exchange rates expanded
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- 1. Exchange Rates
Exchange Rates: why they change, some illustrations
The current crisis in Europe and the future of the Euro
Managing Exchange Risk
Q & A
3. What is the exchange rate?
Price of one currency in terms of another
4. 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?
5. Chinese yuan
6. Trade-weighted USD
Fallen 25% since 2002
15% since 2009
Why do exchange rates change?
8. Fundamental forces..
Changes in demand/supply for goods and services of the respective countries
Japanese yen in the 60s and 70s
Inflation: the law of PPP
Government intervention: but does it work?
Shelter in a Panic
Mundells Impossible Trinity
A dollar on deposit outside the US
$ 5 trillion in april 2011
M1 in US was $1.9 trillion
10. 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
11. Interest Rate Parity
Get $102 in US, convert back to INR at S
Borrow Rs. 4500 in India at 10% p.a.
Invest $100 at2 % p.a. in US
1 USD= Rs. 45
What must S be?
S = 4500 x (1 + 0.1) / 102
12. Interest rates..London Interbank Offered Rate (LIBOR)
13. 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)
14. 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
15. Chinese yuan
16. 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
17. General rule..
If it cant go on forever it wont!
Long run: dollar has to slide enough to make US exports cheap enough to balance the current account deficit. (at least substantially so..
US savings rate must increase so dont need foreign capital to finance investments.
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
19. Now.. Getting nervous..
If dollar falls (yuan rises), enormous loss to Chinese Treasury
Chinese push for alternative reserve currency
But in reality cant do anything.. Just want others to bail them out of a mess..but not willing to do anything about it themselves
20. 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!
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
22. 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..
23. 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.
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!)
25. 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.
26. 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? )
27. 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
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 ..
29. The Asian Crisisand why China and India escaped it!
In a word, because didnt have free capital mobility, didnt allow capital to slosh in and out..
Is convertibility on the capital account always good?!
30. 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)
31. 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
32. What are Thais doing with the money?
Indonesia: Peregrine and Suhartos daughter
Who are the finance companies anyway?
Merely channels, close links to politicians
What incentive to make good loans? Moral Hazard!
33. The Shock of 1997
Some of the finance companys 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 cant print yen!
Could have reduced baht supply but fear of recession
Or: could have let baht slide
34. 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
35. Ok, so did the sterling
Happy ending, right?
No.. Because positive feedback loop
Baht fell 50% in 3 months..
36. The positive feedback loop
Loss of confidence
Financial problems for
Full Scale Melt-down!
37. Why did China and India escape?
Didnt allow capital to flow in and out.
Moral: if your house is not in order, dont open up to the world and expect to be safe!
The real tipping point: foreign debt.
(RBIs recent curbs on ECB.. Make sense?)
38. A Greek Tragedy..
And Spanish, and Irish, andPortuguese and
39. The Crisis
Ultimately triggered by the collapse of the real estate bubble
As in the US
40. The Origins..
Money had poured into Greece, Spain, Ireland to finance housing, resorts..