Exchange Rates

Overview

• Exchange Rates: why they change, some illustrations

• The current crisis in Europe and the future of the Euro

• Break• Managing Exchange Risk• Q & A

What is the exchange rate?

• Price of one currency in terms of another

Allows room for creativity..!

• Goldman Sachs in 2001– Greek govt not allowed to have budget deficit

in excess of 3%– So created a loan in dollars, swapped it for

euro at a fictional exchange rate– Taking repayment in future lottery receipts!– What is the exchange rate?

• Whatever you want it to be?

Chinese yuan

Trade-weighted USD

• Fallen 25% since 2002• 15% since 2009

So..

• Why do exchange rates change?

Fundamental forces..• Changes in demand/supply for goods and

services of the respective countries– Japanese yen in the ‘60s and ‘70s

• Capital Flows• Inflation: the law of PPP• Government intervention: but does it

work?– Euromarkets

• Shelter in a Panic• Mundell’s Impossible Trinity

Euromarkets

• A dollar on deposit outside the US• $ 5 trillion in april 2011• M1 in US was $1.9 trillion

Purchasing Power Parity

• April 2011, buy 1 widget for USD 1 in US,• Rs. 45 in India

• Inflation in US = 0%, India = 10%

• April 2012: Same widget will sell for USD 1 in US, Rs. 49.50 in India

• In 2012, 1 USD must equal Rs. 49.50

if 1 USD = Rs. 55, could have sold widget in US, converted to Rs. 55, bought widget in India at Rs. 49.50, made profit of Rs. 5.50

Interest Rate Parity

April 2011Spot rate 1 USD= Rs. 45

Borrow Rs. 4500 in India at 10% p.a.Invest $100 at 2 % p.a. in US

1 year

Get $102 in US, convert back to INR at S

What must S be?

S = 4500 x (1 + 0.1) / 102

Interest rates..London Interbank Offered Rate

(LIBOR)

US- 3 months

US – 1 Year UK – 3 months

UK – 1 year

T-Bill 0.06% 0.37% 0.57% 0.72%

LIBOR 0.37% 1.13% 0.73% 1.46%

Principle is..

• Cannot make money without taking risk• To really eliminate risk, should have sold

USD forward at F• So ‘covered interest rate parity’ says:

• F= 45 x (1 + 0.1) / (1+0.02))• F = current spot rate x (1 + int rate 1)/(1 +

int rate 2)

PPP and IRP

• Interest rate = real rate plus inflation• Real rates tend to be similar and small• So interest rate differences mirror inflation

differences

• PPP and IRP are in step with each other.. Though not perfectly

Chinese yuan

Why the slide in the dollar?

• Everyone agrees: US current account deficit = 6% GDP, twice as high as when previously collapsed (under Reagan), higher than Indonesia and Argentina before their crises!

• Today, Japan finances 25% of the deficit by buying US assets

• Japanese population ageing, investments will have to be liquidated to pay for their upkeep– Anyway Japan is not in great shape after the nuclear

disaster

General rule..

• If it can’t go on forever… it won’t!

• Long run: dollar has to slide enough to make US exports cheap enough to balance the current account deficit. (at least substantially so..

• OR• US savings rate must increase so don’t

need foreign capital to finance investments.

China…• Probably currency is undervalued, by

government fiat• Helps exports but hurts imports• Sitting on trillions of dollars of US treasury

securities • Why? Because exports booming and

capital flowing in – could have let yuan rise, but did not want to, so kept soaking up the dollars as they flooded in

Now.. Getting nervous..

• If dollar falls (yuan rises), enormous loss to Chinese Treasury– Chinese push for alternative reserve currency– But in reality can’t do anything.. Just want

others to bail them out of a mess..but not willing to do anything about it themselves

The Impossible Trinity: Robert Mundell

• The 3 Wishes…– Stable exchange rates– Open financial markets– Flexibility in monetary policy

• Theorem: you cannot have all 3 !• System only has 2 degrees of freedom.• You choose which 2 you want!

Illustration..

• Argentina: Currency Board, i.e., fixed exchange rate of peso wrt dollar (1 to 1)- 1991

• Opened up markets to allow free flow of capital

• So far so good

Argentina 1991 to 1993

• Inflation at home: 40% over 2 years versus 6% in US.

• Law of Purchasing Power Parity says peso overvalued

• ’93: Collapse of Mexico caused investors to panic: get out of Latin America!

• US Bank calls back loan to Argentine client – client withdraws pesos from his Argentine bank, converts to dollars, returns loan.

• Now Argentine bank must replenish its reserves, so calls its own peso loans.. Net result: credit squeeze in Argentina, businesses suffer..

What can Argentine Central Bank do?

• Normally, simply print more pesos to halt the decay.. But can it? Remember the currency board!

• Other investors start worrying about Argentine economy, start converting pesos into dollars and sending it out of the country..

• Panic and Terror! Economy slides into Recession..Government can do nothing.

Why?

• Because allowing capital to flow (desirable no. 2) and fixed exchange rate (desirable number 1)

• So lost control of ability to manage the economy (desirable number 3!)

Another illustration: UK and George Soros

• 1990: UK joined the European Exchange Rate Mechanism (ERM)… midway point to common currency.

• Germany reunification: raised interest rates. UK, along with rest of Europe, forced to raise interest rates too else capital would flow from UK to Germany (since it could)

• UK already in recession.. Recession gets worse.

Enter Soros!

• Soros foresaw that UK would be forced to drop interest rates and get out of the ERM – Dropping rates to remove choke on economy,

let sterling fall so UK assets would become cheaper, capital can flow to UK assets, UK exports also become cheaper, good for economy in recession.

• He decided to make it happen! (sounds familiar? )

The modus operandi

• Established $15 billion credit line to borrow in sterling and convert to $ at will.

• Began short-selling the sterling and telling everyone about it.

• Other investors start believing it and pulling out of sterling.

• Bank of England attempted to defend by buying sterling and selling $ - no effect. Tried raising interest rates, public outcry forced it to withdraw.

• Sterling taken off the ERM, fell 15% and stabilized. Soros made $1 billion in 3 weeks

Moral:

• You cannot have low interest rates and liberal monetary policy to stimulate your economy if you have free capital markets and fixed exchange rates!

• But.. Happy ending, in a way. UK economy did not suffer, Soros made $1B ..

The Asian Crisisand why China and India escaped it!

• In a word, because didn’t have free capital mobility, didn’t allow capital to slosh in and out..

• Is convertibility on the capital account always good?!

The Story of Thailand (and Indonesia)

• Asian Tigers! Capital flowed to ‘emerging markets’, partly because interest rates in UK and US far too low.

• 1994: $256 billion flowed to Asia (mostly yen, sterling and dollar stayed on the sidelines)

Typical transaction

• Japanese bank/fund makes loan in yen to a Thai ‘finance company’, who goes to Central Bank of Thailand, converts to baht and makes loan to Thai businessman

• Increase in demand for baht by finance company, supply of yen: baht exchange rate rising.

• Bank of Thailand committed to stable exchange rate, so had to flood domestic economy with baht to keep its value constant.

• Most of the credit went into real estate..• So far so good

What are Thais doing with the money?

• Indonesia: Peregrine and Suharto’s daughter

• Who are the finance companies anyway?– Merely channels, close links to politicians– What incentive to make good loans? Moral

Hazard!

The Shock of 1997

• Some of the finance company’s investments tanked..real estate bubble!

• Foreign lenders reduced lending..• Meanwhile demand for imports continued

unabated, but supply of yen declining..now baht declining and yen rising

• Now Central Bank forced to do opposite: keep baht up and yen down. Not so easy because you can’t print yen!

• Could have reduced baht supply but fear of recession

• Or: could have let baht slide

Twist in the tale

• Why not let the baht slide and the yen rise? Because too many businesses had loans in yen!

• Thais saw the writing on the wall and began pulling out of baht and putting their money in yen/dollar deposits abroad: even more pressure on Central Bank, running out of dollars now!

• Thai government failed to either let currency slide or stop movement of capital. Reserves ran down to zero.

• Baht in free fall finally.• Should have fallen 15% for stability

Ok, so did the sterling

• Happy ending, right?• No.. Because positive feedback loop

• Baht fell 50% in 3 months..

The positive feedback loop

Loss of confidence

Financial problems for Companies.. recession

Currency falling,

Full Scale Melt-down!

Why did China and India escape?

• Didn’t allow capital to flow in and out.

• Moral: if your house is not in order, don’t open up to the world and expect to be safe!

• The real tipping point: foreign debt. • (RBI’s recent curbs on ECB.. Make sense?)

A GREEK TRAGEDY.. And Spanish, and Irish, and Portuguese and …

The Crisis

• Ultimately triggered by the collapse of the real estate bubble

• As in the US…

The Origins..

• Money had poured into Greece, Spain, Ireland to finance housing, resorts..

• Incomes had soared as money poured in• Easy to borrow as interest rates low

across Europe, same as Germany (it’s a Euro loan, after all, isn’t it?)

• When the bubble burst…• Government Revenues plunged (hardly

anyone pays income tax in Greece)• Wages and Prices are 20-30% too high

Governments finances ..

• Greece: debt is 150% of GDP (govt had lied about it… panic when discovered)

• Spanish banks active in lending to Ireland, UK and all over Europe, may need to be rescued

• Ireland: government unilaterally guaranteed all deposits of banks, putting its own solvency into question

• Spain, Greece are welfare states, unemployment benefits..

Rescue?

• IMF, European Central Bank (effectively Germany and France) have created credit lines– At very high interest

• Current yield on 10 year bonds (in Euros!)– Greece: 12%– Ireland: 9%– Spain: 6%– Germany : 3%

Meanwhile..pain at home

• Riots in Athens as government cuts back spending

• Employment fallen 10% in Spain, 14% Ireland

Why is all this happening?

• Counter-examples: Iceland

Iceland..

• Let currency drop 40%• Forces across-the-board wage and price

cuts• Exports have increased• Economy is recovering..

What is the difference?

• Have we seen this movie before?

Remember Argentina?

• The peso board is the same as the Euro!

• Can Spain, Greece, Ireland devalue their currencies?

• Can they pump money into their economies to revive it?

• Do they HAVE their own currency?

Counter –example 2

Ireland Nevada

Small economy surrounded by large ones

ditto

Population a few million ditto

Had a real estate boom ditto

In deep trouble Ok, in trouble, but no more than the rest of the US

What’s the difference?

• Nevada is part of the US, social security cheques come from the Federal Government, stimulus money comes from Washington

• People can move to another state (California is next door) in search of jobs

Despite all the dreams..

• Labor mobility in Europe remains low:– Language, culture, biases still barriers

• Economic integration has fallen far behind monetary integration– Mundell foresaw this before 1999..

So.. What is the future of Europe?

Option 1: Blood, Sweat, Toil and Tears

Wages, prices slowly forced down until equilibrium

Option II:

Restructure Debt

Euphemism for

DEFAULT !!!

Markets may be expecting this: why else would yields on government bonds be so high?

Option III:

Abandon the Euro: be like Iceland!

Is it even possible?

Even the slightest hint of it will cause a run on banks.. But what if the run happens anyway?

Option IV:

United States Of Europe

Germany, France pay off other countries’ debts..

Which is why the US works.. Remember Nevada!

DEALING WITH EXCHANGE RISK

So.. What can an Indian Company do?

• • Predict the exchange rate..?

• Who is good at it?

• What is the best predictor of the exchange rate?

What business are we in?

• Should we try to predict the exchange rates, make money on it?

• Should we trust to God and donothing?• Should we insulate our business

completely from forex risk?

• If we do hedge, how much should we hedge?

Forecasting…

Exchange Rates:Euromoney Contest – 12 experts, as good as a monkey tossing a coin!

Best: expected exchange rate tomorrow = today’s rate!!

Much better than sophisticated econometric models, better than experts..

Yet we pay for experts.. Why?

Hedge your bets..• Forward ‘Cover’..!• Is it free? Forward premium = expected change

in exchange rate!– Forward rate is an unbiased predictor of the

future spot rate • (I didn’t say ‘good’ predictor’!!)

• Can you ‘cover’ reduction in business volume?!• What if $ rises and US economy contracts? • They will balance each other without hedging

– $ rose 15% in the 3 quarters of recession in 2009

• Options.. Cost is about 6%, depending on tenure etc

Today: send invoice for $100

Payment expected $100 from client

30 days

Spot rate: 1 USD = Rs. 45.00

Spot rate 1 USD = Rs. 44.80

Go to Bank: sell USD forward at Rs. 44.50.

Collect INR 100 x 44.50

So.. Forward Contract

• Establishes the price today for a transaction that will happen in the future

• Regardless of what the spot price ison that future date

Forward rate quoted..

• Usually as premium or discount to current spot rate, e.g.

• Spot rate 44.440• 1 week forward: 7.5 = 44.515• 1 month forward 25.5 = 44.655• 1 year forward 286.5 = 47.305

Caution!!

• Forward contract is not optional– If entered into, HAS to be fulfilled

• What if bid on contract and don’t get it?- Then buy/sell options, not forwards

Managing exchange Risk

• Match outflows and inflows– Shift operations to destination country:

Volkswagen in Brazil– Borrow in currency of revenues– Swap existing debt into currency of revenues

• Improve brand image• Diversify across Geographies .. Is Europe

different from the US?

A study by McKinsey

• 198 companies• Goal: reduce volatility of pre-tax earnings• Assume absolutely optimal level of

hedging with forward contracts– Only 1 company reduced volatility by 20%– Only 20 by 10% or more

• Forex risk is not the most important source of risk, so why bother so much with it?

• ‘the more you know about international finance, the more you realize how unimportant it is..’– Paul Krugman, Trade Theorist