Currency markets and their effects on the U.S. economy - Essay Example

Currency Markets and their Effects on the U.S. Economy This paper discusses currency markets, how they operate, and how they affect the economy of the United States. The specific cases of two foreign currencies - the Euro and the Japanese Yen - and the impact of their movements on the U.S. economy are analyzed to provide a clearer picture that would facilitate the understanding of the theory. Although the term "currency" is synonymous with "money" that is a medium of economic exchange, what would be discussed in this paper is the currency market, not the money market. The reasons for this distinction will be explained below. Currency Markets A currency market, like any other market, is a place where currencies are bought and sold. This is different from a money market, which is where monetary or financial instruments such as bonds, stocks, derivatives, insurance policies, mutual funds and similar goods are transacted. However, currency and money markets share four key elements that allow transactions in any market to take place. First, the market should exist either physically in a building as the New York Stock Exchange, the Chicago Mercantile Exchange for commodities, or a neighborhood flea market, or virtually in a computer system which is the case for most markets where bonds, derivatives, or currencies are bought and sold. In the currency market, there is no single location where currencies are traded. Instead, there are many trades taking place, in banks, moneychangers, shops, even hotels, and each venue has a set of exchange rates for "buy" and "sell" bids, with the latter usually higher by a fraction. These rates are the prices that the agent is willing to pay for (buy) or get paid for (sell) in transacting each currency. Then, there should be goods that are exchanged in this market; buyers and sellers who either buy or sell the goods; and money that is used as the medium of exchange. A market transaction is therefore where buyers acquire from sellers certain goods in exchange for money at an agreed price. The main difference between all the other types of markets such as money markets and a currency market is that in a currency market, the goods bought and sold are currencies and the payments are also made in currencies that are denominated differently from that which is sold or bought. Therefore, in a currency market, someone or an entity that wants to buy U.S. dollars can buy it using Euros (denomination of the Eurozone currency), Yen (Japan), Pounds Sterling (United Kingdom), and so on. This brings an important question to mind: how much is a U.S. dollar worth, and if what it is worth determines the price that others are going to pay for it, why is the currency of the U.S. not the same as the currency of other countries What determines the price of currencies in the market The answers to these questions depend on an understanding of what is called the monetary system, or the way the money supply is determined in each country and, therefore, in the whole world. Knowing how the monetary system operates will give a better understanding of how currency prices are determined in the currency market. Monetary System A clear understanding of the world's monetary system will explain how a currency is valued, how its value compares with other currencies defined by the exchange rate, the roles that exchange rates play in the world economy, and how exchange rates are determined. Solomon (in Samuelson and Nordhaus) described the monetary system as follows: 'The world's monetary system is like the traffic lights in a city, taken for granted until it begins to malfunction and to disrupt people's livesA well-functioning monetary system will facilitate international trade and investment and smooth adaptation to change. A monetary system that functions poorly may not only discourage the development of trade and investment among nations but subject their economies to disruptive shocks when necessary adjustments are prevented or delayed" (1, 7). The world's monetary system therefore is a "set of policies, institutions, practices, regulations, and mechanisms that determine the rate at which one currency is exchanged for another" (Shapiro 80). It is the coordinated way each nation manages its supply of money so that we can buy and sell each other's goods. There are almost two hundred sovereign nations in the world, each with its own currency. In the recent past, each nation was free to decide how much of its currency to circulate to buy food, clothes, and stuff. This turned out to be unwise because printing money and giving it artificial value resulted in absurd price increases caused by the uncontrolled supply of money. This price increase is what we now know by a word that sends shivers down central bankers' spines: inflation. However, since a discussion of inflation is not the objective of this paper, what would be discussed next is the process by which exchange rates are determined in the market by any of three ways: currency speculation, government intervention, and world trade. Suffice it to say that because inflation is a danger that most countries want to avoid, they have realized that printing endless amounts of money to buy foreign currencies or deciding on their own what their exchange rate should be are not a sustainable activity (in fact, it was the problem of East Asian countries prior to the Asian Financial Crisis of 1997-1998), so they respect the exchange rate agreements currently in force (Willett et al. 25-44). Currency Speculation and Trading Currency speculation is a transaction conducted in the currency market to earn profits by taking advantage of differences in currency prices. A speculator, therefore, can buy U.S. dollars from one bank at a certain price and sell it to another bank at a higher price. Some 95 percent of foreign currencies are traded in the inter-bank market consisting of major banks and currency dealers that trade with each other. The remaining 5 percent are traded in other places such as hotels, money shops, and private transactions (Bessembinder 348; OANDA 1). Currency dealers trade "over-the-counter" which means that any two parties can transact business over the telephone or electronic network, except for currency futures and options that trade on special exchanges. Dealers advertise exchange rates - the prices they are willing to buy and/or sell currencies - using a distribution network such as Bloomberg and Reuters and use the information to do their trade. As of the end of 2006, an estimated average of $2.9 trillion worth of currencies are traded each day in the major currency markets of London, Tokyo, New York, Singapore, and Hongkong. In comparison, the daily turnover at the New York Stock Exchange is only $60 billion, making the currency markets the largest in the world (OANDA). One reason for the growth of the market is its 24-hour/5-days-a-week availability, as trading begins Monday morning in Sydney (Australia) and then moves around the world through different trading centers until closing time at 4:30 p.m. EST in New York on Friday evening. The huge volume of trades make it difficult for central banks and governments to affect exchange rates of the most liquid currencies such as the US Dollar, Japanese Yen, the Euro, Swiss Franc, and the Canadian and Australian Dollars. Over 85% of all currency exchange transactions involve a few major currencies: the US Dollar (USD), Japanese Yen (JPY), Euro (EUR), Swiss Franc (CHF), British Pound (GBP), Canadian Dollar (CAD), and Australian Dollar (AUD). In the currency exchange market, most of the currencies are traded only against the US Dollar. The term cross rate refers to an exchange rate between two non-dollar currencies. Trading between two non-dollar currencies usually occurs by first trading one against the US Dollar and then trading the US Dollar against the second non-dollar currency. Because of this, the spread in the exchange rate between two non-dollar currencies is often higher. There are a few non-dollar currencies that are traded directly, such as GBP/EUR or EUR/CHF. The vast majority of trading volume and thus considered to be the most important ones are cross-trading in EUR/USD, USD/JPY, EUR/JPY, USD/CAD, EUR/GBP, GBP/USD, USD/CHF, AUD/USD, and AUD/JPY. Currency trading is always done with currency pairs, such as EUR/USD, which makes it useful to consider the currency pair as an instrument that can be bought or sold. The liquidity of a currency is one factor for its strength and stability, which is why the increased trading of the U.S. dollar in currency markets is good for the currency and the U.S. economy (Dornbusch 1165-67). Buying the currency pair implies buying the first, base currency and selling (short) an equivalent amount of the second quoted currency (to pay for the base currency). It is not necessary for the trader to own the quoted currency prior to selling, as it is sold short. A speculator buys a currency pair, if he believes the base currency will go up relative to the quote currency, or equivalently that the corresponding exchange rate will go up. Selling the currency pair implies selling the first, base currency (short), and buying the second quoted currency. A speculator sells a currency pair if he believes the base currency will go down relative to the quoted currency, or equivalently, that the quoted currency will go up relative to the base currency. After buying a currency pair, the trader will have an open position in the currency pair. Right after such a transaction, the value of the position will be close to zero, because the value of the base currency is more or less equal to the value of the equivalent amount of the quoted currency. In fact, the value will be slightly negative because of the spread involved. In today's currency market, a trade goes through a three-step process: First, the trader communicates the currency pair and the amount he would like to trade with another dealer. Then, the dealer responds with a bid and an ask price. Lastly, the trader responds to the bid and ask price in any of the following ways: buy (by saying "Mine" or "I buy" or "I take"), sell (by saying "yours" or "I give you" or "I sell"), or refuse. The transaction occurs if the final response is either a buy or a sell. The dealer is required to quote a "good" market price, since he does not know whether the trader will buy or sell. The currency exchange market just described is referred to as the spot market and the transaction described is referred to as a spot deal. A spot deal consists of a bilateral contract between a party delivering a specified amount of a given currency against receiving a specified amount of another currency from a second counter party, based on an agreed exchange rate, within two business days of the deal date, which is referred to as the settlement date. Speculators rarely deliver, however, and use what is referred to as a rollover swap, designed to allow the changing of an old deal date to the current date by simultaneously closing an open position for today's date and opening the same position for the next day at a price reflecting the interest rate differential between the two currencies. When a trader buys or sells a currency pair, the value of the currency pair, as an instrument, initially is close to zero. This is because (in the case of a buy) the quote currency is sold to buy an equivalent amount of the base currency. As the market rates fluctuate, however, the value of the currency pair position held will also fluctuate. Thus, if the rate for the currency pair goes down, the speculator's long position will lose in value and become negative. To ensure that the speculator can carry the risk for the case where the position results in a loss, banks or dealers typically require sufficient collateral to cover those losses; this collateral is typically referred to as the margin. To limit down-side risk, traders often specify a Stop-Loss rate for each open trade. The Stop-Loss specifies that the trade should be closed automatically when the currency exchange rate for the currency pair in question reaches a certain threshold. For long positions, the Stop-Loss rate is always lower than the current exchange rate; for short positions, it is always higher. Traders, at times, also specify a Take-Profit rate for their trades in order to lock in a profit when the exchange rate reaches a certain threshold. For long positions, the Take-Profit rate must be above the current rate, while for short positions, it must be below the current rate. A trader may also leave an order with a bank, broker or dealer. These so called leave orders are orders that a trade should be executed in the future when certain market conditions occur. There are three types of leave orders: (1) entry orders specify that a currency pair should be traded when it reaches a certain exchange rate. Entry orders are used when the trade would not offset a current position; (2) take-profit orders clear a position by buying (or selling) the currency pair of the position when the exchange rate reaches a specified level; and (3) stop-loss orders clear a position by buying (or selling) the currency pair of the position when the exchange rate reaches a specified level. How much of the $2 trillion daily average in currency transactions are due to speculation It is difficult to say. Government Intervention in Exchange Rates: Law of Supply and Demand In any market, the price of a good depends on the supply of that good and the demand for that good. This rule applies to currency markets: the higher the demand and the lower the supply for a currency, the higher would be its price. The factors that determine the supply and demand of a currency therefore affect its exchange rate (Dornbusch, 1161-76). The government (more specifically the Central Bank or the Fed in the U.S. case) is in control of the supply of currency. This is what economists and bankers call the money supply, and depending on the level of economic activity in the country, the government can either tighten (decrease liquidity or the amount of money circulating in the country's monetary system) or loosen the money supply. There are many ways of doing this: raising interest rates and increasing taxes are two ways of accomplishing this, but the more popular strategy that Central Banks use is to raise or lower the bank reserve requirements. These strategies are called monetary (such as those that influence interest rates and reserve requirements) or fiscal (raising taxes, mandating wage hikes, or increasing pump-priming infrastructure projects are examples) policies. Through these policies, government intervenes in the economy and, as a result, its intervention can increase or decrease the money supply. Money supply targeting, achieved through upward or downward adjustments of short-term interest rates, worked well and proved popular in the late 1970s because of the link between money-supply growth and future inflation. In an uncertain world, the central bank's target is a reference, a guide to countless other decisions that affect us all. Using different tools of monetary policy, central bankers control inflation and keep prices stable. Some, like the Fed, have the added duty to promote employment and economic growth. How they actually do it is a fascinating combination of rocket science, knowledge of psychology, and perfect command of syntax and grammar to communicate to the public which of the many inflation-controlling tools the central banker will use, either singly or in combination. The government can also affect the supply and demand of its currency by managing the exchange rate, which is the price of the currency in the currency markets. Here, the government can do two things: it can set exchange rate targets and intervenes when the exchange rate goes beyond (above or below) an established band or it can allow the exchange rate to float. Very few countries (such as China for reasons that only its government knows1) resort to managed exchange rates, but most countries allow their currencies to float in the market. Some countries like Singapore, Brunei, and Argentina, however, have a currency board instead of a central bank. The currency board issues notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency (normally the US Dollar). The currency board holds as reserves high-quality, interest-bearing securities denominated in the reserve currency. Its reserves are 100%, or slightly more, of its notes and coins in circulation. The board does not determine monetary policy and market forces alone determine the money supply (Shapiro 55-57). Therefore, the exchange rates of countries with currency board are tied to the inflation rate of the country issuing the reserve currency. This results in price stability and promotes fiscal responsibility, forcing the government to balance the budget by borrowing from private banks instead of requesting the central bank to monetize the deficit. Currency boards have one other drawback: there is no central bank that can act as a lender of last resort to troubled banks. If as in the case of Argentina, the government does not have the will to manage its finances properly, the country goes into repeated crises (Radelet and Sachs 68-72). Effects of World Trade: Case of the Euro and Japanese Yen A currency's price (exchange rate) in a floating exchange rate system is determined by forces of supply and demand. Aside from currency speculation and government intervention, another determinant of exchange rates is world trade, where goods are bought and sold from one country to another (Stiglitz 1080-82). Imports require payments in foreign currencies while exports bring in foreign currencies as income. According to the latest statistics of the World Trade Organization (1-45), the U.S. exported $10.12 trillion and imported $10.48 trillion worth of goods, which resulted in a trade deficit of over $300 billion. One perceived effect of the continuing trade deficit is the weakening of the U.S. dollar as shown in Table 1 and Figure 1, which shows that the Euro strengthened (or appreciated) vis--vis the U.S. Dollar, which weakened (or depreciated) over the last three years. The opposite can be observed with the Japanese Yen, which weakened during the same period. The U.S. trade deficits in 2006 with the Eurozone ($45 billion) and Japan ($153 billion) have alarmed several economists, but as Shostak (1-2) of the Mises Institute argued, this is nothing to be paranoid about provided the government takes the necessary steps to maintain the competitive position of the U.S. economy. There are two reasons for this assurance. First, the Americans are paying for our expenses using money that we have saved, funds that are backed by real American assets, and the earning capacity of our economy. Unlike many other countries that have entered into cycles of economic crises that spent way beyond their means (Mishkin 714-718), America can afford to spend at a deficit provided, however, that it is the consumers who have earning capacity that do the spending. What is not good is if it is the government that incurs the deficit, since it does not generate revenues and spends much. Second, as the world's largest economy with a GDP last year of $13.22 trillion growing at 3% per year (CIA Factbook; Carson 2-5), America would continue being a significant force driving the global economy forward. Much has been said about America being the largest borrower of funds, but since the currency being borrowed is our own, it would be in the best interests of the major lenders such as Japan and the Eurozone with which America has trade deficits not to trigger an economic collapse by collecting on our debt. The collapse of the American economy given its size would be harder on those countries that have the U.S. as a major trading partner and, at the same time, its biggest borrower. The only cause for concern is the huge public sector debt of $8.5 trillion or 64.7% of 2005 GDP (CIA Factbook). The government is not a wealth creating entity and as such derives its livelihood from the private sector (Kogan). Consequently, every foreign debt the government incurs means that the private sector will have to foot the bill some time in the future. Better than drafting policies to bring down our trade deficit and a weakening currency, what our government should do is to balance its budget, continue looking for ways for business to be more productive, and not to create a cause for useless panic. America is rich, and as long as we can control the spendthrift in the house that is the Federal Government, there would be no cause for alarm. Works Cited Artus, Patrick. "Do the economic problems of the United States come from the Eurozone, or: could the economy spark a conflict between the United States and Europe" Ixis Corporate Research Flash Report 123 (2005): 1-10. Bessembinder, Hendrik. Bid-Ask Spreads in the Interbank Foreign Exchange Markets". Journal of Financial Economics June (1994): 317-348. Carson, Iain. "A Special Report on European business." The Economist 10 February 2007, p. 1-20. Central Intelligence Agency (CIA). The World Factbook. Updated 15 March 2007. 31 March 2007. "China and the World Economy" The Economist July 30-August 5, 2005: 65-67. Dornbusch, Rudiger. "Expectations and Exchange Rate Dynamics". Journal of Political Economy December (1976): 1161-1176. Kogan, R. (January 6, 1997). Enforcement of a constitutional balanced budget amendment: questions without answers. Center for Budget and Policy Priorities. 30 March 2007 Mishkin, Frederic S. "Lessons from the Asian Crisis". Journal of International Money and Finance 18 (1999): 709-723. OANDA. Introduction to Currency Exchange and the FX Market. OANDA.com. 2 April 2007. Radelet, Steven and Jeffrey D. Sachs. "The East Asian Financial Crisis: Diagnosis, Remedies, and Prospects" Brookings Papers on Economic Activity 1 (1998): 1-74. Samuelson, Paul A. and William D. Nordhaus. Economics, 18th Ed. New York: McGraw-Hill, 2005. Shapiro, Alan C. Multinational financial management, 7th Ed. New York: Prentice Hall, 2003. Shostak, Frank. "Does the widening US trade deficit pose a threat to the economy" Ludwig von Mises Institute Posted February 2, 2006. 31 March 2007. 2/2/2006 . Solomon, Robert. The International Monetary System, 1945-1976. An Insider's View. New York: Harper & Row, 1977. Stiglitz, Joseph E. Capital market liberalization, economic growth, and instability. World Development 4 (2000): 1075-1086. Willett, Thomas, Aida Budiman, Arthur Denzau, Gab-Je Jo, Cesar Ramos, and John Thomas. "The Falsification of Four Popular Hypotheses about the Asian Crisis." The World Economy 27.1 (2004): 25-44. World Trade Organization. World Trade Report 2006: Exploring the links between subsidies, trade, and the WTO. Geneva: WTO, 2006. Table 1: The U.S. Dollar against other Currencies Per $1.00 2006 2005 2004 2003 GBP 0.541 0.550 0.546 0.612 JPY 116.18 110.22 108.19 115.93 EUR 0.796 0.804 0.805 0.886 CNY 7.972 8.198 8.276 8.277 Legend: GBP (U.K. Sterling) JPY (Japan Yen) EUR (Euro) CNY (Chinese Yuan) [Source: CIA] Figure 1: U.S. Dollar against Euro and Yen [Source: Artus 7] Read More