Friday, January 2, 2009

Understanding Currency Markets

The rules of currency exchange are some of the most confusing aspects of the international economy. As with all economic phenomena, once you understand the basics, it all becomes a matter of common sense.

To our island: imagine your small island of 15 people is prospering, with all of you engaged in useful production and commerce with each other. But then, someone comes from a nearby island shows up, and he has a nice supply of a special kind of wood that you would like to acquire. So, you offer him a nice sum of your money to buy the wood. However, he laughs at you, and points out that your money is no good on his island, he could not spend it. Hmmm, what could you do?

In order for two countries to trade, they can either barter their goods directly, or take payment in the form of money. If money is exchanged, we face a problem, as you see from the above example. You are accustomed to paying dollars for all purchases, but if the seller is a foreigner, why would he take your dollars? He cannot use them in his home country. Nor could you use his currency, in your own land. So, the big question is, in which currency shall the exchange take place? If he takes dollars, he can only spend them in your country, and if you take his money, you can only spend it in his country. Which shall it be? This meeting of the values of two different national currencies must be overcome for any international trade to take place.

Let's say the traveling salesman realizes that he will be coming back to your island again some time, so even if he can't use your money on his current trip, he could use it in the future. In that case, he would accept payment in your coin. This is the dilemma of an exporter: he brings goods to a foreign country, but must do business in that foreign currency. His aim then becomes to spend that money on some foreign goods that he can bring back to his home country, to sell again to get back into his own currency.

But what if he makes the sale of his own goods, but has to go home without a store of foreign goods? If he goes home with a pocket full of foreign money, what good would it do him? In effect, he has just made himself poorer, having lost his original store of goods in a foreign land, bringing home only worthless foreign money. His only hope at that time is that someone else in his homeland is making a trip to that foreign country and needs a supply of that foreign money. Such person might be a tourist, or a government agent, who is not going to take goods to exchange, but only needs the money to get around in that foreign land. Thus, he would be willing to buy your supply of the foreign money. Soon, a market would develop in the foreign coin, to match the people going to and coming from that foreign land, needing to either buy or sell a stock of that foreign money.

Sounds easy enough, doesn't it? Complications are quick to arise, especially due to the amount of money in circulation. For example, say you make a sale in the foreign land, and acquire its money (imagining it is Japan, and the currency, yen). You have, say, 1000 yen notes, and you hold onto them until the following year, when you are able to go back. However, you discover, to your dismay, that 1000 yen is no longer worth that much, because in the intervening year, the Japanese bank has been flooding Japan with more yen. Having ten times more yen in circulation, everything in Japan, you find, now costs 10 times as much as the previous year. So, your holding of yen just fell to a tenth of their value from the year previous.

On your arrival home, you spread the news of the falling value of the yen, which causes everyone who has yen to sell them at a much lower price. The yen was devalued by inflation, and no one wants to hold on to them, because they are constantly losing value. In fact, because of the falling value of yen, exporters like yourself start to refuse taking yen as payment, instead demanding that they pay you in dollars. All the yen that was previously used in circulation and held in foreign countries, now comes flowing back to Japan, as no one wants to hold the falling yen. The international supply of yen is quickly liquidated, converted to other currencies, or directly into goods which can be taken back to the home country and sold for solid money. The extra yen returning to Japan further fuels the domestic yen inflation because more yen are then in circulation. It would also make it harder for the Japanese to purchase foreign goods, as foreigners demand more and more yen to cover their costs or refused to accept yen at all. A rapidly inflating yen could, in fact, destroy international trade with Japan, as no foreigner would be foolish enough to accept a yen that was destined to lose all its value. Japanese purchasers would have to acquire dollars to pay for their imports, but they could afford fewer and fewer dollars because the falling yen, or they would be forced to barter directly for the imported goods with domestically-made goods of their own. Such is the case of inflation.

What of recession? Let's go back to when you were sitting on your stack of 1000 yen, gained from your previous year's trades. You find out that the Japanese economy has suffered some sort of calamity and their overall production has fallen. For you, that means that there are fewer things in Japan to purchase with your yen. The basic law of supply and demand comes into play, as the same amount of money in circulation will now be chasing fewer Japanese goods. An oversupply of money means the value of money falls. Everything costs more, because there is too much money, not enough production. So, the rule is, a downturn in their domestic production means their currency will be worth less.

How do interest rates fit into the equation? Well, let's say the Bank of Japan is offering a 10% return on the bonds it issues. Wow, that is a way better return than you could get anywhere else, so you decide to invest your 1000 yen. In fact, you realize you could make a killing there, so you try to get as many yen as possible to invest in those bonds. However, the price of yen is now going up, you find, because everybody wants more yen to invest, so a shortage of yen develops. Yen is sucked out of trading activity, as people find it more profitable to invest in the bonds rather than in the trade of goods. The value of the yen shoots up, as less yen are in circulation. The Japanese people are able to afford more imports, because fewer yen buy more goods and foreigners are interested in trading more goods to acquire more yen. Interest rates on money shoot up throughout Japan as private banks have to offer more in exchange for deposits.

What if the Bank of Japan slashes interest rates down to almost nothing? That means Japanese banks will practically be giving yen away, increasing the overall market supply of yen. However, there will be very little reason to invest in Japanese banks, who are offering such low rates of return, so savings in yen are discouraged. However, borrowings in yen are encouraged, further increasing the supply. A carry trade could develop, as you borrow money in yen, to be paid back at low rates, if you could then invest that money elsewhere at a higher rate of return. Just like printing money, borrowing low then investing high in guaranteed government bonds. These yen borrowings would flood the world with yen, driving down the price of yen through oversupply. When the carry trade ended, the yen would be driven back up, as yen supply decreased and investors moved to liquidate their yen holdings.

Inflation: increased supply, decreased value
Recession: oversupply, decrease value
High interest rates: decrease supply, increase value
Low interest rates: increase supply, decrease value

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