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“Why Exchange Rates are Important”

By Paul Sullivan,
Georgetown University

An exchange rate is essentially what its name implies: it is the rate at which one would need to exchange one’s currency for the currency of another country. These rates of exchange can change at a moment’s notice (or less) in currency markets where the currencies are freely floating. Some currencies are pegged to others. The currencies of Venezuela, Saudi Arabia and the United Arab Emirates are pegged to the dollar. That means that their exchange rates for the dollar are essentially fixed. Other currencies are controlled in a “managed float”, where by the Central Bank or other organizations of a country try to manage the increases and decreases in the value of their currency relative to others. This can often entail buying up huge amounts of one’s currency in order to keep the impression that it is still “strong” compared to other currencies. Sometimes a country wants its currency to be overvalued. So their government, aka their Central Bank and the like, goes out and buys large lots of their own currency and sells of currency reserves of those currencies its wants to be stronger than theirs – if they have them in reserves.
Pegged currencies give businesses and governments a certain sense of stability and a sense of lower uncertainty in budgeting and figuring out how expensive imports and exports might be. Over time such pegs are often changed or currencies are allowed to head toward a managed float because the forces of supply and demand are giving a different value to the currency than the pegged rate is. Managed floats are a way to try to control the sometimes whipsawing nature of currency and world economic markets. If the managed float rate is close to what the market says it should be then the pressures to buy and sell currencies to manage the currency are less. If the market says something different as the pressures increase more of the country’s currency would have to be sold or bought to start to even things out. If the pressures mount rapidly then the country may have to let the currency float. When that happens currencies may crash. They lose value rapidly.
Examples of these currency crashes occurred during the Asian Financial Crises of the late 1990s. As the internal and external economic and financial pressures built up to the popping point in Indonesia, Thailand, Malaysia and the Philippines, for examples, their governments were forced to let their currencies fall. They ran out of reserves to continue to prop up their currencies. They were also hugely in debt and the IMF sent conditionality restrictions to them if they were to get loans from the IMF. The IMF is really a lender of last resort. So these countries hardly had much of a choice. Speculators also attacked their currencies that brought their value down even more so. Some speculators made piles of money as the people of these countries suffered. One could put that down to something we economists call “information asymmetry”. The regular folks do not know as much as the speculators and others do.
When currencies collapse and the economies go down with them things can get rather ugly both economically and politically. This is even more so when the countries import a lot of things, such as food, transport and industrial equipment, medicines, and more. The more reliant a country is on imported things the more its costs will increase as its currencies head down hill compared to its trading partners. On the other side of the equation as a country’s currency loses value its exports become cheaper and it really should be able to export more. However, if the economy is heading south that sometimes does not happen. This is especially so if the country and businesses within it have a lot of loans that are denominated in other currencies. For example, a lot of government and even private debt in Indonesia, Thailand and other crisis states were in yen and other much stronger currencies then their own.
If someone takes out a $100 million dollar loan in dollars that needs to be paid back in dollars and the local currency drops by 30 percent then the costs of servicing that loan goes massively upward in terms of the local currency. If the local currency was 10 to the dollar then it became 40 to the dollar, then those payments will become onerous rather quickly. It is often best to have loans denominated in the local currency if there is an expectation that the local currency will lose value. However, if the bankers are thinking the same thing they will expect a higher interest rate to make up for the prospective losses due to the drop in the currency’s value.
Another way of looking at currency changes and investments is with this example. Let us say that you are an outside investor who has most of his/her money in dollars. You want to invest in a country, let us pick Egypt. The yield on Egyptian government bonds is now about 15 percent. If you are thinking in the short run then this might look good — for a while. However, if they Egyptian pound drops by 15 percent then your actual real yield is zero. You just lost your yield on the loss of the currency’s value. You may also lose more due to administrative fees and even taxes in your own country and Egypt on the 15 percent yield. If the Egyptian pound drops by 5 percent things are looking better. If it goes up 5 percent, that is even better. However, you have to figure out what you think is going to happen.
However, if you could have gotten a better yield in another country with less currency risk you actually may end up losing even more in what we economists call opportunity cost. Let us say you lost your yield on the 15 percent bond. So now you have zero yield. Now let us say you could have made a return of 3 percent on a less risky bond in another place. You have actually lost not just your yield, but your yield plus what you could have made elsewhere. But nothing is perfect and information is not perfect. Most of us muddle through on limited information and seem to do alright. The fully focused players cannot jut muddle through they need to make the most from what they have. That is the name of the international currency “game”. It is potentially very risky. And, by the way, nobody really can tell the future can they?
See the picture. Investing across borders is very complicated, especially at times of great fluctuations in currency rates. One could hedge by buying a put option to buy Egyptian pounds at the old rate, but what is the chance in such a volatile market that one could guess exactly what the pound would be in the time that the bond matures? That is a tough one. You would also need what is called a counterparty to agree to let you buy pounds at the old rate — or even better.
When the currency for a country loses value relative to yours the prices of land, businesses, stocks and so forth also decline relative to your valuation based on your currency. Let us say you are thinking of buying a farm worth one million xcurrency of country x. Your currency is expected to go up relative to xcurrency. It might make sense to wait until the situation settles and buy the property at a lower price based on your currency? Sometimes that is the case.
Sometimes central banks manipulate currencies even though they do not say that is exactly what they are doing. When a central bank floods its market with its local money supply then normally interest rates will drop. When interest rates drop money will flow out of the country to those countries with higher interest rates if there are no capital controls.
Governments often take risks on other markets as well. When a country imports a lot of its fuel it faces the risks of fuel market fluctuations. However, it also faces currency fluctuations. The worst of all possible worlds for government budgetary reasons is the combination of a fuel price shock and the decline of the value of the local currency – when the fuel is denominated in dollars, let us say. Then add in that the fuel in the country is subsidized and you see some real budgetary stresses as well as financial exchange shocks.
The same could go for food. There were serious food price shocks in 2008. (This was at about the same time as the oil shocks and there is a story there as well.) If the food is not subsidized then the increased costs of the food in local currency terms goes up – sometimes more than the loss in the exchange rate. Given that the poor in most developing countries spend about 50-70 percent of their incomes on food the foreign exchange price shocks can go directly to them. There could be political ramifications from this. If the food is subsidized the government will have to pay the foreign exchange shock. If the government budget is already stressed out and it needs to turn to the IMF then it will be asked to lessen or get rid of subsidies. Then the shocks are transferred to the people, and especially to the poor.
If a local currency drops in value pretty much all imports from places where their currencies remained strong will go up. The country’s local costs for exporters will go down for things using mostly local things in production. The local costs will go up especially for those things made with lots of imported parts, raw materials, etc.
A country’s tourism could improve–all else being equal–if its currency goes down. More people may choose to visit that country given how inexpensive hotel rooms and more might be. I went to one of the Asian Financial Crisis countries in 1998 and stayed at a 5 star hotel for a much cheaper price in dollar terms than going to places closer to where I was at the time. Also, that country’s airline was charging very low prices to get tourists and their hard currencies into the country. We both won in many ways. My family had a great vacation in a wonderful and friendly country. We boosted their economy a bit. Have a few thousand or hundred thousand more tourists come in and that boost gets even greater.
Surely there is a lot more to the exchange rate story and I will be writing more about this in the future. There are lots of uncertainties in these complex markets. Also, exchange rate markets can sometime make or break an economy. Exchange rates changes can help an economy rebuild and come back from recessions some times. This is much more difficult when a weak economy is locked into a stronger currency, such as Greece is locked in (for now) with the Euro.
When a person buys eggs, bread or meat from the local market he/she often does not think of foreign exchange transactions, but in many countries the price of food can be determined by such “outside” influence. When a person turns on the lights, the washer and dryer or the stove, there foreign exchange transactions involved “behind the scenes”.
It is really important for everyone to understand how exchange rates can affect them. We are all part of the globalized and very much interconnected economy where many currencies are trading hands in the multiple trillions of dollars each day for trade, finance, speculation and other purposes.
Did you know that a change in the exchange rate of your currency can lose you your job in some circumstances? Think about it. Why would this happen?

Short URL: http://ubpost.mongolnews.mn/?p=2535

Posted by on Jan 16 2013. Filed under Opinion. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry

2 Comments for ““Why Exchange Rates are Important””

  1. “So their government, aka their Central Bank and the like…”

    Why not tell the truth about their ‘central bank’? That it is a private corporation, independent and above their government? Your articles reek of propaganda, sir! Your intentional misdirection and cover for the criminals will come to light soon.

    • From the Bank of Mongolia website:http://www.mongolbank.mn/eng/aboutbank.aspx

      The BoM is operationally independent from the Government though the Parliament of Mongolia monitors whether the Bank’s activities are consistent with the legislation. However, neither the Government, nor the Parliament is to interfere in activities relating to the implementation of State monetary policy by the BoM. The independence of the BoM is empowered under the Law on Central bank approved in 1996.

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