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The Exchange Rate Mechanism and the Bank of England

June 8, 2017 Leave a comment

I was teaching managed exchange rates with my AS Level class and couldn’t get away from the events in Britain on the 16th September 1992 – known as Black Wednesday. On this day the British government were forced to pull the pound from the European Exchange Rate Mechanism (ERM).

Background

The Exchange Rate Mechanism (ERM) was the central part of the European Monetary System (EMS) and its purpose was to provide a zone of monetary stability – the ERM was like an imaginary rope (see below), preventing the value of currencies from soaring too high or falling too low in realtion to one another.

It consisted of a currency band with a ‘Ceiling’ and a ‘Floor’ through which currencies cannot (or should not) pass and a central line to which they should aspire. The idea is to achieve the mutual benefits of stabel currencies by mutual assistance in difficult times. Participating countries were permitted a variation of +/- 2.25% although the Italian Lira and the Spanish Peseta had a 6% band because of their volatility. When this margin is reached the two central banks concerned must intervene to keep within the permitted variation. The UK persistently refused to join the ERM, but under political pressure from other members agreed to join “when the time is right”. The Chancellor decided that this time had come in the middle of October 1990. The UK pound was given a 6% variation

Black Wednesday

Although it stood apart from European currencies, the British pound had shadowed the German mark (DM) in the period leading up to the 1990s. Unfortunately, Britain at the time had low interest rates and high inflation and they entered the ERM with the express desire to keep its currency above 2.7 DM to the pound. This was fundamentally unsound because Britain’s inflation rate was many times that of Germany’s.

Compounding the underlying problems inherent in the pound’s inclusion into the ERM was the economic strain of reunification that Germany found itself under, which put pressure on the mark as the core currency for the ERM. Speculators began to eye the ERM and wondered how long fixed exchange rates could fight natural market forces. Britain upped its interest rates to 15% (5% in one day) to attract people to the pound, but speculators, George Soros among them, began heavy shorting* of the currency. Spotting the writing on the wall, by leveraging the value of his fund, George Soros was able to take a $10 billion short position on the pound, which earned him US$1 billion. This trade is considered one of the greatest trades of all time.

* In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to that third party. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than it received on selling them. Wikipedia.

Brexit and trade – UK can learn from New Zealand’s experience

March 17, 2017 Leave a comment

With the departure of the UK from the EU there have been many questions asked about the future of UK trade. No longer having the free access to EU markets both with imports and exports does mean increasing costs for consumer and producer.

New Zealand’s Experience

A similar situation arose in 1973 when the UK joined the then called European Economic Community (EEC). As part of the Commonwealth New Zealand had relied on the UK market for many years but after 1973 50% of New Zealand exports had to find a new destination. However with the impending loss of export revenue New Zealand had to make significant changes to its trade policy. In 1973 the EEC took 25% of New Zealand exports and today takes only 3%. Add to this the oil crisis years of 1973 (400% increase) and 1979 (200% increase) and protectionist policies in other countries and the New Zealand economy was really up against it.

What did New Zealand do?

1. It negotiated a transitional deal in 1971 with agreed quotas for New Zealand butter, cheese and lamb over a five-year period, which helped to ease the shift away from Britain.

2. New Zealand was very active in signing trade deals of which Closer Economic Relations with Australia was the most important in 1983. The other significant free trade deal was with China in 2008. Below is a list of New Zealand’s current free trade deals and a graph showing the changing pattern of New Zealand trade:

NZ Free trade Deals

NZ exports goods 1960-2015.png

With brexit around the corner it will be imperative that the UK starts to develop trade links with non-EU countries of which New Zealand might be one. The UK is the second largest foreign investor in New Zealand and its fifth largest bilateral trading partner.

Brexit Result – what does it mean for New Zealand, the RBNZ, Gold and Sterling?

June 28, 2016 Leave a comment

The impact of Brexit on the New Zealand economy should be limited when you consider the following statistics:

  • 3.5% of total exports from NZ go to the UK – mainly sheep and wine.
  • 2.7% of total imports from the UK to NZ – mainly transport goods
  • 6.7% of all short-term visitor arrivals come from the UK

When the UK joined the EEC (as it was then know as) in 1973 there was a major shift away from trade with the Commonwealth. However New Zealand has been able to move away from the traditional dependency of the Commonwealth to become increasingly integrated to the Asia Pacific region.

Reserve Bank of New Zealand

The RBNZ is a good position even with a record low OCR of 2.25% which paradoxically is among the highest in the developed world. By not being aggressive with OCR cuts the RBNZ has the ammunition to stimulate aggregate demand further which is in contrast to the European Central Bank and the Bank of Japan who are in negative territory. With the turmoil in Europe over Brexit the US Fed will most likely hold off on a rate hike to ease the pressure on markets – it may even cut the US Fed rate.

Gold and Sterling – US$ rate

The graph below shows the reaction to the Brexit – GBP drops significantly against the US$ and gold, as a safe investment, appreciates in value. The uncertainty that surrounds Brexit saw more investors buy gold, which rose to about $1,315 an ounce on June 24th, up by 4.7% on the previous day. This was the largest increase since the global financial crisis in 2008. The rise was in stark contrast to the plunging pound, which tumbled to its lowest level in 30 years.

 

Brexit - Gold USD

Below is video from the FT looking at Five Consequences of the UK’s exit form the EU.

Categories: Euro, Trade Tags: ,

Brexit – consequences of leaving or staying

June 21, 2016 Leave a comment

On Thursday the UK vote whether to stay or leave the European Union. Below are some consequences and also a good video clip from the FT.

Brexit

Categories: Euro, Trade Tags:

FT Pub Quiz – What has the EU ever done for us?

February 23, 2016 Leave a comment

Remember the line in Monty Python movie ‘Life of Brian’, ‘What have the Romans ever done for us?’ This can be applied to the question of a British exit from the EU – ‘What has the EU ever done for us?’ Below is an informative video clip from the FT with a bit of humour. The questions in the Pub Quiz are:

  1. Which country I am describing in the year it joined the EU? Is the poorest European nation – incomes slipping behind its European competitors by £185 per year. Regular power cuts.
  2. In 2015 who was richer? The average person in German, France and Italy or England, Scotland and Wales?
  3. What caused Britain’s improved performance?
  4. How has Britain’s membership of the EU improved economic performance?
  5. Has the EU made Britain richer?

Basically the answers suggest that EU membership has been very beneficial to the British economy.

 

Categories: Euro, Trade Tags: ,

When not to put your money in the bank.

January 4, 2016 2 comments

Negative interest ratesIt seems that in Europe negative interest rates are common place. Below are the current rates of some central banks:

European Central Bank -0.3%
Swiss National Bank -0.75%;
Danish Central bank -0.75%
Swedish Central Bank -1.1%

Why are they in negative territory?
For all these countries it is the the exchange rate against the Euro that is important. Negative interest rates weaken a country’s currency and make imports more expensive and exports cheaper. Furthermore central banks could be trying to prevent a slide into deflation, or a spiral of falling prices that could derail the recovery.

In theory, interest rates below zero should reduce borrowing costs for companies and households, driving demand for loans. In practice, there’s a risk that the policy might do more harm than good. If banks make more customers pay to hold their money, cash may go under the mattress instead. Janet Yellen, the U.S. Federal Reserve chair, said at her confirmation hearing in November 2013 that even a deposit rate that’s positive but close to zero could disrupt the money markets that help fund financial institutions. Two years later, she said that a change in economic circumstances could put negative rates “on the table” in the U.S., and Bank of England Governor Mark Carney said he could now cut the benchmark rate below the current 0.5 percent if necessary. Deutsche Bank economists note that negative rates haven’t sparked the bank runs or cash hoarding some had feared, in part because banks haven’t passed them on to their customers. But there’s still a worry that when banks absorb the cost themselves, it squeezes the profit margin between their lending and deposit rates, and might make them even less willing to lend. Ever-lower rates also fuel concern that countries are engaged in a currency war of competitive devaluations. Source: Bloomberg

Categories: Euro, Interest Rates Tags:

Clarke & Dawe on Grexit

August 19, 2015 Leave a comment

Another satirical clip from Clarke and Dawe of ABC in Australia, this time on the crisis in Greece and understanding Grexit. Interesting use of the word ‘Grexitentialism’.

Categories: Eco Comedy, Euro Tags:

Greece – the problems started with the euro-entry exam in 2000

July 4, 2015 Leave a comment

When Greece went through euro-zone entry exam in 2000 it is said that it cheated on its deficit figures. Greece was able to enter the currency bloc after claiming its deficit was less than 1% of GDP, well within the bloc’s 3% threshold. EU reports have since revealed Greece’s budget hasn’t been within the 3% limit a single year since its accession. Below is a video from RealNews which explains the background to the present crisis. Worth a look

Categories: Euro Tags:

What would happen if there was a Grexit?

July 3, 2015 Leave a comment

The Greeks vote on Sunday whether to accept a June 25 offer from the International Monetary Fund, European Union and the European Central Bank (collectively known as “the Troika”) to provide Greece with desperately needed bailout money. In exchange, the Troika demanded that Greece implement a list of tax increases, spending cuts, and economic reforms. If there is a no vote then there could be the following scenario.

Negatives
* Overnight the Greek authorities would have to circulate a new currency (most likely the Drachma)
* The Drachma would depreciate against the Euro – according to some analysts this would increase Greek debt from the current level of 175% to 230% of GDP.
* Interest rates would increase causing businesses to go bankrupt – some have indicated that this would be around 50% of businesses
* The risk of a run on the banks would mean that the monetary authorities would have to introduce controls on money flows – especially abroad.
* Social unrest would no doubt escalate in the short-term and many Greeks will leave the country (if they can afford it).
* The Greek government would find it difficult to raise funds from overseas as investors become more prudent and see Greek bonds as an even bigger risk than before.
* A devaluation will would do nothing to change Greece’s structural problems.
* The euro will lose credibility in the long run and its weaker members will be exposed to bank runs which will ultimately extinguish any chance of a recovery.

Positives
* A weaker currency would make Greek exports a lot cheaper and may resurrect the textile industry that collapsed a few years ago.
* However the biggest benefit would be the tourism industry where holidays would become very cheap relative to similar destinations in Europe.
* The Greek government could keep printing money to finance the promises made Alexis Tsipras’ government – maybe an inflationary threat.
* Interest rates would no longer be determined by the ECB and a more expansionary monetary policy could be implemented by Greek authorities to tackle the downturn.

We’ve been here before as Jeff Sachs mentioned in his piece from Project Syndicate.

Almost a century ago, at World War I’s end, John Maynard Keynes offered a warning that holds great relevance today. Then, as now, creditor countries (mainly the US) were demanding that deeply indebted countries make good on their debts. Keynes knew that a tragedy was in the making.

“Will the discontented peoples of Europe be willing for a generation to come so to order their lives that an appreciable part of their daily produce may be available to meet a foreign payment?” he asked in The Economic Consequences of the Peace. “In short, I do not believe that any of these tributes will continue to be paid, at the best, for more than a few years.”

The Greek government is right to have drawn the line. It has a responsibility to its citizens. The real choice, after all, lies not with Greece, but with Europe.

Below is a chart from Bloomberg Business explaining the outcomes.
Greek referendum

Greek Crisis – A game of chicken

June 6, 2015 Leave a comment

Chicken gameThe negotiations between Greece and the Eurozone financial chiefs represent a typical game of ‘Chicken’. Chicken readily translates into an abstract game. Strictly speaking game theory’s chicken dilemma occurs at the last possible moment of a game of highway chicken. Each driver has calculated his reaction time and his car’s turning radius, which is assumed to be the same in both cars. There comes a time when each driver must decide to either swerve or keep going straight towards the other car. This decision is irrevocable and must be made in ignorance of the other driver’s decision. There is no time for one driver’s last-minute decision to influence the other driver’s decision. In its simulations, life or death simplicity, chicken is one of the purest examples of John von Neumann’s concept of a game. The way players rank outcomes in highway chicken is obvious. The worst scenario is for both players not to swerve – they crash and both are killed. The best thing that can happen is for you to keep driving straight letting the other driver swerving. The cooperative outcome is not so bad as both drivers are still alive although no one can call the other chicken.

As in the game of Chicken, both Greece and the Eurozone have the option to make concessions (Swerve) or hold firm in negotiations (Drive Straight). As with most negotiations, the best outcome for a party is to stand their ground while the other party makes the concessions. However, as both parties want this outcome, this raises the possibility of both sides holding firm and no settlement being reached. In the Greek-Eurozone crisis, this would mean a Greek default and the associated consequences that would ensue for the rest of the Eurozone.

Fortunately there is a third outcome that can prevail in Chicken – both parties can swerve their car at the same time. If both sides are willing to make concessions, then the second best outcome in this game can be attained for everyone. This co-operative outcome could be reached if the Eurozone extended further concessions to Greece, while Greece made binding promises to implement meaningful reforms to get their economy back on track.

However this is unlikely as each player achieves their best outcome by doing the opposite of their opponent. For example, if Greece believes the Eurozone will make concessions, it will achieve the best outcome by standing firm; if it believes the Eurozone will stand firm in negotiations, it’s best option is to make concessions to avoid the dire consequences of a full-blown default.

Chicken - Greece Germany

From the beginning of June until the end of December Greece needs to find another EUR28bn in total. After that point repayments drop off – one reason why Greece’s creditors are keen to ensure new reforms are enacted ASAP.
The inference however is clear: Greece won’t make it that far without a new deal. Greece is waiting on further funding from the IMF and the ECB (EUR 7.2bn) in order to meet some of these payments, but with both sides digging in, it isn’t a given that Greece will receive the funds. See graph below.

Greece repayments

Sources: NAB Australian Markets Weekly, Christoph Schumacher Massey University, Open Economy – Open minded Economics, Prisoner’s Dilemma – William Poundstone

Greece’s problem is insolvency not liquidity shortfall.

March 4, 2015 Leave a comment

This is an interesting video clip from the RT Network featuring Max Keiser. Everyone knows Greece is insolvent but no-one has ever stated it officially. Some have suggested that the issue is a liquidity shortfall and lending it more money will help Greece meet its current debt service obligations and fund structural reforms that will lead to renewed growth and increased income, enabling to meet its obligations in the future. However Yanis Varoufakis, current Finance Minister of Greece, disagrese with this interpretation. He believes that Greece will never recover. The bailout programme locks it into a debt deflationary spiral which simultaneously reduces its income and increases its debt burden. Continuing to accept more loans in order to meet debt service obligations only makes matters worse.

Categories: Euro Tags: ,

Euro Zone’s Divergent Economies and Monetary Policy

June 1, 2014 Leave a comment

I got this image from The Economist and used it for a recent A2 Test on Macro-Economic conflicts. Recently the OECD and the IMF have urged the European Central Bank (ECB) to cut the bank’s main lending rate from the already low 0.25% to zero. How might this effect countries in the Euro-area? It will tend to impact euro zone countries differently because of where they are in the business cycle. If you look at the unemployment and inflation figures from the graph you see the following:

Unemployment
Austria 4.9%, Germany 5.1%, well below the EU average of 11.8%.
Spain 25.3% and Greece 26.7% very high unemployment.

Some countries have had unemployment dropped significantly during the period –
Latvia approx. 22% to 11.6
Estonia approx.. 18% to 7.8%

Inflation
Highest rate Malta &Austria 1.4%, Finland 1.3%
Lowest – Greece -1.5%, Cyprus -0.9%

Euro divergent economies

The loss of monetary sovereignty has its problems

Reducing the interest to zero is an expansionary monetary policy which is a tool to increase aggregate demand, economic growth and employment. Monetary Policy, which is determined by the ECB, will have different effects in different countries. The ECB responds to aggregate levels of inflation and unemployment, not individual country levels – Unemployment is 11.8% and Inflation is 0.5%. Therefore it is a one size fits all policy. However some member states maybe experiencing rising levels of inflation and lower levels of unemployment whilst others might be the opposite – falling levels of inflation and higher levels of unemployment.

Assume an EU member experiences an asymmetric shock. It will have a different inflation and unemployment rate than the rest of the EU. With the ECB setting a common interest rate for the whole area, countries have lost an important part of their monetary policy. This is a major problem if a countries economy is at a different stage in the business cycle. For instance in 2014, Austria and Germany are growing with falling unemployment and a further lowering of interest rates may not be the best option for them. This is in comparison to other countries who need lower interest rates and a more stimulatory environment. With low interest rates and falling unemployment, Austria and Germany could experience inflation levels above the 2% target of the ECB and also a tight labour market which could put pressure on prices. Furthermore a lower interest rate affects those who want to save money in those countries.

At the other end of the spectrum Slovakia, Portugal, Cyprus, Spain and Greece are experiencing deflation and very high levels of unemployment. They therefore require more stimulus through lower interest rates to try and boost growth and employment and get out of the dangerous deflationary cycle.

Other countries with low inflation and high levels of unemployment will benefit from the cut in interest rates – Ireland has had unemployment fall from approx. 15% to 11.8% and an inflation rate of 0.3%. Therefore monetary stimulus is warranted. However the interest rate whether expansionary, neutral, or contractionary is unique to where each country is in the business cycle. The loss of monetary sovereignty clearly poses problems for members states whose economy is out of line with the euro zone norm.

Some big questions for Europe’s trade position.

April 18, 2014 Leave a comment

EU US TradeWith Europe keen on a transatlantic deal with the US, there have also been calls for a separate EU-China trade pact. Although they have shown a lot of enthusiasm to the US deal, the pact with China has been met with scepticism.

Here are the facts:

* China has overtaken the US as the biggest single trader
* China will overtake the EU as the biggest single trader in 2020
* China will surpass the EU in global GDP by 2020
* By 2020 the biggest destination for German exports will be China
* By 2020 the second biggest destination for French exports will be China
* Italy and Germany will export more to developing markets their euro-zone partners.

Therefore if Euro countries start to trade more with countries outside Europe the commitment to a single currency may weaken. With countries less or more reliant on exports and imports the exchange rate will not satisfy all members. If it is going to work Euro members economy’s will have to become more affiliated and better equipped to withstand unbalanced shocks from external partners.

Categories: Euro, Trade Tags: ,

Deflation threat for Euro area

January 17, 2014 Leave a comment

Today inflation in the Euro area is at dangerously low levels – 0.8% in the year to December. This is well below the target of 2% set by the European Central Bank. It doesn’t help that unemployment in the area is 12.1% and this will need to fall if there is to be some sort of recovery which will put upward pressure on prices. The ECB cut its Main Refinance Rate to 0.25% on 13th November last year and could be running out of options. It might be looking at imposing negative interest rates on deposits held at the ECB by trading banks.

Euro Area Inflation

Why is deflation a concern?

1. Holding back on spending: Consumers may opt to postpone demand if they expect prices to fall further in the future

2. Debts increase:

• The real value of debt rises when the general price level is falling and a
higher real debt mountain can be a drag on confidence
• Mortgage payers on fixed mortgage interest rates will see the real cost of servicing their debt increase

3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices

4. Lower profit margins: This can lead to higher unemployment as firms seek to reduce their costs.

5. Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence – leading to further declines in AD. Higher savings can lead to the paradox of thrift

Source: Tutor2u

Categories: Deflation, Euro, Inflation Tags:

% Change – GDP per person – 1999 – 2014

January 13, 2014 Leave a comment

Useful graphic from The Economist that shows the % change in GDP from 1999 – 2014.
1999 was when the Euro currency was introduced and with Latvia joining the currency bloc at the start of this year that makes 18 members. Spain, Greece, Portugal and Italy have struggled since the GFC especially Italy – negative GDP. Germany’s GDP per person has increased by over 20% since 1999. Benefitting from export revenue in recent times with a weak euro.

GDP by country 1999-2014

Spain looking to follow Japanese-style deflation

November 28, 2013 Leave a comment

Spain deflationIn October Spanish authorities reported a 0.1% decrease in the general level of prices which has suggested a repeat of a Japanese style stagnation. With the ECB cutting rates to 0.25% earlier this month to avoid such an issue it could be too little too late. Also with rates as low as they are they are starting to run out of ammunition to stimulate the economy. With little support in the eurozone area for quantitative easing or fiscal stimulus one wonders how they avoid the slide in prices.

The US Fed has used three rounds of quantitative easing to avoid a deflationary environment and Fed Chairman Ben Bernanke alluded to this in 2002 when he said:

“Deflation is in almost all cases a side effect of a collapse of aggregate demand – a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending – namely, recession, rising unemployment, and financial stress,”

Speaking before the Global Financial Crisis Bernanke debated the idea of QE as a potential solution after the lowering of interest rates. But the biggest worry for low inflation countires in the eurozone is deflationary expectations as cosumers delay purchases which ultimate reduces demand.

Categories: Economic Cycle, Euro, Trade Tags:

Currency Wars – a race to the bottom.

November 20, 2013 1 comment

Many thanks to A2 student Emersen Tamura-Paki for this paper on Currency Wars by Fred Bergsten which was delivered in May this year. Although it is a long document it is very readable and contains some interesting points.

* Virtually every major country is looking to keep its currency weak in order to strengthen its eocnomy and save/create jobs.

* Over 20 countries have been intervening in foreign exchange markets to suppress their currency value which has led to the build-up of reserves totaling over US$10 trillion.

* It has been led by China but includes a numer of Asian as well as several oil exporters and European countries. They account for two-thirds of global current account surpluses.
Global surpluses of currency manipulators have increased by $700-900 billion per year – see Figure 1.

Balances of currency manipulators

* The largest loser is the USA – current account deficits have been $200bn – $500bn per year as a result. Estimate that 1 – 5 million jobs have been lost under the present conditions and likely to continue.

* Japan this year talked down its exchange rate by about 30% against the US$.

* France has called for a weaker euro – which seems the only feasible excape from many more years of stagnation. This favours, in particular, the German economy with its export growth.

However some countries have been justified in their intervention. Some countries currencies have become overvalued and produced external deficits due to widespread manipulation. Brazil and New Zealand are countries which have been justified in their intervention. Our neighbours Australia have also expressed concerns as the appreciation of the AUS$ has been the result of the significant demand for minerals from China. This does leave other exporters struggling to maintain competitiveness especially if their goods/services are elastic in nature.

Currency GridThe systemic problem arrises when there is continued intervention and undervaluation of currencies. Fred Bergsten illustrates the application of these principles in grid where the orange coloured cell constitutes the objectionable behaviour.

According to Bergsten the practice is widespread and the flaw in the entire international financial architecture is its the failure to effectively sanction surplus countries, especially to counter and deter competitive currency policies.

Stronger Renminbi the solution to PIIGS economies?

September 4, 2013 1 comment

Franz Nauschnigg wrote a piece in Project Syndicate about an emerging imbalance in the goods and services deficits that Portugal, Italy, Ireland, Greece and Spain (PIIGS) have with China. Up to 2004 the biggest deficits of the PIIGS economies was with the rest of the eurozone. But in subsequent years the figures were the following:

Combined deficits of PIIGS 2004 – 2011 (bn euro)
PIIGS deficit table

PIIGS deficits

From the figures you can see that over the last 4 years the deficit with China has remained significant while it has narrowed with the eurozone especially with Germany. There are two reasons for this:

1. The euro has appreciated against the renminbi.
2000 – € = ¥7.4
2007 – € = ¥10.4

With this appreciation the eurozone countries exports became less competitive. The early 2000’s saw a lot of investment into the PIIGS economies which increased inflation and prices.

2. With the southern economies dependent on textiles, footwear etc the stronger euro made Chinese imports a lot cheaper than the domestic alternative. The IMF acknowldeged the fact that Chinese exports were responsible for the deficits in the PIIGS but Northern Europe wasn’t as badly affected as their export focus is more machine based which China is not able to compete with.

With monetary and fiscal expansion becoming ineffective external adjustments under three conditons might be the answer:

1. Stronger external demand
2. A less onerous financing environment
3. A weaker euro

Much of the above could be achieved by a weaker euro against the renminbi. This would provide the boost to export revenue and reduce fiscal and external deficits.

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