" China is reported to be accelerating the appreciation of the yuan to combat inflaton instead of increasing its interest rates, in part because of expectations of further cuts in US interest rates. How does appreciation combat inflation?" - Jane
That's an excellent question! There are a number of avenues available for the central bank to try to combat inflation. They've already tried price controls, that I've argued elsewhere will ultimately fail. They've also raised interest rates a number of times as well, an avenue that is more likely to be successful. But perhaps the most effective way to combat China's inflation rate is to allow the currency to appreciate more quickly.
How would that work? Well, as I wrote here, inflation ultimately results from demand exceeding supply within the Chinese economy. An increase in the value of the currency makes Chinese goods relatively more expensive and foreign-made goods relatively cheap. Thus demand for Chinese goods will fall, reducing demand and therefore inflation pressure in China.
There's a related effect as well. China is accumulating foreign reserves at a rapid rate, which means that it is buying foreign currency with domestic currency. To do this, it is expanding the domestic money supply. As Milton Friedman famously said, "Inflation is Always and Everywhere a Monetary Phenonemon." Increase the price of RMB and the demand for RMB will fall- reducing the need for Mainland authorities to increase the money supply.
Showing posts with label Exchange rates. Show all posts
Showing posts with label Exchange rates. Show all posts
Thursday, January 31, 2008
Tuesday, November 20, 2007
How Rich is China?
A recent article in the Financial Times (thanks to Marginal Revolution for the pointer) suggests that some soon-to-be released numbers will show that living standards in China are 40% lower than had previously been believed.
Of course it remains to be seen what is really in the data when it is released, but let me clarify what this news is about. When we measure GDP across countries, we do so at market prices. We're left with nominal GDP, which is a measure of the market value of production in the economy over a period of time (typically a quarter or a year).
But to make that number meaningful, we need to adjust it to real terms. So we also construct real GDP, where we measure the total value of production if prices had remained at the same level as in some base year.
But what if we wish to compare GDP across countries, as a means of comparing the standard of living across countries? We have real GDP in China measured in Chinese RMB, against US GDP measured in USD, for example, which are not directly comparable.
One simple approach would be to just use the market exchange rate, but that may not be ideal for several reasons. First exchange rates are highly volatile. It is not uncommon for nominal exchange rates to fluctuate by 10-30% in a single year, while underlying living standards change very little! But more importantly, the cost of living can vary radically across countries. Some countries may experience high incomes (and therefore high GDP: total income = total output), but also high costs, while other countries may experience the reverse. We therefore need to filter out any systematic differences in the cost of living to get an accurate idea of comparable living standards.
How do we do that? Well, we need detailed price data on similar items sold in different countries. We compare GDP not at market exchange rates, but at PPP (or "purchasing power parity") rates, that seek to adjust for differences in the cost of living.
And that's where this revision in mainland GDP is reputed to come from. Apparently prices in mainland China that have been used for making the PPP adjustment have been poorly measured in the past, and the result is a systematic understatment of the cost of living.
I'll be following this story with interest....
Of course it remains to be seen what is really in the data when it is released, but let me clarify what this news is about. When we measure GDP across countries, we do so at market prices. We're left with nominal GDP, which is a measure of the market value of production in the economy over a period of time (typically a quarter or a year).
But to make that number meaningful, we need to adjust it to real terms. So we also construct real GDP, where we measure the total value of production if prices had remained at the same level as in some base year.
But what if we wish to compare GDP across countries, as a means of comparing the standard of living across countries? We have real GDP in China measured in Chinese RMB, against US GDP measured in USD, for example, which are not directly comparable.
One simple approach would be to just use the market exchange rate, but that may not be ideal for several reasons. First exchange rates are highly volatile. It is not uncommon for nominal exchange rates to fluctuate by 10-30% in a single year, while underlying living standards change very little! But more importantly, the cost of living can vary radically across countries. Some countries may experience high incomes (and therefore high GDP: total income = total output), but also high costs, while other countries may experience the reverse. We therefore need to filter out any systematic differences in the cost of living to get an accurate idea of comparable living standards.
How do we do that? Well, we need detailed price data on similar items sold in different countries. We compare GDP not at market exchange rates, but at PPP (or "purchasing power parity") rates, that seek to adjust for differences in the cost of living.
And that's where this revision in mainland GDP is reputed to come from. Apparently prices in mainland China that have been used for making the PPP adjustment have been poorly measured in the past, and the result is a systematic understatment of the cost of living.
I'll be following this story with interest....
Monday, November 12, 2007
Oil, Gold, Exchange Rates, and Inflation....
Does the rapid appreciation of the price of oil and gold signify increased inflation? Here's a careful analysis by James Hamilton on Econbrowser.
Friday, November 9, 2007
What will happen to the USD?
The value of the USD has been falling dramatically against all major currencies. What is the likely future direction? Well, that's the billion dollar question.... literally. If I knew, I would not be writing it here, but would use my information to speculate on the currency! But alas, I'm not sure which way the dollar will move. (As I've argued earlier, part of the reason why we can't predict exchange rates well is the ease with which we can speculate on them). So instead, I'll write a blog entry about it!
I'm not alone. Menzie Chinn provides a very careful survey of academic thinking on the behaviour of exchange rates here, and ends up being about as non-committal as me.
For the record, I think we can predict the exchange rate with a little success. First, high interest rate bearing currencies tend to appreciate relative to low interest rate ones- the motivation for the "carry trade" (see my earlier posts here and here).
Second exchange rates tend to over-correct in the short run, like most other assets- thanks perhaps to "momentum traders" who tend to buy assets that are appreciating simply because they're appreciating, rather than due to underlying fundamental value. So ultimately someone will make a lot of money by buying USD at the bottom of the market. (That person will probably not be me, as we have no way of knowing when we're at the bottom until after the fact!)
And third in the long run, purchasing power parity is an important driver of exchange rates. Based on this, I still consider my earlier position to be reasonable: the USD will have appreciated a long wayt from its current value (and even its value as of 6 months ago) within 5 years.
I'm not alone. Menzie Chinn provides a very careful survey of academic thinking on the behaviour of exchange rates here, and ends up being about as non-committal as me.
For the record, I think we can predict the exchange rate with a little success. First, high interest rate bearing currencies tend to appreciate relative to low interest rate ones- the motivation for the "carry trade" (see my earlier posts here and here).
Second exchange rates tend to over-correct in the short run, like most other assets- thanks perhaps to "momentum traders" who tend to buy assets that are appreciating simply because they're appreciating, rather than due to underlying fundamental value. So ultimately someone will make a lot of money by buying USD at the bottom of the market. (That person will probably not be me, as we have no way of knowing when we're at the bottom until after the fact!)
And third in the long run, purchasing power parity is an important driver of exchange rates. Based on this, I still consider my earlier position to be reasonable: the USD will have appreciated a long wayt from its current value (and even its value as of 6 months ago) within 5 years.
Thursday, November 8, 2007
The Economics of Remittances....
Every year, domestic helpers in Hong Kong send money home to support their families. In this post, I want to briefly examine the economics of these remittances. (This post is motivated by this story about the remittances of polish truck drivers from the UK).
First, how large are the remittances? We can get some idea from looking at the level of "current transfers" in the Balance of Payments. For 2006, outflows were 24.6 billion. This is an upper bound on remittances, since it includes all flows of money that are not in exchange for goods and services, such as donations. Still, that's about 1.6% of GDP- a non-trivial sum by any measure.
So what's the effect of this outflow? Conventional wisdom is that this is a drain on the HK economy. But as is often the case with economics, the conventional wisdom is wrong. In order to remit finances home, the HKD earned in Hong Kong must be converted to some other currency. But there has to be a counter-party to that transaction: for every seller of HKD in exchange for Philippines Pesos, there's a buyer of HKD who wishes to sell Philippines Pesos. And why would someone want to buy HKD? In order to buy goods, services, assets, or some other item of value denominated in HKD.
So the bottom line is that there is no drain. This is simply a result of the Balance of Payments being zero- outflows must be matched with inflows.
But there are exceptions to this argument. What if the remittance is made in terms of HKD banknotes? If those bank notes are eventually spent in Hong Kong, then we return to the above case. And if they are not spent in Hong Kong (i.e. circulate elsewhere, or are stored in a safe somewhere), things are even better for Hong Kong. The Hong Kong economy benefits from the services of a worker in Hong Kong, and in exchange the worker contributes 100% of their earnings to Hong Kong's official foreign reserves.
Let me explain. When bank notes are issued, every 7.8HKD issued must be backed by a 1USD increase in the exchange fund. So additional banknotes result in the following transaction: the bank "sells" you banknotes (against your bank balance, say), and in exchange "buys" those banknotes from the exchange fund with USD. With the exchange rate fixed, this has negligible effect on the net wealth of the bank, but leaves you with your bank notes and the exchange fund with larger USD reserves.
If bank notes now leave Hong Kong, then approximately the same quantity of additional bank notes will be required to meet demand. So the reserves increase further by approximately the amount of the remittances. And the HK economy continues to benefit from the accumulated exchange fund balance in the form of interest income from the USD assets in the exchange fund.
If we did not have a currency board in HK, then bank notes circulating outside of HK would be similar to the example in the link above: effectively, the Hong Kong economy would have benefitted from the labour of a domestic helper in exchange for some pieces of paper that can be printed for a few cents each. This may be a trivial source of wealth for a place like Hong Kong, but it provides the United States with a windfall of 20-30 billion USD every year!
First, how large are the remittances? We can get some idea from looking at the level of "current transfers" in the Balance of Payments. For 2006, outflows were 24.6 billion. This is an upper bound on remittances, since it includes all flows of money that are not in exchange for goods and services, such as donations. Still, that's about 1.6% of GDP- a non-trivial sum by any measure.
So what's the effect of this outflow? Conventional wisdom is that this is a drain on the HK economy. But as is often the case with economics, the conventional wisdom is wrong. In order to remit finances home, the HKD earned in Hong Kong must be converted to some other currency. But there has to be a counter-party to that transaction: for every seller of HKD in exchange for Philippines Pesos, there's a buyer of HKD who wishes to sell Philippines Pesos. And why would someone want to buy HKD? In order to buy goods, services, assets, or some other item of value denominated in HKD.
So the bottom line is that there is no drain. This is simply a result of the Balance of Payments being zero- outflows must be matched with inflows.
But there are exceptions to this argument. What if the remittance is made in terms of HKD banknotes? If those bank notes are eventually spent in Hong Kong, then we return to the above case. And if they are not spent in Hong Kong (i.e. circulate elsewhere, or are stored in a safe somewhere), things are even better for Hong Kong. The Hong Kong economy benefits from the services of a worker in Hong Kong, and in exchange the worker contributes 100% of their earnings to Hong Kong's official foreign reserves.
Let me explain. When bank notes are issued, every 7.8HKD issued must be backed by a 1USD increase in the exchange fund. So additional banknotes result in the following transaction: the bank "sells" you banknotes (against your bank balance, say), and in exchange "buys" those banknotes from the exchange fund with USD. With the exchange rate fixed, this has negligible effect on the net wealth of the bank, but leaves you with your bank notes and the exchange fund with larger USD reserves.
If bank notes now leave Hong Kong, then approximately the same quantity of additional bank notes will be required to meet demand. So the reserves increase further by approximately the amount of the remittances. And the HK economy continues to benefit from the accumulated exchange fund balance in the form of interest income from the USD assets in the exchange fund.
If we did not have a currency board in HK, then bank notes circulating outside of HK would be similar to the example in the link above: effectively, the Hong Kong economy would have benefitted from the labour of a domestic helper in exchange for some pieces of paper that can be printed for a few cents each. This may be a trivial source of wealth for a place like Hong Kong, but it provides the United States with a windfall of 20-30 billion USD every year!
Monday, November 5, 2007
Pressure on the HKD peg...
The HKMA has been intervening regularly lately to maintain the HKD peg. The currency is nominally fixed at 7.80 HKD per USD, but allowed to fluctuate between 7.75 and 7.85. When it hits the weak side of the band (7.85), the HKMA is obliged to buy HKD in exchange for USD. And when it hits the strong side, the HKMA sells HKD in exchange for USD.
Lately, it has been stuck up against the strong side of the band. The most likely reason for this is the large value of IPO's in Hong Kong at present. To invest in an IPO, you need HKD. Ergo there is upward pressure on the value of the exchange rate. But this will pass, as the value of IPO's in the city returns to more normal levels in due course. (Indeed, it's back down as I write to 7.7659HKD per USD).
However, maintaining the currency board is not a costless policy. In this case, the total value of HKD in circulating is increasing, which must ultimately lead to higher inflation rates.
But let's put this into context. Seasonally adjusted M1 stood at 407 Billion HKD as of August 2007 (the latest available data). Based on media reports, the HKMA's interventions so far have amounted to about $10Billion HKD, or 2.5% of the money supply. The current level of intervention would need to be sustained for some time for the inflationary costs to become large.
Lately, it has been stuck up against the strong side of the band. The most likely reason for this is the large value of IPO's in Hong Kong at present. To invest in an IPO, you need HKD. Ergo there is upward pressure on the value of the exchange rate. But this will pass, as the value of IPO's in the city returns to more normal levels in due course. (Indeed, it's back down as I write to 7.7659HKD per USD).
However, maintaining the currency board is not a costless policy. In this case, the total value of HKD in circulating is increasing, which must ultimately lead to higher inflation rates.
But let's put this into context. Seasonally adjusted M1 stood at 407 Billion HKD as of August 2007 (the latest available data). Based on media reports, the HKMA's interventions so far have amounted to about $10Billion HKD, or 2.5% of the money supply. The current level of intervention would need to be sustained for some time for the inflationary costs to become large.
Thursday, November 1, 2007
The US dollar de-internationalisation....
The US dollar is the most internationalised of all currencies at the current point in time. But it is loosing ground, especially to the Euro. Psychology plays a role here, and the large depreciation of the USD relative to most other currencies over the last 18 months has not exactly helped the dollar's case. According to this Bloomberg article, the USD is becoming less acceptable in some economies.
Monday, October 29, 2007
Froth and Bubbles....
"What should China do to try to reduce excess liquidity and inflation" - Qin
China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.
What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.
That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.
My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.
Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.
China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.
What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.
That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.
My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.
Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.
China's Growing Reserves....
"China has accumulated huge USD reserves. How might these affect the US in future?" -Arun
China currently holds official reserves of approximately 1.4billion USD, mostly in USD denominated assets. The source of these growing reserves is official activity in the foreign exchange market, as Beijing seeks to control the value and stability of the Chinese currency. The end result is that the United States government is becoming increasingly in debt to the Mainland Chinese government.
In thinking about the effects of this growing reserves mounting, the are two possibilities that I would focus on. First, in principle, China could seek to use these holdings of debt to try to influence US policy positions. For example, suppose the United States were to increase protectionism by imposing punitive tariffs on China's exports. China could threaten to throw the foreign exchange market and the fixed income market in the United States into disarray by dumping huge quantities of USD assets on the world market.
I do not think that this is a likely outcome. Such a threat would not be in China's best interests. The very threat of wholesale selling would significantly drive down the value of a significant part of the Chinese government's balance sheet, imposing real costs on China. The only reason for making such a threat would be in the hope that the US would alter its behaviour so that China would never need to carry through with the threat. But the United States would never be willing to be seen to bow to Chinese pressure, as the political cost domestically would be too great. So a threat to sell is neither credible nor optimal for China.
The second effect of the growing debt mountain is that in the longer term, the United States is like any other debtor, and China like any other creditor. Future income in the United States will flow in increasing amounts to creditors in China and elsewhere, at the expense of future prosperity of US citizens. However, I want to be careful not to overstate this: even if all of China's reserves were in USD, at current US Tbill rates of about 5%, this amounts to a flow of $70Billion USD per year- or just 0.5% of current US GDP.
China currently holds official reserves of approximately 1.4billion USD, mostly in USD denominated assets. The source of these growing reserves is official activity in the foreign exchange market, as Beijing seeks to control the value and stability of the Chinese currency. The end result is that the United States government is becoming increasingly in debt to the Mainland Chinese government.
In thinking about the effects of this growing reserves mounting, the are two possibilities that I would focus on. First, in principle, China could seek to use these holdings of debt to try to influence US policy positions. For example, suppose the United States were to increase protectionism by imposing punitive tariffs on China's exports. China could threaten to throw the foreign exchange market and the fixed income market in the United States into disarray by dumping huge quantities of USD assets on the world market.
I do not think that this is a likely outcome. Such a threat would not be in China's best interests. The very threat of wholesale selling would significantly drive down the value of a significant part of the Chinese government's balance sheet, imposing real costs on China. The only reason for making such a threat would be in the hope that the US would alter its behaviour so that China would never need to carry through with the threat. But the United States would never be willing to be seen to bow to Chinese pressure, as the political cost domestically would be too great. So a threat to sell is neither credible nor optimal for China.
The second effect of the growing debt mountain is that in the longer term, the United States is like any other debtor, and China like any other creditor. Future income in the United States will flow in increasing amounts to creditors in China and elsewhere, at the expense of future prosperity of US citizens. However, I want to be careful not to overstate this: even if all of China's reserves were in USD, at current US Tbill rates of about 5%, this amounts to a flow of $70Billion USD per year- or just 0.5% of current US GDP.
Understanding Hyperinflation
Zimbabwe has the highest inflation rate in the world today, and provides an illustration of the effects of inflation. Consider this news article on CNN on inflation in Zimbabwe, which has picked back up to 7982% in the year ended September.
Relatedly, the Government recently devalued the official exchange rate from 250 Zimbabwe Dollars per USD to 30,000. At the time, commentators mentioned that this was not enough, as the underlying black market rate was closer to 250,000 ZimD per USD. Well now, just one month later, the black market rate has deteriorated to close to 1million ZimD per USD. And that was on October 18.
To understand what 7982% inflation means, that implies a daily compounding inflation rate of 1.21%. (That is, (1+0.0121)^365=(1+79.82)) That's about Hong Kong's annual inflation rate every day, compounding! Put another way, prices double every 57 days ((1+0.0121)^57=2), or about every 2 months. Every 4 months, they quadruple, etc. Based on this back-of-the-envelope calculation, in the unlikely event that you hold some ZimD, sell them fast- the value of the ZimD will be falling approximately proportionally with the inverse of the price level. Since the news story I linked to above was published 11 days ago, the black market rate has likely fallen to about 1.14 million ZimD per USD already!
Relatedly, the Government recently devalued the official exchange rate from 250 Zimbabwe Dollars per USD to 30,000. At the time, commentators mentioned that this was not enough, as the underlying black market rate was closer to 250,000 ZimD per USD. Well now, just one month later, the black market rate has deteriorated to close to 1million ZimD per USD. And that was on October 18.
To understand what 7982% inflation means, that implies a daily compounding inflation rate of 1.21%. (That is, (1+0.0121)^365=(1+79.82)) That's about Hong Kong's annual inflation rate every day, compounding! Put another way, prices double every 57 days ((1+0.0121)^57=2), or about every 2 months. Every 4 months, they quadruple, etc. Based on this back-of-the-envelope calculation, in the unlikely event that you hold some ZimD, sell them fast- the value of the ZimD will be falling approximately proportionally with the inverse of the price level. Since the news story I linked to above was published 11 days ago, the black market rate has likely fallen to about 1.14 million ZimD per USD already!
Monday, October 22, 2007
How will the USD depreciation affect the US economy?
"What is the benefit of a depreciating USD? In particular, will it reduce interest in investing in US assets, as they will offer a lower return? And does it make the US better off?" - Catherine
I have already discussed the effects of the exchange rate on the current account elsewhere- see in particular this post. A lower exchange rate results in exports being relatively cheap and imports relatively expensive, and so tends to directly improve the current account balance.
On the capital account, the effects are less clear. First consider the static case: what is the effect of a low value of the USD on demand for USD denominated assets? To be precise, consider an asset that offers a fixed stream of future income payments, such as a US government bond. A lower exchange rate decreases the exchange-rate adjusted return on the bond, but it also decreases the exchange-rate adjusted price by the same percent amount, so the real returns to foreign asset holders should be independent of the exchange rate.
More importantly, the capital account is influenced by the dynamics of the exchange rate, particularly its expected future path. For example, if we expect the value of the USD to continue to weaken, then we have less incentive to buy USD-denominated assets, as we would then suffer a capital loss when the exchange rate falls. This may be self-fulfilling: the USD is expected to depreciate, so investors do not wish to hold USD assets, so the demand for USD falls, so the USD depreciates, as expected.
This self-fulfilling path has limits, however. We know that in the long run, the exchange rate tends to over-correct. Thus the further it falls, the more likely it is to increase in the coming years, making the purchasing of USD assets more inviting. Thus USD assets will eventually find buying support as investors start to believe that the USD is more likely to appreciate rather than depreciate. I'm not saying that we're at the point yet: any exchange rate investment decisions are risky, especially in the short run.
Regarding your final question, an exchange rate depreciation does not make the US better off. Yes, it helps the US economy to adjust to shocks (in this case a negative wealth shock), but it also makes USD asset holders and income earners worse off. They can no longer afford the same quantity of foreign-sourced consumption goods. In that sense, a currency depreciation makes Americans worse off.
I have already discussed the effects of the exchange rate on the current account elsewhere- see in particular this post. A lower exchange rate results in exports being relatively cheap and imports relatively expensive, and so tends to directly improve the current account balance.
On the capital account, the effects are less clear. First consider the static case: what is the effect of a low value of the USD on demand for USD denominated assets? To be precise, consider an asset that offers a fixed stream of future income payments, such as a US government bond. A lower exchange rate decreases the exchange-rate adjusted return on the bond, but it also decreases the exchange-rate adjusted price by the same percent amount, so the real returns to foreign asset holders should be independent of the exchange rate.
More importantly, the capital account is influenced by the dynamics of the exchange rate, particularly its expected future path. For example, if we expect the value of the USD to continue to weaken, then we have less incentive to buy USD-denominated assets, as we would then suffer a capital loss when the exchange rate falls. This may be self-fulfilling: the USD is expected to depreciate, so investors do not wish to hold USD assets, so the demand for USD falls, so the USD depreciates, as expected.
This self-fulfilling path has limits, however. We know that in the long run, the exchange rate tends to over-correct. Thus the further it falls, the more likely it is to increase in the coming years, making the purchasing of USD assets more inviting. Thus USD assets will eventually find buying support as investors start to believe that the USD is more likely to appreciate rather than depreciate. I'm not saying that we're at the point yet: any exchange rate investment decisions are risky, especially in the short run.
Regarding your final question, an exchange rate depreciation does not make the US better off. Yes, it helps the US economy to adjust to shocks (in this case a negative wealth shock), but it also makes USD asset holders and income earners worse off. They can no longer afford the same quantity of foreign-sourced consumption goods. In that sense, a currency depreciation makes Americans worse off.
Wednesday, October 17, 2007
The current account and the exchange rate...
"What is the effect of the current account balance on the exchange rate?" - Vincent
To answer this question, let's take the case of a current account surplus. The current account is determined largely by the level of net exports- the other components of the current account (net factor payments and net transfers) are generally relatively small. So a current account surplus implies that exports are larger than imports.
Paying for exports requires domestic currency, and imports foreign currency. Thus an increase in exports will result in increased demand for domestic currency, and a decrease in imports in decreased demand for foreign currency (=supply of domestic currency)- so positive net exports imply upward pressure on the value of the currency, as the demand for domestic currency is increasing faster than the supply. Thus, to answer your question, a current account surplus will result in upward pressure on the currency. The arguments reverse for a current account deficit.
Empirically, there is not alway a clear link between the value of the currency and the current account, and even where there is, we often observe the exact reverse: after a lag, a decrease in the currency results in an increase in the current account, and vice versa. So what explains this link?
The explanation is that exchange rates are determined largely by capital account flows, rather than current account flows, as the former are much larger. Suppose there is a large capital outflow, for example. This will push down the value of the currency. But as the value of the currency decreases, exports become relatively cheaper and imports relatively more expensive. The direct effect of these price effects is to result in a decrease in the current account balance.
To put this another way, the current account balance may be defined as
CA = Price(exports) x Quantity(exports) - Price(imports) x Quantity(imports)
The effect of the currency depreciation on prices will decrease the current account surplus. But that is ignoring the quantity effects. Over time, trade flows adjust to the exchange rate change, and the quantity of relatively cheaper exports will rise, while the quantity of relatively more expensive imports will fall. After a year or more, the quantity effects will tend to be larger than the price effects, so that the current account will start to rise.
We typically refer to the relationship between exchange rates and trade flows as the "J-curve," since a depreciation results in an initially fall in net exports but an eventual rise, much like the letter J.
To answer this question, let's take the case of a current account surplus. The current account is determined largely by the level of net exports- the other components of the current account (net factor payments and net transfers) are generally relatively small. So a current account surplus implies that exports are larger than imports.
Paying for exports requires domestic currency, and imports foreign currency. Thus an increase in exports will result in increased demand for domestic currency, and a decrease in imports in decreased demand for foreign currency (=supply of domestic currency)- so positive net exports imply upward pressure on the value of the currency, as the demand for domestic currency is increasing faster than the supply. Thus, to answer your question, a current account surplus will result in upward pressure on the currency. The arguments reverse for a current account deficit.
Empirically, there is not alway a clear link between the value of the currency and the current account, and even where there is, we often observe the exact reverse: after a lag, a decrease in the currency results in an increase in the current account, and vice versa. So what explains this link?
The explanation is that exchange rates are determined largely by capital account flows, rather than current account flows, as the former are much larger. Suppose there is a large capital outflow, for example. This will push down the value of the currency. But as the value of the currency decreases, exports become relatively cheaper and imports relatively more expensive. The direct effect of these price effects is to result in a decrease in the current account balance.
To put this another way, the current account balance may be defined as
CA = Price(exports) x Quantity(exports) - Price(imports) x Quantity(imports)
The effect of the currency depreciation on prices will decrease the current account surplus. But that is ignoring the quantity effects. Over time, trade flows adjust to the exchange rate change, and the quantity of relatively cheaper exports will rise, while the quantity of relatively more expensive imports will fall. After a year or more, the quantity effects will tend to be larger than the price effects, so that the current account will start to rise.
We typically refer to the relationship between exchange rates and trade flows as the "J-curve," since a depreciation results in an initially fall in net exports but an eventual rise, much like the letter J.
Monday, October 15, 2007
Why have a currency board?
"Notwithstanding the fact that the currency peg is very political, are there any compelling reasons why the HKD should not be "unpegged" from the USD, particularly in view of expected further depreciation of the greenback?"
That's an excellent question! To answer it, first we need to take a slight detour, into the world of currency unions. A currency union is a form of monetary policy where two or more countries use the same money- for example, the Euro area, or Ecuador and the US- who both use USD. There is a substantial amount of evidence that countries in currency unions benefit economically from large increases in trade, investment flows, and output (see the links on this page put together by Andy Rose at UC Berkeley, and my own modest contribution published in Pacific Economic Review that you can view here).
So currency unions are good- but what's that got to do with Hong Kong, with doesn't have a currency union, but a currency board? It's hard to say anything definitive, as there just aren't enough cases of currency boards to undertake the kind of empirical studies linked to above. But I think it is a reasonable conjecture that the same benefits that accrue to currency unions also accrue to currency boards. Both fix the exchange rate in a way that is politically costly to reverse; the main difference between them is that in one case, the countries retain different notes and coins from each other, and in the other case they do not. If my conjecture is correct, Hong Kong benefits from higher capital flows (important for the establishment of the growing international finance centre here), higher trade flows (one of the corner stones of the Hong Kong economy), and higher economic growth.
That doesn't mean that a currency board is without costs. Since the exchange rate cannot adjust to absorb shocks, other variables do instead- including output and unemployment. Our business cycles may be more volatile, but that may be a price that is worth paying.
That's an excellent question! To answer it, first we need to take a slight detour, into the world of currency unions. A currency union is a form of monetary policy where two or more countries use the same money- for example, the Euro area, or Ecuador and the US- who both use USD. There is a substantial amount of evidence that countries in currency unions benefit economically from large increases in trade, investment flows, and output (see the links on this page put together by Andy Rose at UC Berkeley, and my own modest contribution published in Pacific Economic Review that you can view here).
So currency unions are good- but what's that got to do with Hong Kong, with doesn't have a currency union, but a currency board? It's hard to say anything definitive, as there just aren't enough cases of currency boards to undertake the kind of empirical studies linked to above. But I think it is a reasonable conjecture that the same benefits that accrue to currency unions also accrue to currency boards. Both fix the exchange rate in a way that is politically costly to reverse; the main difference between them is that in one case, the countries retain different notes and coins from each other, and in the other case they do not. If my conjecture is correct, Hong Kong benefits from higher capital flows (important for the establishment of the growing international finance centre here), higher trade flows (one of the corner stones of the Hong Kong economy), and higher economic growth.
That doesn't mean that a currency board is without costs. Since the exchange rate cannot adjust to absorb shocks, other variables do instead- including output and unemployment. Our business cycles may be more volatile, but that may be a price that is worth paying.
Tuesday, September 25, 2007
Hong Kong's Money...
Want to know how monetary policy is really set in Hong Kong, and the intricacies of the Currency Board system? Look no further than "Hong Kong's Money," a new book written by Tony Latter and Published by Hong Kong University Press. Mr Latter is a former Deputy Chief Execuative of the Hong Kong Monetary Authority, and his association with monetary policy stretches back to the formation of the currency board in 1983. But his understanding of Hong Kong's monetary history stretches back a long way before then....
Friday, September 21, 2007
The Canadian Dollar
Further to my earlier post, the Canadian dollar was worth more than the US dollar last night for the first time in 31 years. As I write, $1CDN will buy $1.0014USD!
As this Bloomberg story notes, the Canadian dollar has appreciated by more than 62% since 2002. This has also largely been a real (as opposed to nominal) exchange rate change, as the inflation experiences of the US and Canada have been similar over this period.
There's a warning implicit in the there for all international transactions: exchange rate fluctuations are huge, and can easily dwarf all other risks faced by businesses.
As this Bloomberg story notes, the Canadian dollar has appreciated by more than 62% since 2002. This has also largely been a real (as opposed to nominal) exchange rate change, as the inflation experiences of the US and Canada have been similar over this period.
There's a warning implicit in the there for all international transactions: exchange rate fluctuations are huge, and can easily dwarf all other risks faced by businesses.
Arbitraging the HKD
"What is the role of arbitrage in HK's exchange rate arrangement?" - Vincent
Arbitrage plays an important role in ensuring that the interest rate in Hong Kong remains close to the value in the United States. To illustrate this point, suppose interest rates in Hong Kong were significantly higher than in the United States. It would then be profitable to borrow large sums of money in the United States, convert them into Hong Kong dollars, and deposit them in the Hong Kong banking system- because the interest income earned on your HKD deposits would exceed the interest that must be repaid on your US dollar loan. When the loan comes due, you would withdraw your HKD deposit, convert it back to USD, repay your USD loan, and have money left over!
Of course there are more efficient ways of taking highly leveraged positions to benefit from any interest rate mis-match. Using currency futures markets, you could take a long position in HKD and a short position in USD- if the exchange rate remains fixed, your profits would be approximately equal to the difference between the interest rates in the two economies, multiplied by the size of your position held.
When investors take advantage of interest rate differentials like this, the very act of arbitraging will move interest rates closer together- borrowing USD will raise the US interest rate, and lending HKD will lower the HK interest rate. So interest rates in HK will remain close to those in the US- adjusted for relevant risks between the two markets.
The above argument only applies to currencies with fixed exchange rates. For most currency pairs, there may be large and persistent differences between interest rates, as taking leveraged positions across currencies is very risky due to exchange rate volatility. Exchange rate movements are often large, and may more than cancel out any gains from trying to arbitrage away interest rate differentials- see the previous story about the volatility of the Canadian dollar. But the presence of exchange rate volatility doesn't stop people trying to profit from interest rate differentials. Strategies designed to take advantage of this are typically referred to as the "Carry Trade." For an earlier discussion about this, see the comments here.
Arbitrage plays an important role in ensuring that the interest rate in Hong Kong remains close to the value in the United States. To illustrate this point, suppose interest rates in Hong Kong were significantly higher than in the United States. It would then be profitable to borrow large sums of money in the United States, convert them into Hong Kong dollars, and deposit them in the Hong Kong banking system- because the interest income earned on your HKD deposits would exceed the interest that must be repaid on your US dollar loan. When the loan comes due, you would withdraw your HKD deposit, convert it back to USD, repay your USD loan, and have money left over!
Of course there are more efficient ways of taking highly leveraged positions to benefit from any interest rate mis-match. Using currency futures markets, you could take a long position in HKD and a short position in USD- if the exchange rate remains fixed, your profits would be approximately equal to the difference between the interest rates in the two economies, multiplied by the size of your position held.
When investors take advantage of interest rate differentials like this, the very act of arbitraging will move interest rates closer together- borrowing USD will raise the US interest rate, and lending HKD will lower the HK interest rate. So interest rates in HK will remain close to those in the US- adjusted for relevant risks between the two markets.
The above argument only applies to currencies with fixed exchange rates. For most currency pairs, there may be large and persistent differences between interest rates, as taking leveraged positions across currencies is very risky due to exchange rate volatility. Exchange rate movements are often large, and may more than cancel out any gains from trying to arbitrage away interest rate differentials- see the previous story about the volatility of the Canadian dollar. But the presence of exchange rate volatility doesn't stop people trying to profit from interest rate differentials. Strategies designed to take advantage of this are typically referred to as the "Carry Trade." For an earlier discussion about this, see the comments here.
Wednesday, September 19, 2007
Fed Rates and Exchange Rates....
One effect of the Fed rate cut has been a further fall in the value of the US dollar against most other currencies, as a direct result of the drop in relative returns on US fixed income assets.
To focus on just one currency pair, for the first time in 30 years, the Canadian Dollar looks set to surpass the US dollar (see graph above).
Given the increasing importance of oil and other commodity prices in driving the appreciation of the Canadian dollar, I think an abrupt fall in commodity prices is the only possibility of the Canadian dollar not surpassing the value of the US dollar in short order. (According to http://www.xe.com/, the Canadian dollar is currently trading at 0.9904 US Dollars).
To focus on just one currency pair, for the first time in 30 years, the Canadian Dollar looks set to surpass the US dollar (see graph above).
Given the increasing importance of oil and other commodity prices in driving the appreciation of the Canadian dollar, I think an abrupt fall in commodity prices is the only possibility of the Canadian dollar not surpassing the value of the US dollar in short order. (According to http://www.xe.com/, the Canadian dollar is currently trading at 0.9904 US Dollars).
Wednesday, August 1, 2007
Is China's currency REALLY undervalued?
There's some new evidence that the mainland currency may not actually be undervalued, despite commonly held views to the contrary. In a recent HKIMR working paper (11/2007, available here), Cheung, Chinn and Fujii argue that using standard empirical methods, there is little statistical evidence that the RMB is undervalued.
For my earlier take on this topic, see here.
For my earlier take on this topic, see here.
Friday, June 15, 2007
China vs. US... round 574322
So some American senator's are once again trying to pressure China to cause the RMB to appreciate, by various diplomatic and legal means. That's nothing new. But how can we be sure that the RMB is undervalued? The simple truth is that we cannot.... and there are compelling reasons to believe that the RMB may actually be OVERVALUED at the current time.
What we know is that at the existing exchange rate, RMB demand exceeds supply. The People's Bank of China responds by selling RMB in exchange for USD and other currencies. If this was the full story, then we could make a strong case that the RMB is selling for below its market value, and is therefore undervalued.
But in the case of China, we do not actually observe the underlying market supply and demand for currency. That is because the market is heavily distorted by capital controls. Investors in China cannot freely invest in other parts of the world. This does not only reduce capital outflows, but capital inflows as well, as outsiders may be less willing to invest money in an economy from which it may be difficult to extract the investment later.
I would argue that the underlying equilibrium value of the RMB is the value that it would take, absent capital controls. And if China were to remove capital controls today, both capital inflows and outflows would likely rise. The former would put upward pressure on the RMB, while the latter would put downward pressure.
Which one of these is likely to dominate? The best place to look for this is the presence of distortions in asset prices. If controls are disproportionately discouraging inflows of capital, China should be a sea of promising investment opportunities that offer higher risk-adjusted returns than those available elsewhere. In contrast, if capital controls are disproportionately discouraging outflows of capital, too much money will be chasing too few assets in China, driving up asset prices and therefore driving down asset returns.
We don't need to look any further than the arbitrage opportunities that exist between H-shares and A-shares to find compelling evidence that the RMB may be OVERVALUED. Based on equivalent shares trading in both Hong Kong and Shanghai, Chinese asset prices are approximately 3 times higher than they would be without capital controls. A correction in asset prices sufficient to remove this arbitrage opportunity would likely require a massive capital outflow, and with it a large depreciation of the RMB in the short run.
Prediction: just as with all earlier rounds, the senators will once again lose this round with China.
(For an excellent analysis of the underlying economics of the RMB/US exchange rate, check Menzie Chinn here.)
What we know is that at the existing exchange rate, RMB demand exceeds supply. The People's Bank of China responds by selling RMB in exchange for USD and other currencies. If this was the full story, then we could make a strong case that the RMB is selling for below its market value, and is therefore undervalued.
But in the case of China, we do not actually observe the underlying market supply and demand for currency. That is because the market is heavily distorted by capital controls. Investors in China cannot freely invest in other parts of the world. This does not only reduce capital outflows, but capital inflows as well, as outsiders may be less willing to invest money in an economy from which it may be difficult to extract the investment later.
I would argue that the underlying equilibrium value of the RMB is the value that it would take, absent capital controls. And if China were to remove capital controls today, both capital inflows and outflows would likely rise. The former would put upward pressure on the RMB, while the latter would put downward pressure.
Which one of these is likely to dominate? The best place to look for this is the presence of distortions in asset prices. If controls are disproportionately discouraging inflows of capital, China should be a sea of promising investment opportunities that offer higher risk-adjusted returns than those available elsewhere. In contrast, if capital controls are disproportionately discouraging outflows of capital, too much money will be chasing too few assets in China, driving up asset prices and therefore driving down asset returns.
We don't need to look any further than the arbitrage opportunities that exist between H-shares and A-shares to find compelling evidence that the RMB may be OVERVALUED. Based on equivalent shares trading in both Hong Kong and Shanghai, Chinese asset prices are approximately 3 times higher than they would be without capital controls. A correction in asset prices sufficient to remove this arbitrage opportunity would likely require a massive capital outflow, and with it a large depreciation of the RMB in the short run.
Prediction: just as with all earlier rounds, the senators will once again lose this round with China.
(For an excellent analysis of the underlying economics of the RMB/US exchange rate, check Menzie Chinn here.)
Monday, May 21, 2007
Hong Kong's Monetary Policy... continued
In my last post, I argued that HK doesn't have independent monetary policy because of the fixed exchange rate. Here I respond to the question
"Why doesn't the same argument apply to the US?"
The key difference is the exchange rate. Between HK and US, there is very little exchange rate risk. Therefore any difference in interest rates can be arbitraged by investors, at little risk to investors.
In comparison, between most currencies, exchange rate risk is high. For example, interest rates in the US are about 4% higher than Japan. That means borrowing yen to invest in the US yields approximately 0.015% in expected return per trading day. But this is trivial compared to the exchange rate risk.... according to Bloomberg, today the Yen has depreciated by 0.11% so far today already- that's an order of magnitude larger! Today the depreciation of the Yen would increase the profits of someone engaged in arbitrage. More generally, it might increase profits or wipe them out, replacing them with large losses.
The important point is that the exchange rate change is typically far larger than the interest rate differential. Investors are risk averse, so exchange rate uncertainty leads them to avoid fully arbitraging interest rate differentials.
That doesn't mean that investors aren't engaged in borrowing low interest rate currencies like the Yen to invest in higher interest rate currencies like the USD. It's called the Carry Trade- see my earlier posts here and here.
"Why doesn't the same argument apply to the US?"
The key difference is the exchange rate. Between HK and US, there is very little exchange rate risk. Therefore any difference in interest rates can be arbitraged by investors, at little risk to investors.
In comparison, between most currencies, exchange rate risk is high. For example, interest rates in the US are about 4% higher than Japan. That means borrowing yen to invest in the US yields approximately 0.015% in expected return per trading day. But this is trivial compared to the exchange rate risk.... according to Bloomberg, today the Yen has depreciated by 0.11% so far today already- that's an order of magnitude larger! Today the depreciation of the Yen would increase the profits of someone engaged in arbitrage. More generally, it might increase profits or wipe them out, replacing them with large losses.
The important point is that the exchange rate change is typically far larger than the interest rate differential. Investors are risk averse, so exchange rate uncertainty leads them to avoid fully arbitraging interest rate differentials.
That doesn't mean that investors aren't engaged in borrowing low interest rate currencies like the Yen to invest in higher interest rate currencies like the USD. It's called the Carry Trade- see my earlier posts here and here.
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