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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.

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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:
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