Strong US$ bad news for global recovery

The recent tightening of monetary policy by US Fed Chair Jerome Powell to combat inflation has seen higher borrowing costs and financial-market volatility. The US$ has risen 7% against a series of major currencies since January this year – a two year high. It has always been a safe haven currency and with a rising Fed Rate and market rates even more capital could flow into the US increasing the demand for US dollars and therefore appreciating its value. See mindmap below for the theory behind a stronger currency.

Adapted from: CIE A Level Economics Revision by Susan Grant

A high value of a currency makes exports more expensive but does lead to cheaper imports especially of the inelastic nature. But to foreign economies it does drive up import prices further fueling inflation. For developing countries this is a concern as they are being forced to either allow their currencies to weaken or raise interest rates to try and stem the fall in value. Also developing economies are concerned with the risk of a ‘currency mismatch’ which happens when governments have borrowed in US dollars and lent it out in their local currency. However it is not just developing countries that have had currency issues. This last week saw the euro hit a new five-year low with the US Fed’s aggressive tightening of monetary policy. The real problem for some economies is that they are further down the business cycle than the US so in a weaker position.

“While domestic ‘overheating’ is mostly a US phenomenon, weaker exchange rates add to imported price pressures, keeping inflation significantly above central banks’ 2% targets. Monetary tightening might alleviate this problem, but at the cost of further domestic economic pain.” Dario Perkins – chief European economist at TS Lombard in London

Source: Bloomberg – Dollar’s Strength Pushes World Economy Deeper Into Slowdown. 15th May 2022

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Yen depreciation is good for Japan and its trading partners.

A weaker currency will make exports cheaper and imports more expensive – see mindmap below. As for Japan’s falling yen it is positive for its economy as a whole as it tries to get closer to its 2% inflation target.

The weak yen is also a chance to stimulate exports, even if Japan is no longer the currency-sensitive export machine it once was. Although it has meant more expensive oil and food imports, wages have hardly risen in response to higher prices. It used to be the case that the world was concerned with cheap Japanese exports but this means that it is exporting deflation which is what most developed countries want. The FT article on this topic is very good

Source: CIE A Level Revision – Susan Grant

For more on exchange rates view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

Putin demanding gas be paid in roubles. Can the church help?

This is a useful piece of economic theory which I will be discussing with my classes. After the Russian invasion of Ukraine the Russian currency the Rouble collapsed:

  • Before the invasions 1 euro = 85 Roubles
  • After invasion 1 euro = 110 Roubles
  • After central bank intervention 1 euro = 94 Roubles

This means that it cost post invasion 110 roubles to buy 1 euro, compared to 85 Roubles pre-invasion. The Russian central bank did intervene in the foreign exchange market by using its foreign exchange reserves to buy roubles – demand for roubles goes up. The plan is to sell US$ and euro denomination investments to buy roubles. However a ban on the central bank using swift payments to access reserves overseas has meant that intervention was not an option.

At such low levels the Russian exports are going to bring in less money to ultimately subsidise the war effort. A stronger Rouble will bring in more cash and enhance the image on the country – the value of a country’s currency is a good indicator of how the world views that country.

How will it work?

Putin’s order makes Gazprombank the intermediary in the gas trade. A foreign buyer of gas is required to transfer foreign currency to a special account (so-called K) at Gazprombank. They would then buy roubles on behalf go the gas buyer to transfer roubles to the another special (K) account at Gazprombank – see flow chart.

Why does it matter?

Europe is heavily reliant on Russia for its energy needs, with around 40% of its gas coming from the country. If Moscow decides to turn off the taps it could trigger supply shortages, factory closures and crippling energy costs across the region.

Call in the church to stop the slide in the Rouble

However, a last resort could be a repeat of 2014 (see previous post ‘Russian economy – Priests to halt slide of Rouble?’) when priests blessed the servers at the Central Bank with holy water to reduce the then collapse of the Rouble – see below.

For more on exchange rates view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

High commodity prices but also high input costs for NZ agricultural sector

New Zealand commodity prices have been on the rise over the last year. Global dairy prices have increase by 14% this year with beef and lamb prices setting record highs. Some economists have said that it is the perfect storm of supply and demand factors.

Supply
As it does every year, the weather has influenced the price of dairy prices especially. A wet start to the dairy season accompanied by a very hot summer has reduced the supply of milk and therefore increasing its price. Also Covid has impacted the supply chains especially that of sea freight (see below) which in turn have impacted feed, fertilisers which has reduced supply. Although the NZ inflation rate has hit a 30 year high at 5.9% this is nothing compared to the costs down on the farm. This year farming cost have increased by:

  • Fertilisers 200% (breakdown in the graph below)
  • Chemicals 50%
  • Sea Freight 500%
  • Diesel 40%
  • Electricity 21%
  • Winter grazing 36.9
  • Cultivation, Harvesting & Animal Feed Cost 18.9%

Fertiliser price inflation

Source: Westpac Economic Overview – February 2022

Demand
The Chinese recovery has mainly been responsible for the rebound in demand as well as other countries coming out of Covid restrictions. Another factor helping the primary sector is the weaker NZ$. It is now trading around the US$0.66 from over US$0.70 in late 2021. Remember that a weaker dollar makes it cheaper for consumers overseas to buy our currency and therefore more price competitive goods

Carbon Prices influence farmer’s investments
In the past year the recent doubling of carbon prices to around $85/unit has encouraged some farmers to focus their attention on tree plantations to the detriment of sheep and beef supply. What is noticeable about investment is that with the high returns on commodity prices farmers are repaying debt rather than re-investing back into their business – although still very high agricultural debt fell from $64bn in July 2019 to $62bn today.

Source: Westpac Economic Overview – February 2022

For more on supply and demand view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

Russia puts up interest rates to 20% as rouble tumbles 40%

In an effort to stop the rapid decline of the rouble to protect Russians’ savings the central bank have increased interest rates from 9.5% to 20%. Furthermore, citizens have been withdrawing money from ATM machines with the loss of confidence in the economy. In order to try and stem the 40% decline in its currency the Russian central bank has been buying roubles with its foreign currency reserves. In the foreign exchange market this, in theory, should have the following effect:

  • increases the demand for the rouble – Demand curve to the right – price up of rouble
  • increases the supply of foreign currency – Supply curve to the right – price down foreign currency.

Another worry for Russia is the downgrade of Russian debt to junk status by Standard & Poor’s the credit rating agency. Below is a mind map that shows the factors that are impacted by a falling exchange rate.

Adapted from: CIE A Level Economics Revision by Susan Grant

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OCR – LSAP – FLP = New Zealand’s Monetary Policy Toolkit

Below is a useful flow diagram from the ANZ bank which adds Large Scale Asset Purchases (LSAP) and Funding for Lending Programme (FLP) to the Official Cash Rate (OCR – Base Rate)

LSAP – this is the buying of up $100 billion of government bonds – quantitative easing
FLP – this gives banks cheap lending based on the Official Cash Rate – could be about $28 billion based on take up
OCR – wholesale interest rate currently at 0.75%. Commercial banks borrow at 0.5% above OCR and can save at the Reserve Bank of New Zealand (RBNZ) at 1% below OCR.

With FLP and more LSAP this will mean lower lending rates and deposit rates. This should provide more stimulus in the economy and allay fears of future funding constraints making banks more confident about lending. Add to this a third stimulus – an OCR of 0.75%. Although there is currently a tightening policy the rate is probably still stimulatory. The flow chart shows the impact that these three stimulus policies have on a variety of variables including – exchange rates – inflation -unemployment – consumer spending – investment – GDP. Very useful for a class discussion on the monetary policy mechanism.

For more on Monetary Policy view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

Africa’s resource curse lingers on.

Africa may have enormous natural reserves of oil, but so far most Africans haven’t felt the benefit. In Nigeria, for instance, what’s seen as a failure to spread the country’s oil wealth to the country’s poorest people has led to violent unrest. However, this economic paradox known as the resource curse has been paramount in Africa’s inability to benefit from oil. This refers to the fact that once countries start to export oil their exchange rate – sometimes know as a petrocurrency – appreciates making other exports uncompetitive and imports cheaper. At the same time there is a gravitation towards the petroleum industry which drains other sectors of the economy, including agriculture and traditional industries, as well as increasing its reliance on imports. It is estimated that for every extra dollar in foreign currency earned from exporting resources reduces non-resource exports by $0.74 – Torfinn Harding of the NHH Norwegian School of Economics and Anthony Venables of Oxford University.

Economists also refer to this as the Dutch Disease which makes reference to Holland and the discovery of vast quantities of natural gas during the 1960s in that country’s portion of the North Sea. The subsequent years saw the Dutch manufacturing sector decline as the gas industry developed. The major problem with the reliance on oil is that if the natural resource begins to run out or if there is a downturn in prices, once competitive manufacturing industries find it extremely difficult to return to an environment of profitability.

According to the UN a country is dependent on commodities if they are more than 60% of its physical exports – in Africa that makes up 83% of countries. One of the major concerns for resource rich countries is the wild fluctuations in commodity prices which can lead to over investment – Sierra Leone created two new iron-ore mines in 2012 only for them to close in 2015 as prices collapsed. However the amount of jobs created in the mineral extraction industry is limited – across Sierra-Leone of 8m people, about 8,000 work in commercial mines. A major problem in these countries is that when there is money made from resources it tends to go on government salaries rather than investing in education. infrastructure and healthcare etc.

Norway – has a different approach.
In Norway hydrocarbons account for half of its exports and 19% of GDP and with further oil fields coming on tap Norway could earn an estimated $100bn over the next 50 years. Nevertheless there is a need to wean the economy off oil and avoid not only the resource curse that has plagued some countries – Venezuela is a good example as approximately 90% of government spending was dependent on oil revenue – but also the impact on climate change. Norwegians have been smart in that the revenue made from oil has been put into a sovereign wealth fund which is now worth $1.1trn – equates to $200,000 for every citizen. This ensures that they have the means to prepare for life after oil.

Source: The Economist – ‘When you are in a hole…’ January 8th 2022

Turkey cuts interest rates to control inflation?

Most economists are in agreement that when there is an increase in inflation the central bank increases the base interest rates in order to reduce spending and encouraging saving. This takes money out of the circular flow and should lead to less borrowing and therefore less pressure on prices.

The Turkish lira dropped by 15% last week with three cuts in interest rates since September. This comes as inflation has climbed to 20%. So why would you drop interest rates when you have rapidly increasing inflation? President Erdogan sacked the governor of the head of central bank Naci Agbal who had been hiking interest rates to dampen down inflation – he was the third governor to lose his job in the last two years. Erdogan believes that raising interest rates would raise inflation rather than reduce it and he proceeded to cut rates further which saw an even steeper decline in the lira. An argument for this policy could be that the cheaper exports can drive economic growth.

The collapse of the lira make exports competitive and imports more expensive and in September Turkey posted a current account surplus thanks in large to a recovery in tourist numbers. Turkey relies heavily on imports of raw materials and energy and with the exchange rate falling these have become a lot more expensive. Although Turkish exports should be cheaper, the heavy import component of finished exports makes those goods more expensive so this outweighs the benefits of having a cheaper lira – e.g. in assembling kitchen appliances the price of imports of the component parts make the overall price of the appliance more expensive. This just fuels more inflation. Supermarkets are limiting customers to one item as they know people will stockpile produce with the ever increasing inflation rate.

So with inflation around 20% and real interest rates -5% further cuts will lead to the lira falling further and inflation will get even worse. This will then get the local population to turn to other currencies – US$ Euro – in order to protect the value of their money. Below is a very video clip from Deutsche Welle (German World Service) outlining the problems that Turkey face.

What determines the value of the New Zealand dollar?

In a free market the rate of exchange is determined by the market forces of supply and demand. Where these conditions apply the exchange rate is said to free, fluctuating or floating. Therefore the following have a great impact on the rate of exchange in a free market:

An increase in the demand for the $NZ will result from more people wanting get or buy $NZ.

* Increase in the value of exports
* Increase in tourists travelling to NZ
* Increase in foreign investment in NZ (buying assets / companies / depositing savings)
* Increase in NZer’s taking out loans overseas

An increase in the supply for the $NZ will result from more people wanting get or buy other currencies (as they have to supply $NZ to the market to get the other currencies)

* Increase in the value of imports
* Increase in NZer’s travelling to other countries
* Increase in NZ investment overseas
* Increase in NZer’s repaying loans made overseas

For these purposes NZ residents must obtain foreign currencies. Banks, acting on their behalf, will buy these currencies in the foreign exchange market and pay for them with dollars. Thus, an increase in NZ imports will increase the supply of dollars in the foreign exchange market. With floating exchange rates, changes in market demand and market supply of a currency cause a change in value.

An example using the US$ and Euro
French citizens want to buy goods from the USA and supply euros (Graph A) to their banks and demand dollars (Graph B) to import goods and services from the United States. The value of the euro falls from $1.00 to $0.98. Simultaneously, the value of the dollar appreciates from 1.00 to 1.02 euros.

If U.S. citizens want to buy goods from France they must supply dollars to their banks (Graph C) to demand euros to import goods and services from France (Graph D). The value of the dollar falls from 1.02 euros to 1.00 euro.

Exchange rates

Could there be Demand-Pull inflation in New Zealand?

The recent GDP figures the March Quarter 2021 and the Annual figure were significantly different from those predicted by the Reserve Bank. The key component of GDP is Private Consumer Expenditure which increased way above the 0.5% of the RBNZ – see table.

This no doubt encouraged more investment which saw an increase by 15.5%. This suggests that the economy is creeping towards the threat of demand-pull inflation – i.e. the economy is running hot and demand is outstripping supply – see graph.

Source: BNZ Markets Outlook.

While New Zealand’s GDP growth might pale against global comparisons this year, it’s already strong enough to be telling of rapidly diminishing economic slack and rising core inflation. Indeed, that excess demand is now arguably the order of the day in NZ, partly as the ability to supply goods and services is compromised in many ways, compared to pre-COVID times.

Furthermore the weakening NZ$ – has made exports cheaper. This is also part of the overall aggregate demand in the economy. So with C+I+G+(X-M) all increasing there is pressure on the supply-side. The NZ trade-weighted exchange is at 73.2 this morning whilst the RBNZ forecasted 75.3. However predicting anything in an economy today is very difficult considering what we have experienced with COVID 19.

TWI – An index that measures the value of $NZ in relationship to a group (or “basket”) of other currencies. The currencies included are from NZ’s major export markets i.e. Australia, USA, Japan, Euro area, UK, China. – $A, $US, ¥, €,  £, Yuan.

With this, there are cracks appearing amongst central banks around the world, as to how long they can reasonably continue with their extreme monetary policy settings. Interest rate markets have been asking the question and at least some central bankers have now given a bit of ground –notably the US Federal Reserve last week. Yes, there is still the debate about how much of the ramp-up in headline CPI inflation, globally,is transitory. However, there is also the fundamental question of whether underlying inflation is firm enough, and labour markets recovered enough, to recommend policy rates to start to normalise, whatever that means. It’s a different question, with more important implications.

Source: BNZ Markets Outlook

The Pound, the Exchange Rate Mechanism (ERM) and George Soros pockets $1bn

Teaching  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). The video below explains the drama that unfolded very well.

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 relation 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.

Impact of an appreciating currency

Currently looking at exchange rates with my AS class. Below is a mindmap showing the causes and effects of a rise in the value of a currency. Also looks at how a rise in the currency may reduce inflationary pressure. Good for revision purposes when dealing with exchange rates and trade. Also gives a structure for essay questions / long answers in CIE and NCEA respectively.

Adapted from CIE A Level Revision by Susan Grant.

US dollar – journey to reserve currency status and where to from here?

From CNBC – a short history of how the US dollar became the reserve currency and could that status be under threat. The main points from the video are:

  • how investors rush to buy US$ during crisis times
  • the history behind the gold standard
  • 88% of foreign exchange transactions are done in US$
  • Could other currencies threaten the US$ as the global reserve currency?
  • Central banks have added the Chinese Yuan as part of its reserves.
  • European autonomy is being mooted so that they are independent of payment channels in the US$
  • Holdings of of US$ reserves in the global banking system – see image below

Dollar vs Renminbi for reserve currency status

In doing most introductory courses in economics you will have come across the four functions of money which are:

  • Medium of exchange
  • Unit of Account
  • Store of Value
  • Means of deferred payment

Since the Bretton Woods Agreement in 1944 the US dollar was nominated as the world’s reserve currency and ranks highly compared to other currencies in the above functions. As a medium of exchange the US dollar is very prevalent:

  • 60% of the world’s currency reserves are in US dollars
  • 50% of cross-border interbank claims
  • After the GFC, purchases of the US dollar increased significantly – store of value.
  • Around 90% of forex trading involves the US dollar
  • Approximately 40% of the world’s debt is issued in dollars
  • In 2018 banks of Germany, France, and the UK held more liabilities in US dollars than in their own domestic currencies.

Is the Yuan challenging the US dollar for reserve currency status?
In 2015 Chinese authorities were keen on the currency going global and the following points would indicate this.

  • Deposits in renminbi = 1trn renminbi = US$144bn
  • Yuan transactions have grown in Taiwan, Singapore, Hong Kong and London.
  • Investment by Chinese firms into Belt and Road project = US$3.75bn which was in the renminbi
  • China settles 15% of its foreign trade in renminbi
  • France settles 20% of its trade with China in renminbi
  • 2018 – Shanghai sock market launched yuan-denominated oil futures.
  • The IMF suggest that the ‘yuan bloc’ accounts for 30% of Global GDP – the US$ = 40%

However as reported by the FT – see video below – the goal of reserve currency status was made more complex by the decision to maintain a loose peg to the US dollar. This means that the value of the renminbi would follow the non-specific value of the US dollar. So when the US dollar appreciated so did the renminbi and with a higher exchange rate Chinese exports became more expensive. This led the People’s Bank of China to intervene and devalue the currency by approximately 2% in 2015 – a weaker currency makes exports cheaper.

How do the Peoples Bank of China set the Yuan’s value?
Basically at 9.15am the Peoples Bank of China (Central Bank) and the SAFE (State Administration for Foreign Exchange) issues a circular to all the trading banks stating that this is the exchange of the renminbi to the US$ for today.

However this panicked investors who off-loaded their renminbi assets and sent its value downward. The reaction of China was to impose strict capital controls to stabilise the currency. But since the end of 2015 there has been a Chinese foreign exchange policy with the market forces of supply and demand being more prevalent. Nevertheless, there is still a long way to go before the renminbi is a freely floating exchange rate and the benefits that come with it.

Is China still influencing the value of the yuan?

I have blogged quite a bit on this topic and refer back to a very good video clip from PBS Newshour on how the Chinese authorities influenced the value of the yuan back in 2010.

Basically at 9.15am the Peoples Bank of China (Central Bank) and the SAFE (State Administration for Foreign Exchange) issues a circular to all the trading banks stating that this is the exchange of the Renminbi to the US$ for today. When companies sell goods overseas the US$ etc that they acquire are then exchanged for Renminbi with the Central Bank – therefore the Central Bank accumulates significant amounts of US$.

Today it could be said that China has done well economically relative to other countries largely due to its large trade surplus. However one would think that with a large trade surplus the yuan would increase in value as there is a greater demand for the currency in order to buy China’s exports. This raises the question as to whether China has been manipulated its currency in order to maintain its competitive edge in the export market.

  • When a country’s currency is getting too strong the governments/central banks sells its own currency and buys foreign currency – usually US$.
  • When a country’s currency is getting too weak the governments/central banks sells its foreign currency – usually US$- and buys its own currency.

For two decades until mid-2014 China’s prodigious accumulation of foreign-exchange reserves was the clear by-product of actions to restrain the yuan, as the central bank bought up cash flowing into the country. A sharp drop in reserves in 2015-16 was evidence of its intervention on the other side, propping up the yuan when investors rushed out. Since then, China’s reserves have been uncannily steady. This year they have risen by just 1%. Taken at face value, the central bank seems to have refrained from intervening. That is certainly what it wants to convey, regularly describing supply and demand for the yuan as “basically balanced”.
Source: The Economist – “Caveat victor” – October 31st 2020

With the surge in China’s trade surplus the yuan has remained fairly stable and with this you would expect that there would be an increase in foreign exchange reserves with Chinese authorities buying foreign exchange with yuan.

A couple reasons why this may not be the case:

  • Commercial banks foreign assets have increased by US$125bn since April. The commercial banks are state owned so it is plausible that the government has used them as a substitute. Adding these foreign reserves to the offical figures suggests invention to keep the yuan at an artificially lower rate. There is the possibility that the central bank has special trading accounts at the state banks. Also exporters have wanted to keep their US$ as they are worried that the disharmony with the US could damage the yuan.
  • The central bank made it cheaper to short the yuan in forward trades – shorting a currency means that the trader believes that the currency will go down compared to another currency.
  • Chinese officials want the yuan to be volatile but within a narrow range in order to convince other countries that they are not intervening whilst persuading people in the market that they will intervene if necessary.

Caught between a rock and a hard place

The Peoples Bank of China (PBOC) are trying to protect domestic producers by keeping a weak yuan so to make Chinese products attractive to overseas buyers. At the same time they are trying to prevent domestic capital from flowing too quickly out of China to stronger currencies. However a longer term scenario is that China would like the yuan to be more prevalent as a currency in the global market. The yuan currently accounts for approximately 2% of global foreign exchange reserves, although by 2030 it is estimated that it will account for 5% to 10% of global foreign exchange reserve assets.

Source: The Economist – “Caveat victor” – October 31st 2020

GDP comparison between countries and Big Mac Index worksheet

Here is something that I use with my Year 12 & 13 Economics students when looking at the comparison between nominal GDP and PPP – NCEA Level 3 Growth external and CIE A2 Unit 4. I have found the worksheet that follows useful for students to workout the price of a Big Mac in US dollars in each country, the Big Mac exchange rate and compare it with the actual exchange. The table below gives the Nominal GDP in various countries expressed in US dollars. If you convert the value of GDP in local currency into one common currency (US$) it gives you a false idea of many countries’ economic status. The cost of different goods and services can vary widely – countries like China and India have much lower costs for most consumer items compared to more developed countries like the US and Germany. Therefore to make a more accurate comparison economists tend to use the purchasing power parity (PPP). This is a simple calculation where a base currency is chosen (usually US$) and a basket of goods and services is chosen. They are then compared to the value of the same items in another country using traditional exchange rates. However it is not as simple as that as countries use a wide variety of goods and services that are not the same or not as popular in certain countries.

Countries by Nominal GDP US$ – October 2019 (ranking is on Nominal GDP)

IMF’s World Economic Outlook Database, October 2019

*New Zealand’s GDP in NZ$ is approximately – NZ$ 314 billion (March 2020)

The Economist came up with the Big Mac index in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries. Here is something that I put together using the the Big Mac index from The Economist website. Students have to complete the table below.

The Big Mac Index – July 2020

  1. Complete the table above. In which country was their actual exchange rate on July 2020 closest to their Big Mac exchange rate?
  2. Which country’s currency is suggested by your calculations above as being
    a) the most undervalued against the dollar, and the most overvalued against the dollar?
  3. What factors could have an influence on exchange rate values on a given date as shown in the table above.
  4. In which country was their actual exchange rate on July 2020 closest to their Big Mac exchange rate?

You can check your answers and other countries Big Mac Index by going to The Economist’s website – click below:

https://www.economist.com/news/2020/07/15/the-big-mac-index

US dollar under pressure as the reserve currency.

In doing most introductory courses in economics you will have come across the four functions of money which are:

  • Medium of exchange
  • Unit of Account
  • Store of Value
  • Means of deferred payment

Since the Bretton Woods Agreement in 1944 the US dollar was nominated as the world’s reserve currency and ranks highly compared to other currencies in the above functions. As a medium of exchange the US dollar is very prevalent:

  • 60% of the world’s currency reserves are in US dollars
  • 50% of cross-border interbank claims
  • After the GFC, purchases of the US dollar increased significantly – store of value.
  • Around 90% of forex trading involves the US dollar
  • Approximately 40% of the world’s debt is issued in dollars
  • n 2018 banks of Germany, France, and the UK held more liabilities in US dollars than in their own domestic currencies.

So why therefore is there pressure on the US dollar as the reserve currency?

The COVID-19 pandemic has closed borders and will inevitably lead to more regionalised trade, migration and money flows which suggests a greater use of local currencies. However China has made its intention clear that the Yuan should become a more universal currency. Some interesting facts:

  • Deposits in yuan = 1trn yuan = US$144bn
  • Yuan transactions have grown in Taiwan, Singapore, Hong Kong and London.
  • Investment by Chinese firms into Belt and Road project = US$3.75bn which was in yuan
  • China settles 15% of its foreign trade in yuan
  • France settles 20% of its trade with China in yuan
  • 2018 – Shanghai sock market launched yuan-denominated oil futures.
  • The IMF suggest that the ‘yuan bloc’ accounts for 30% of Global GDP – the US$ = 40%

However if the past is anything to go by the US economy has gone through some very turbulent times but the US dollar has remained firm. This suggests that how we perceive the US economy doesn’t seem to relate to the value of its currency.

Source: The Economist – China wants to make the yuan a central-bank favourite
7th May 2020

Why do developing countries like a strong currency?

In the majority of economics textbooks a depreciation of the exchange is beneficial to an economy especially those like developing countries which depend a lot on export revenue.

A fall in the value of the exchange rate will make exports cheaper and so acts as an implicit subsidy to firms that sell abroad. Exposure to world markets also helps companies in the developing world learn and improve.Finished imported products that are still purchased will be more expensive and some of these will count in the country’s consumer price index. Costs of production will be pushed up because the cost of imported raw materials will rise. Domestic firms may also feel less competitive pressure to keep costs and prices low.

A rise in the value of exchange rate will make exports more expensive in terms of foreign currencies, and imports cheaper in terms of the domestic currency. Such a change is likely to result in a fall in demand for domestic products. A higher exchange rate may also reduce inflationary pressure by shifting the aggregate supply curve to the right because of lower costs of imported raw materials. The price of imported finished products would also fall and there would be increased competitive pressure on domestic firms to restrict price rises in order to try to maintain their sales at home and abroad.

It has been traditional for developing countries to try and engineer a weaker currency to make their exports more competitive especially as this revenue is one way in which their economies can start to grow. China and other South East Asian economies adopted this strategy as they went through industrialising their economy. Empirical studies suggest that an undervalued currency boosts growth more in developing rather than developed economies.

Why then is it that some African countries still want to maintain a strong currency? Primary sector exports and overseas aid raises the demand for local currencies making them appreciate. Governments are concerned about a weaker currency as

  • Some are dependent on capital imports to finance infrastructure projects
  • It forces them to spend more income to pay back foreign debts.
  • Pushes up the cost of imported goods, including food, medicine and fuel – mainly impacts the city population who are more likely to complain to politicians.
  • Some companies in developing countries import a lot of their machinery and raw materials – additional cost to their production.
  • A weaker currency does make exports cheaper but this can be nullified by more expensive imports.

However all of this has been overshadowed by COVID-19. The pandemic is increasingly a concern for developing countries which rely heavily on imports to meet their needs of medical supplies essential to combat the virus.