) this happens because: The market is buying the currency, then Government management involves either selling the pegged currency on foreign exchange markets (thus, buying hard currency) or reducing domestic interest rates. Issues: If the government sells its currency this created to potential for expansion of its domestic money supply and hence inflationary pressures. On the other hand, lowering domestic interest rates can also stimulate domestic investment and economic activity which may lead to inflationary pressures.

Potential Costs to Holding a Peg If market forces push a pegged currency below its peg (i.e., the currency becomes “too weak” or “undervalued”) this happens because: The market is selling the currency, then Government management involves either buying the pegged currency on foreign exchange markets (thus, selling hard currency or raising domestic interest rates. Issues: Does the government want to give up its hard currency (does it have potentially better uses for this (e.g., buying oil or paying off international debts) On the other hand, raising domestic interest rates can dampen economic activity and lead to rising unemployment. Note: The last two slides summarize one reason (i.e., the costs) why major central banks have probably gotten out of the currency management business.

Pegged Currencies As long as the peg is maintained, this regime presents the smallest risk to global firms; however there is the potential for enormous risk, where: Governments either (1) abandon the peg for another foreign currency regime or (2) adjust to a new peg. These changes occur either by An orderly change adopted by the government (e.g., China). Peg coming under successful market attack (e.g., Argentina). These changes can have substantial impacts on the financial situation (as well as the competitive position) of a global firm when they do occur. Especially if the firm did not take advanced steps to protect itself. Thus, Global firms must be on the alert for changes See Appendix 3 for a discussion of China’s move away from a peg to a managed exchange rate regime.

Volatility of Hong Kong Dollar (a Pegged Currency)

Example of Abandoning a Peg: Argentina Peso: 1996 to December 2001

Argentina’s Moves to a Floating Regime: Jan 2002

Abandoning a Pegged Rate and the Currency Weakens: RISKS for Global Firms As noted, changes in exchange rate regimes pose potential risks for global firms. Using the Argentina example, discuss the following: What do you think happened to foreign multinationals located in and selling in Argentina after the peso weakened? For Example: McDonalds’ U.S. dollar profits in Argentina? What do you think happened to foreign multinationals exporting to Argentina after the peso weakened? For example: Boeing ability to export airplanes to Argentina?

Abandoning a Pegged Rate and the Currency Weakens: OPPORTUNITIES for Global Firms However, changes in exchange rate regimes also offer potential opportunities for global firms. Again, using the Argentina example: What do you think happened to foreign multinationals importing from Argentina after the peso weakened? For Example: Wal-Mart’s U.S. dollar cost associated with importing goods from Argentina? What do you think happened to foreign multinationals considering expanding FDI into Argentina after the peso weakened? For Example: The new U.S. dollar cost to Ford Motor Company considering setting up a production facility in Argentina?

Web Sites for Foreign Exchange Rates Intra-day quotes (and charts) http://www.fxstreet.com/ Historical Data (and charts) University of British Columbia http://fx.sauder.ubc.ca/ More Historical Data Federal Reserve Board http://www.federalreserve.gov/releases/ Daily commentary and analysis http://www.cnb.com/business/international/fxfiles/fxarchive/fxarchive.asp

Appendix 1: Intervention in Foreign Exchange Markets While the world’s major central banks have essentially gotten out of the business of foreign exchange intervention, some developing and emerging country central banks still do. In addition, there is nothing preventing the world’s major central banks from intervening if they so desire.

Monitoring FX Intervention Most major central banks provide timely information regarding their intervention activities in foreign exchange markets. As on example see: http://www.ny.frb.org/markets/foreignex.html This site provides a quarterly report on both the U.S. dollar and intervention activities on behalf of the dollar. Go to archives, July 30, 1998 to view intervention activity.

Intervention by Major Central Banks Historically, central banks of the major countries of the world did use intervention even with their floating rate regimes. However, they have done this in the past usually only under “extreme” market forces circumstances. Intervention occurred if a situation produced exchange rate volatility which was seen as potentially too disruptive to financial market stability. For example, U.S. intervened immediately after the attempted assassination of President Reagan on March 30, 1981. But, interestingly enough, did NOT around the 9/11/2001 terrorist attack. At the present time, it appears that the major countries have gotten out of currency intervention. U.S. has been out of the intervention market for a long time (only two interventions in the 1990s; last intervention in 1998) as has the U.K. Japan recently moved away (March 2004).

Why Have the Major Central Banks Stopped Intervening? There are a couple of reasons why this is so: (1) The record on central bank intervention with regard to the major central banks of the world is mixed at best. See next two slides for intervention record since 1985. (2) Intervention can be costly (see earlier lectures slides on this subject). (3) Not intervening is consistent with the philosophy of many central bankers today that the markets should function without government interference or government manipulations and if they do, the prices of currencies will be set efficiently and correctly.

Currency Intervention: A Mixed Record Date Players Goal Result Sept 1985 U.S., U.K. Weaken $ Success: Japan, France $ falls 18% Germany within year Feb 1987 G7 Stabilize $ Failure: $ falls 10% within year. Sept 1992 UK Maintain £ Failure: in ERM ₤ out of ERM within days.

Currency Intervention: A Mixed Record Date Players Goal Result July 1995 Japan, U.S. Halt rising ¥ Success: ¥ drops 26% within a year. June 1998 Japan, U.S. Strengthen ¥ Success: ¥ rises 17%

Appendix 2: How Do Governments Manage their Currencies? Governments (or central banks) using a managed exchange rate regime can support their currencies through two possible policies: (1) direct intervention and (2) interest rate adjustments. The slides that follow discuss these. Note that when major central banks of the world were intervening in foreign exchange markets in support of their currencies, they selected from the same two policies.

Managed Currencies: Direct Intervention Policy Intervention policy when a currency becomes “too weak” Government will buy their currency in foreign exchange markets Create demand and push price up. Intervention policy when a currency becomes “too strong” Government will sell their currency in foreign exchange markets Increase supply to bring price down.

Managed Currencies: Interest Rate Adjustments Some countries also use interest rate adjustments to manage their currencies. When a currency become “too weak:” Governments can raise short term interest rates to attract short term foreign capital inflows. Higher interest rates make investments more attractive. When a currency becomes “too strong:” Governments can lower short term interest rates to discourage short term foreign capital inflows. Lower interest rates will make investments less attactive.

Empirical Findings on the Use of Intervention by Emerging/Developing Countries Conclusion from studies: Many emerging/developing countries still intervene in foreign exchange markets to influence currency values. A survey of emerging/developing countries showed that: One third intervene regularly (more than 50% of trading days). Most emerging/developing market central banks felt that intervention was more effective in influencing the foreign exchange rate over short periods of time: 2 to three days to one week.

Appendix 3: China’s Old and New Exchange Rate Regime On July 21, 2005, China surprised the world by announcing that they were moving away from a peg to the U.S. dollar. The following slides trace the peg period, the new exchange rate regime (which is a managed float), and the move of the yuan since the introduction of the new currency regime.

China’s Currency Regime: 1978 -2005 In late 1978, the Chinese government began moving its economy from a centrally planned system to a market-based system. As part of this process, in 1994, China's central bank pegged (i.e., linked) the Chinese currency, the yuan (also known as the renmimbi, or "people's money“) to the U.S. dollar. In 1994, the peg was set at 8.28 yuan to 1 U.S. dollar.

China Moves to a Managed Float July 21, 2005, the Chinese government announced it was changing to a managed float regime with an immediate adjustment of the rate to 8.11 yuan to the dollar. This represented an immediate strengthening of the yuan, by 2.0% against the U.S. dollar. China’s currency regime is now a managed float against a market basket of currencies (including the U.S. dollar, Euro and Japanese yen – although we don’t know all the currencies and their weights). Chinese Government now manages the yuan within a daily trading range of 0.03% against this basket. The 0.03% range is established each trading day based on the previous close. Thus, the yuan is now allowed to gradually “move” in relation to market forces.