Search This Blog

Saturday, July 12, 2008

Ramblings on currencies

Given the current less than stellar state of the U.S. economy I felt it was time to revisit the thesis behind investing abroad. From a macro perspective when investing abroad there are principally two components which drive returns: asset appreciation (stock, bond, index, etc.) and currency appreciation. I shall first address the latter.

The USD no longer offers the investor an appealing risk/reward trade off, with U.S and consumer debt ballooning the USD will in all likelihood continue its decent. Over the past few years, we have seen a couple of important shifts in currency regimes. The de-pegging of the Chinese Yuan from the Dollar in 2005 was the most important single event. But smaller countries have also moved away from Dollar pegs. Malaysia moved away from its Dollar peg at the same time as China, and we saw Kuwait abandon its Dollar peg in 2007. These developments have raised the question of whether other Dollar pegs are also likely to break. In particular, many investors have been focused on the durability of Dollar pegs in Hong Kong and in the Middle East.

This is particularly interesting due to the recent run of inflation that these countries are experiencing. The reason these countries are experiencing inflation is due to the increased capital inflow from increased exports to the U.S. and the rest of the world, this inflow is then compounded by the effects of a declining dollar, creating a run of inflation. Although an appreciating currency might help ease inflation it also runs the risk of contracting the ever feared "dutch disease" (Dutch disease is an economic concept that tries to explain the apparent relationship between the exploitation of natural resources and a decline in the manufacturing sector combined with moral fallout. The theory is that an increase in revenues from natural resources will deindustrialise a nation’s economy by raising the exchange rate, which makes the manufacturing sector less competitive and public services entangled with business interests).

Determining the optimal currency regime for a given country is a complex matter. But, ultimately, a large part of the choice is about weighing up the costs and the benefits. On the one hand, a fixed exchange rate regime brings benefits in terms of increased stability and lower transaction costs. On the other hand, it also entails a cost, in terms of relinquishing control over domestic interest rates. This is because monetary policy cannot be used to manage the business cycle and/or deal with external shocks when the exchange rate is fixed.

Goldman Sachs recently outlined four parameters to properly analyze the cost/benefit analysis:

Parameter #1 is the Strength of Trade Links: If trade is heavily skewed towards one country, or skewed towards a group of countries using the same currency, then there will be the advantage of having currency stability versus this reference currency. Having a fixed exchange rate versus a currency that accounts for a large share of trade will secure a relatively stable effective exchange rate (trade-weighted exchange rate).

Parameter #2 is the Size Effect: Trade will matter relatively more for small economies, which are typically also more open. Transaction costs related to exchange rate fluctuations will tend to be more important in smaller economies. Size also matters in relation to the efficiency of the currency market. Small countries will have a harder time building efficient currency and capital markets. All told, the cost of exchange rate volatility is likely to be bigger for small countries.

Parameter #3 is the Synchronization of Cycles: If the business cycle is closely correlated (synchronized) to the reference country’s cycle, then there will be less benefit from using the exchange rate to adjust to cyclical shocks. That is, the cost of relinquishing monetary independence—by fixing the currency to a reference currency—is smaller when the domestic cycle is closely synchronized with the cycle in the reference country. On the contrary, a lack of monetary independence may be problematic if an economy faces very different shocks (including terms-of-trade shocks) to the reference country.

Parameter #4 is Policy Credibility: If domestic policy credibility is low, then there is a more compelling argument for ‘importing’ policy credibility from the reference country and anchoring inflation expectations in that way. On the other hand, if the domestic policy framework is credible and domestic institutions enjoy a good reputation relative to the reference country, then the benefit of ‘outsourcing’ monetary policy will be smaller.

I shall now address each one of these four parameters with country specific examples.

Parameter #1:
A key argument in favor of a fixed exchange rate regime is that a fixed exchange rate reduces transaction costs and exchange rate risk, which can potentially discourage trade and investment. But a peg to a specific anchor currency (typically the Dollar or the Euro) will not eliminate exchange rate volatility entirely. Pegged currencies may experience significant exchange rate volatility on a trade-weighted (also called effective) basis, if the anchor currency moves significantly versus other major currencies. This has been an issue in the Middle East in recent years, where currencies have been pegged to the Dollar. As a result of the USD weakness observed since 2002, Middle-Eastern currencies have depreciated notably versus most currencies, especially versus the Euro. This is important because the Middle East has strong trade links with the Euro-zone. The bottom line is that Middle-Eastern currencies have seen significant volatility on a trade-weighted basis despite their fixed exchange rate regimes, and currency depreciation versus key trading partners has placed upward pressure on import prices.

Parameter #2:
A second key parameter in the choice of exchange rate regime is linked to country size. Small countries will typically see bigger benefits from a fixed exchange rate regime than larger countries, for a number of reasons. First, small countries are typically very open, which means that a large proportion of the economy is exposed to exchange rate fluctuations and related adjustment costs. Second, small countries are typically closely integrated with large anchor countries/regions, which means that the business cycle tends to be closely linked to the cycle in the anchor country/region. Third, small countries will have a harder time building efficient local currency and capital markets. This means that transaction costs (both in foreign exchange markets and capital markets more generally), related to a flexible/independent exchange rate regime, are higher. This issue is particularly important for countries that are vulnerable to swings in investor sentiment, and related currency fluctuations. Hence, the smaller the country is, the bigger the benefit of a fixed exchange rate regime, all else equal. On the other hand, the benefit of a fixed exchange rate regime will be more moderate for larger countries. More specifically, the cost of exchange rate variability is likely to be lower for larger countries. The countries that benefit most from this are places like Estonia.

Parameter #3:
The cost of relinquishing monetary independence—by fixing the currency to a reference currency—will be smaller when the domestic cycle is closely synchronized with the cycle in the reference country. More specifically, the intuition is that if business cycle shocks are similar across partner countries, then the need for policy independence is reduced and the net benefits from adopting a currency peg might be higher. This parameter was the logic behind establishing the Euro. In my opinion sometime in the future we will likely see a similar agreement is reached with the U.S., Canada, and Mexico. It is one of the logical solutions to the declining USD that no politician has yet to broach (plus it would be a way to solidify the NAFTA agreement thus appeasing the fears of our neighbors down south).

Parameter #4:
Historically, exchange rate pegs have often been used to ‘import’ monetary policy credibility. That is, countries without a good track-record in maintaining low inflation have often resorted to a fixed exchange rate regime in an attempt to anchor inflation expectations to the level in a reference country.
The basic idea behind this decision is that in the absence of domestic institutions with credibility as ‘inflation fighters’ it is preferable to link the exchange rate to a reference country, which already has institutions with a high degree of credibility in terms of inflation control. For this reason, a move to a fixed exchange rate regime has often been a part of economic stabilization programs in emerging markets. For example, when Poland experienced high inflation rates in the early 1990s, the economic stabilization program involved an exchange rate peg for a period. From this perspective, the credibility of domestic institutions is an important parameter in the cost-benefit analysis of the exchange rate regime choice. Basically, the lower the credibility of domestic institutions in terms of managing inflation, the higher the cost of a floating exchange rate, and the lower the benefit of monetary independence. This is the cornerstone behind my thesis that all of Africa should unite behind the South African Rand. It is especially logical for South Africa’s neighbor Zimbabwe who is currently experiencing hyperinflation to yield to this argument.

What are the ultimate conclusions that we have learned? Investor focus on currency regime issues has increased significantly following the changes in the Chinese currency regime in 2005. In addition, following accelerated USD weakness over the past year, investors have increasingly started to question the sustainability of the remaining USD pegs. For Eastern European EU members the arguments in favor of EUR pegs or adoption of the Euro are very strong across the board. The Eastern European economies have become increasingly integrated in the overall European economy; and most countries in the region, perhaps with the exception of Poland, are too small to build fully efficient domestic capital markets. We conclude that the Eastern European EU members are all suitable for some type of EUR peg within the foreseeable future. It will always be a challenge to pick the right fixing rate, but the end-goal seems very clear. For the Gulf Cooperation Council countries in our sample (Saudi Arabia, Qatar, and United Arab Emirates) the conclusions are also clear. From an economic perspective, the current USD pegs do not look optimal. In the short term, a peg to a basket of both USD and EUR would help reduce the impact of volatility in major currencies. But it would not address the region’s need for greater monetary independence. Such independence may not be technically feasible at this juncture, given that domestic capital markets are not sufficiently developed. But over time, increased flexibility seems highly desirable. This is especially the case since energy shocks are likely to continue to impact the region in the opposite direction to most other countries. Greater monetary independence would provide a better framework for dealing with cyclical dynamics which are likely to run asynchronously with both the US and the Eurozone. Domestic institutions and capital markets should be developed to facilitate gradually more monetary independence and exchange rate flexibility. A GCC monetary union would help to engineer the economies of scale needed to boost efficiency in local capital markets. From this perspective, a single GCC currency is a sensible longer-term goal, albeit perhaps a tricky one to achieve by 2010. For Hong Kong o the USD peg is no longer the optimal arrangement from an economic perspective. This is especially the case now that China, which accounts for a large share of Hong Kong’s trade, is itself allowing more currency flexibility. That said, one big concern for monetary authorities in Hong Kong is that the exit from the current peg itself could generate too much volatility in domestic financial markets broadly. Given the importance of the financial sector in the Hong Kong economy, this potential ‘exit cost’ remains an important consideration.

No comments: