If stockmarkets sometimes behave irrationally, they are a model of sanity compared with the foreign exchange or forex markets in which currencies are bought and sold. Not only are the swings in the value of one currency against another both frequent and dramatic; they also have vital implications for the economic prospects of the countries concerned and often for the prosperity of the whole free-world economy – remember the currency collapses among the onetime ‘tiger economies’ of Asia in 1997? It is no surprise that currency stories migrate so frequently from the detailed and technical foreign exchange reports to become lead items in the financial pages.
Where weighty issues of politics or nationalism are involved, currency stories will even make it to the general news headlines rather than confining themselves to the financial pages. The debate over Britain’s joining – or not joining – the new European euro currency is a case in point. This has generated more heat (and, incidentally, more nonsense) than any other economic story in recent years. But before venturing into this territory later in the chapter, there are a few basic principles to examine.
It is precisely because the influences that move currency values are often so irrational that currency stories can be difficult to understand. Perhaps the easiest approach is to look on the major trading countries as if they were companies quoted on the stockmarket and on their currencies as if they were company shares.
As with shares, the value of each currency is determined by the balance of buyers and sellers in the market, at least since floating exchange rates were adopted in the early 1970s. But just as share prices may be supported by friends of the company, the value of currencies can be affected by official intervention: buying and selling by central banks to try to strengthen or weaken a currency.
Figure 16.1 Dollars to the pound sterling Britain has seen some pretty wild swings in the value of its currency against the US dollar, though things have been calmer in recent years. Source: Datastream.
Where a currency is ostensibly floating (allowed to find its own level) but in practice being kept close to a particular value or parity in relation to other currencies by central bank intervention, commentators talk of a dirty or managed float.
But there is a limit to how far a currency value can be manipulated against the trend of market forces. If the central bank is using its foreign exchange reserves to support its country’s currency when most other participants in the market are selling because they conclude from economic fundamentals that its value should fall in relation to other currencies, the central bank will in due course exhaust its available reserves, be forced to abandon the support operation and the value will then drop in any case. The market forces predominate. Successful intervention often requires concerted action by the central banks of a number of countries (see below). But even this will ultimately fail if the economic fundamentals are out of line.
What are these market forces? Again, there is a parallel between a company and a country. If a company is trading successfully and increasing its earnings, all else being equal its share price will rise. Successful countries which run a current account balance of payments surplus (sell more goods and services to other countries than they buy from abroad) and which keep inflation at a low level will also usually see their own currency strong or rising in value over time.
Even if it is not trading spectacularly well, a company can try to make its shares more attractive to investors by increasing the dividends it pays. A country can also try to increase the attraction of its currency to international investors by increasing its domestic interest rates. This increases the returns investors can earn by depositing money in the country concerned or by buying bonds in that country. Suppose Britain is increasing its interest rates to attract overseas investors. To invest in Britain they will need to convert whatever currency they hold into pounds to deposit in Britain or buy British bonds. So they will be buying pounds, and when there are more buyers than sellers the currency should rise.
So far so good. But investors in the stockmarket will not buy a share if they are certain its value is going to drop, almost regardless of the income it offers. The income is of little use if the benefit is going to be wiped out by capital losses on the shares. The same applies to a currency. If international investors think the pound is going to fall heavily in value, they will be more inclined to sell it than buy it and the interest rates Britain is offering will only have limited effect. This process was very clearly demonstrated in September 1992 when successive rises in interest rates could not maintain the value of the pound sufficiently for it to remain within the Exchange Rate Mechanism of the European Monetary System (see below). Interest rate changes can and do influence the value of a currency and much of what the press writes about currencies is concerned with the way countries are adjusting – or being pressured to adjust – domestic interest rates to adjust the value of their currency. But interest rates are only one factor.
Increasingly, the vital factor is that indefinable element: market sentiment. If investors become enthusiastic about a share, they will buy it. Its price will rise and those who bought will show profits. This in turn may attract other investors to buy, the price rises still further and the process becomes self-fuelling. The same thing happens with currencies. Either longer-term investors or short-term speculators (or probably both) become enthusiastic about the dollar and buy it. Its value rises, which encourages still more investors to put their money in the dollar, so it rises still further. And the process can be self-perpetuating – until something happens to change sentiment or encourage investors to take their profit. When this happens, international investors can sell just as frantically as they previously bought, and the value of the currency can fall as fast as it had earlier risen.
The result is that currency swings can overshoot. That is, they can go much too far in one direction or another, creating havoc for businesses which trade internationally: they can never be certain what price they will receive for their goods when translated into their own currency. Here the analogy between stockmarkets and currency markets breaks down. In the stockmarket individual share prices can be carried ridiculously high or ridiculously low by swings in market sentiment. But at the end of the day there are some reasonably objective yardsticks: what the company earns and is capable of earning; the dividends it pays and therefore the yield it offers. Ultimately these fundamentals tend to reassert themselves and bring investors back to earth.
In the currency markets the fundamentals frequently exert less influence in the short term, so that the currency moves much further than is needed merely to adjust to trading realities. In the very long run the fundamentals will reassert themselves, but before this happens such overshooting may cause serious damage to a country’s trading prospects.
There is another important difference to allow for before we can look more closely at the way currency questions are covered. In the British stockmarkets we measure securities prices in standard units: pounds and pence (though there’s been talk of moving to euros!). But a currency is measured in terms of other currencies and all are moving relative to each other. The pound may be strengthening against the dollar but weakening against the euro. These exchange cross rates – values of each of the major currencies in terms of each of the others – are listed daily in the currencies, money and capital markets pages of the Financial Times, as are the values of major currencies in terms of the pound and of the US dollar, in somewhat more detailed form. Note one complication: by convention the markets always talk of ‘so many dollars to the pound’ rather than ‘so much of a pound to the dollar’, even when talking of the value of the dollar rather than the pound. So the dollar’s value in sterling terms is expressed as, say, $1.6235 to £1 rather than £0.6160 to $1.
Example 16.1 Exchange rates for different currencies against the pound, for immediate and for future delivery. Source: Financial Times.
In reports of currency movements there are two main ways currency values are expressed: in terms of another specific currency or in terms of a trade-weighted index where they are measured against a basket of currencies. In the second case, taking the value of the pound as an example, an index is constructed of the currencies of the main countries with which Britain trades, each weighted according to its importance in trade with Britain. This is expressed not as a monetary value but as an index with a base of 100 in 1990. Thus, on a particular day the pound might rise against the dollar from $1.6200 to $1.6300 (you get more dollars for a pound, so the pound has strengthened) but fall from 103.3 to 102.9 on the trade-weighted index. Overall, the pound was a little weaker against all currencies, but the dollar was weaker still so sterling improved against the dollar.
This is often rather badly reported in the media. You may read or hear that sterling rose one cent against the dollar whereas the reality was simply that the dollar was falling against most currencies and fell one cent against the pound. Again, the Financial Times shows sterling’s value on the trade-weighted index (also known as the sterling index or the Bank of England effective exchange rate index) and similar indices for other major currencies. Dollar, yen, euro and Swiss franc values are frequently quoted.
We have seen that the value of a currency might be expected – all else being equal – to rise if the country concerned is earning more from abroad than it is spending abroad. Other countries are having to buy its currency to buy its goods and it is adding to its foreign exchange reserves, which are roughly equivalent to a country’s bank balance. A country may hold its reserves in the form of other currencies, special drawing rights (see glossary) or gold.
In theory, as the value of a country’s currency rises in relation to other currencies, its goods become more expensive for foreigners to buy. So gradually it sells less abroad, earns less foreign exchange, and – all other things being equal – the currency begins to weaken until its goods become cheaper again and the cycle recommences. A country earning a surplus may also take deliberate steps to prevent its currency from rising too high: reducing interest rates to make the currency less attractive to foreign investors and to stimulate domestic demand so that more goods are consumed at home, more are imported and fewer exported.
In practice the phenomenon of overshoot means that self-correcting mechanisms may be rendered ineffective or only work with considerable delay. The problem is that there is no such thing as the ‘right’ value for a currency against any other currency. It can be argued that if the exchange rate is $1.60 to £1, an item which costs £1 in London should cost $1.60 in New York: the purchasing power parity argument. But such considerations clearly did not apply in the 1980s when the value of £1 fluctuated between more than $2.40 and little more than $1.00, which obviously did not reflect movements in the relative prices of goods in New York and London. Instead, when the dollar stood at $2.40 to £1 American goods were very cheap for the British and at just over $1.00 to £1 they were exceedingly expensive. Currency volatility exaggerates trade imbalances which in turn increase volatility.
We have talked so far mainly about the flows of money between countries that result from their trading performance. These are the current account flows which reflect what a country earns from selling goods and services overseas and what it spends in buying goods and services from overseas.
But there are also capital account flows, which we have encountered briefly in the form of speculative funds moving in and out of a country as a bet on a rise or fall in the value of its currency. Not all capital flows are purely speculative, however: they can also represent long-term investment in a country from abroad. And they can have a long-term effect on the values of currencies. Take an example. In the first half of the 1980s, the US dollar was rising for much of the time despite an escalating balance of trade deficit which passed $100 billion in 1985. This was mainly because of large inflows of investment funds from abroad, particularly from Japan, attracted by relatively high US interest rates. But in 1985, balance of payments worries plus concerted efforts among central banks to curb the dollar’s strength proved all too effective and the currency began to fall even more rapidly than it had risen.
Why should countries worry if their currency becomes too strong? A strong currency can have beneficial effects such as reducing the cost of imported goods. Particularly in the case of a country like Britain, which imports much of the raw materials that it needs, the lower cost of imports helps to keep domestic inflation down. On the other side of the coin, a weak pound means higher import costs and, all else being equal, faster rising prices in Britain.
But if a currency becomes too strong, it can wreak havoc with the domestic economy. Manufacturers find that their products become too expensive to compete with those of other countries in export or home markets, so domestic manufacturers suffer severely. This happened in Britain in the early 1980s and UK manufacturers were again hitting problems as a result of the strong pound in the late 1990s.
Figure 16.2 Sterling effective exhange rate The value of the pound sterling, as measured against a ‘basket’ of currencies by the Bank of England Index. The sharp drop in 1992 shows what happened when sterling failed to hold its place in the European Exchange Rate Mechanism. But the problem in recent years has been one of strength rather than weakness. The very high level of sterling in the late 1990s posed severe problems for British exporters and manufacturers. Source: Office for National Statistics: Financial Statistics.
Where trade imbalances and currency excesses require concerted action, they may be addressed by a meeting of the finance ministers of the major trading nations. These countries – the United States, Japan, Germany, France and Great Britain – are referred to as the Group of Five or G5 and become the Group of Seven or G7 with the addition of Canada and Italy and G8 with Russia.
The start of 1999 saw the decisive step which locked 11 Continental European countries (but not Britain at that point) into a new single currency: the euro. But this was neither the first nor the last step in a process know as Economic and Monetary Union (or EMU) in Europe.
The precursor of full monetary union was a system called the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). The idea was to stabilize currencies between the European Union countries by limiting the extent to which each currency could fluctuate against the others.
Central to the system was the ECU, a notional European currency constructed from an amalgam of the currencies of all European Union members. Each country’s currency was represented in the ECU with a weighting that roughly reflected the country’s economic size. Thus, the German mark had the heaviest weighting within the ECU because the German economy was the largest, and movements in the value of the German mark would therefore be the greatest single influence on the value of the ECU.
Each currency started with an exchange rate against the ECU: its central rate. And the member countries were meant to manage their interest rates and economies in such a way that their currency diverged by no more than a small margin up or down from this central rate or the central rates of other currencies. A slightly larger margin of divergence was allowed for some more volatile currencies (such as the pound sterling when Britain joined the system in 1990 -see below).
Thus, if at any time the strongest currency in the system and the weakest one threatened to diverge more than was permitted against each other, the central banks of the two countries would need to take remedial action to bring them back into line.
If this happened, the central banks of the two countries would sell the strong currency and buy the weak one. In practice, a country whose currency was moving out of line might take action before this by buying or selling its own currency or raising or lowering short-term interest rates.
In other words, if speculators mounted an attack on a particular currency in an attempt to drive its value down, a concerted defence could be mounted. While this could help in the short run, it was not, however, a substitute for changes in economic or interest rate policy to correct the factors which had made the currency vulnerable in the first place.
As a last resort, if all the available measures failed to keep a currency within bounds, the EMS members might be forced to agree a formal revaluation which re-set the particular currency’s central rate within the ERM.
There is a big difference between the Exchange Rate Mechanism and the move to full monetary union in most of Europe which followed it at the beginning of 1999. Under EMU the different participating currencies are locked together at a fixed exchange rate for all time (or that is the intention). The notional ECU is replaced by a real new currency: the euro. After a transition period of just over three years, the euro will replace the existing currencies for all purposes, and these traditional currencies will therefore disappear.
One currency for all brings with it one short-term interest rate for all. The newly constituted and independent European Central Bank (ECB) has taken over responsibility from the individual central banks, and sets a single short-term interest rate for all EMU participants.
We will look at the strengths and weaknesses of the new system in a moment. But first, a few of the practical details.
To qualify for participation in the euro, the individual European Union countries had to be able to demonstrate that they were moving roughly in step with each other. This involved meeting certain convergence criteria on matters such as inflation, interest rates, exchange rates and government borrowing. The assessment was undertaken in the spring of 1998 and (after a certain amount of fudging of the figures) only Greece failed to qualify.
Not all countries had wanted to join at that point, however. Initially, 11 countries both qualified and chose to join what came to be known as the euro zone or (more colloquially) euroland. They were:
Austria
Belgium
Finland
France
Germany
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Of the remainder, Denmark, Sweden and the United Kingdom chose not to join in this first wave, and thus deferred their decision, while Greece was not yet eligible.
The next important step took place at the end of 1998 when the exchange rate of each of the 11 currencies was permanently fixed in terms of the euro and of each other participating currency. A euro was (and is) worth, for example, 1.95583 German marks and 6.55957 French francs. When the financial markets reopened after the Christmas and New Year break on 4 January 1999, the new currency was a fact of life and trading in the euro could begin.
It might have been a fact of life, but there were as yet no euro notes or coins. These were not due to be issued until the start of the year 2002. Then, in the first six months of 2002, the old notes and coins would be phased out and replaced by euro notes and coins (during this six months, either old or new currency could be used). The notes would be issued in denominations of 5, 10, 20, 50, 100, 200 and 500 euros. The coins would come in denominations of 1 euro and 2 euros, plus 1, 2, 5, 10, 20 and 50 euro cents (there are, needless to say, 100 euro cents to a euro).
What about the three-year interim period between the creation of the euro at the start of 1999 and the issue of notes and coins at the start of 2002? During these three years, transactions could take place either in the old currencies or in the euro. Many government functions switched over to the euro (new issues of government bonds were to be denominated in euros) and other investments could substitute a face value in euros for the old national currencies. Euro-zone companies could chose whether to invoice in euros or the old currencies. As far as private individuals were concerned, if they had euro bank accounts they were at liberty to write cheques or undertake payment-card transactions in euros, though the absence of notes and coins ruled out euro transactions in cash until the start of 2002. Shops in the euro zone were encouraged to show prices in both old and new currencies to familiarize customers with the euro by the time the notes and coins arrived. During these three years, bank account holders could choose to convert their existing accounts into euros or they could stick with the old currencies. But at the start of 2002, any accounts not already converted would automatically be redesignated in euros. Likewise, many other forms of contract (savings and insurance contracts, for example) would automatically convert into the equivalent euro values.
For countries outside the euro zone, whether members of the European Union or not, the euro is just another foreign currency. British residents may open euro bank accounts if they choose, just as they may hold dollar accounts. But for a Briton a euro account will be a foreign currency account as long as Britain remains outside the euro mechanism. What the money in it is worth in terms of sterling will fluctuate with changes in the sterling/euro exchange rate.
Example 16.2 Exchange rates against the euro, spot and forward. Source: Financial Times.
The coming of the euro has consequences for countries outside the euro zone, and particularly for businesses. Any company trading with a euro zone member must be ready to make and receive payment in euros. And the investment world in particular has had to adapt to the new currencies. Financial information and news agency group Reuters, for example, has had to translate all of its historical records of the 11 euro-zone currencies (and investment price information denominated in these currencies) into terms of the euro in order to provide meaningful price and exchange rate histories.
In Britain the public debate on Britain’s joining or staying outside the euro has been conducted at a number of levels, not all of them very useful. The main strands – including the more fatuous ones often played up by the popular press – might be summarized as follows:
• Are we prepared to wave goodbye to our historic pound?
• Will we allow the Queen’s head to be removed from our currency?
• Do we want our interest rates set by some faceless European bankers?
• Can we retain control over our own economic affairs if short-term interest rates are set elsewhere?
• Is the euro just a first step to full economic and political integration in Europe, removing individual countries’ rights to set their own tax rates and manage many other aspects of national life?
• Would Britain lose in competitiveness (and, in particular, would the City of London lose its financial pre-eminence) if Britain stayed outside the euro?
• Will the euro system work?
Arguably, the last of these questions is by far the most important – there is not much point in debating the rest until you have formed a view of the likely success of the euro experiment. Yet it has probably been the least discussed aspect of the whole affair, certainly in the popular media.
By linking their currencies, the euro-zone members look for a number of advantages. The cost of financial transactions between member states will be reduced. While the euro will fluctuate against the world’s other currencies, euro-zone members are spared disruptive fluctuations between member’s currencies. A new Europe-wide financial and investment market is being created which should assist in attracting funds. Europe and its industries will form a powerful economic bloc, on a par with, say, the United States. And monetary integration is a necessary step towards the full economic and political integration that parts of Europe undoubtedly want.
The corresponding dangers have received less coverage. The ‘one-interest-rate-for-all’ strategy has its problems. What happens if one euro-zone member – Italy, say – finds itself moving into recession at a time when most of the other members are booming? The European Central Bank may see a need to raise interest rates to damp down activity and prevent overheating and possible inflation in the European economies as a whole. But Italy would be pleading for a reduction in interest rates to get its own economy moving, and a rise could push it deeper into recession. Could an Italian government survive the resultant rise in unemployment and the popular unrest that would probably accompany it?
The theoretical argument is that the unemployed Italians could seek work in the booming euro-zone member countries. But unless and until labour mobility in Europe improves greatly, this may be pie in the sky. It is possible to envisage euro-zone members being forced to drop out of the euro system if faced with insurmountable economic and political pressures at home.
And there are risks in the other direction. Ireland, which was enjoying a heady boom at the end of 1998, had to reduce its short-term interest rates in brief stages from over 6 per cent to 3 per cent -the starting rate for the euro zone – by the time that the new currency was launched. Thus it was obliged to reduce rates at a time when domestic considerations might have argued for a rise to prevent the economy from overheating. Early evidence suggested that the rate reduction had indeed fuelled the boom – particularly in the property market – in 1999 and that trouble might follow.
So there is no guarantee of success for the euro experiment. However, not too much attention should be paid to the comparative weakness of the euro against the dollar and sterling in the first year of its existence: one euro was worth around 71p at its launch and had fallen to about 62p by the end of 1999. While Britain’s anti-euro brigade made much of this decline, it was probably what the euro-zone countries needed. A relatively weak currency increased their competitiveness and helped the climb out of recession. The real tests of the euro were yet to come.
Britain has had severe currency and inflation problems since the Second World War. Usually these have been the problems of sterling weakness and an inflation rate well above that of our main competitors. But, as we have seen, there were also periods in the early 1980s and late 1990s where sterling’s excessive strength was the problem.
In the early 1980s a combination of North Sea oil revenues, a high oil price and high domestic interest rates in Britain saw sterling climbing strongly and not only against a then-weak dollar. At one point the dollar exchange rate went above $2.40 to £1. The strong currency helped to curb Britain’s domestic inflation. But it proved a severe blow for the country’s manufacturers who found themselves unable to compete on price in home or export markets. Much manufacturing capacity was destroyed in consequence: some of it inefficient and deserving to go, some of it probably not.
Figure 16.3 Value of one euro in UK pence This chart traces the steady decline of the euro from its launch at the beginning of 1999 (the 1998 values are for a ‘synthetic’ euro – what it would have been worth had it already existed). Here the euro is shown in terms of sterling, but its fall against the dollar was quite as dramatic. In other words, the problem was the euro’s weakness rather than the strength of other currencies. But the euro weakness may have helped the main euro-zone countries in their climb out of recession. Source: Office for National Statistics: Financial Statistics.
But the strength was relatively short-lived and by the middle of the decade a strong dollar and weak sterling saw a pound buying little more than a single dollar. An improvement in government finances resulted in some strengthening of the pound again in 1987 and 1988, but then rising inflation and mounting balance of payments problems intervened.
Because Britain had such problems in controlling its inflation rate and maintaining its currency at a sensible level, there were obvious attractions in looking for help from outside. If the value of sterling could be linked into a strong currency system, this would both impose a discipline on domestic economic policy and provide for some concerted support when the pound came under attack. It would mean surrendering some autonomy. But up to a point this was a recognition of the facts of economic life. In an increasingly global economy, each country’s interest rates and currency value are affected by the actions of others, and the scope for totally independent action is increasingly limited. Unfortunately, when Britain first looked for help from outside by joining the European Exchange Rate Mechanism (ERM) on 8 October 1990 with the wider 6 per cent fluctuation limit, it probably joined at the wrong exchange rate and at the wrong point in its own economic cycle.
To hold its position within the ERM, Britain would have needed to get its inflation rate in line with that of other EC members, since high inflation normally leads to depreciation of the currency. The hope in Britain had been that membership of a system dominated by the stability of the German mark would ultimately bring the benefits of low inflation that Germany had enjoyed. It was also hoped that the protection afforded by the ERM mechanism would allow Britain gradually to reduce its domestic interest rates and emerge from recession without sparking a run on sterling. In the event, the UK succeeded in cutting both its inflation rate and interest rates to a level consistent with other members of the ERM.
Unfortunately, this was not enough to allow sterling’s continued membership. Germany’s own position was affected by the way it chose to integrate the former East Germany. One consequence was that Germany felt obliged to impose considerably higher interest rates than normal to control domestic inflation. Because of Germany’s dominant influence, this in turn imposed high interest rates on the whole ERM structure. The consequences were serious for Britain whose inflation rate had been brought under control but which then badly needed to pull itself out of the severe recession that the earlier government medicine of high interest rates had caused. The domestic situation in Britain therefore seemed to demand a further reduction in interest rates to stimulate economic activity but a cut in rates relative to the other European countries would cause sterling to weaken and might make it impossible for the pound to maintain its position in the ERM.
The events of September 1992 when sterling was obliged to drop out of the ERM have passed into financial folklore. Whatever the British government maintained, the speculators thought that the pound must fall: either through a formal devaluation within the ERM or by dropping out of the mechanism and finding its own level. And, as so often happens, government intervention to support the pound offered them a one-way bet. The authorities were there as buyer when the speculators wanted to sell. On 16 September the pound was at its lower limit within the ERM and at mid-morning the government announced that Minimum Lending Rate had been raised from 10 per cent to 12 per cent. But with everybody except the authorities betting on sterling’s fall, this failed to lift it from the floor. As a final throw it was announced in the afternoon that MLR would rise again to 15 per cent the following day. Again, it failed to work. Sterling’s suspension from the ERM was announced that evening and the MLR rise to 15 per cent was never implemented.
No longer supported, sterling fell 10 per cent more against the German mark from the level at which it had dropped out of the ERM, and the speculators collected their winnings – able to buy back more cheaply the pounds they had earlier sold short at the higher level. One so-called hedge fund (see glossary) had supposedly made $1billion on the operation. The Bank of England, according to the newspaper speculation of the time, had spent some £15 billion in its (ultimately unsuccessful) support of the currency, though only a fraction of this would have been money actually lost. Once attempts to maintain the pound’s ERM parity were abandoned, interest rates in Britain were rapidly reduced in a series of steps.
Sterling was not the only currency to suffer from ERM turmoil at the time, though the mechanism ultimately survived to be replaced by full monetary union at the start of 1999.
Ironically, Britain enjoyed considerably more success in controlling its inflation rate in the 1990s than it had done previously. After sterling had dropped out of the ERM and short-term interest rates had been reduced, Britain eventually began to pull out of recession. When New Labour won the election of May 1997, it inherited a healthy economy and relatively low interest rates. As seen, one of its first actions was to surrender the government’s responsibility for setting short-term interest rates to the Bank of England.
At the end of 1999 the British repo rate at 5.5 per cent was still well above the 3 per cent applied by the European Central Bank to all the euro-zone countries. The disparity illustrated one of the problems if Britain were to join the euro. Its economic cycle had been out of step with the economic cycles of the main euro-zone members. It had pulled out of recession and moved into a modest boom in the 1990s when the continental European countries, which moved later into recession, were still trying to climb out of it. The politicians, as usual, were not slow to interpret this to suit their own ends. The strength of Britain’s economy was proved by the fact that it had the lowest unemployment rate in Europe, and so on. The reality was a little more complex. It would have been surprising if Britain’s employment situation had not looked relatively rosy when it was near the peak of its own economic cycle and its European competitors were close to the low point of their own cycles.
Britain would clearly have problems if it were to seek to join the euro at a point when it reckoned it needed short-term interest rates of 5.5 per cent or more to keep its own economy in balance, but membership would imply rates of only 3 per cent. But there are structural problems as well as problems of timing. For example, Britain has an unusually high level of home ownership. Most home-buyers buy with the help of a mortgage loan, whose cost is linked to interest rates. A change in short-term interest rates can thus have a direct impact on a much larger proportion of the population than in many continental European countries.
Now that governments have only limited control over the value of currencies, it is up to businesses to protect themselves against the effect of wild swings as best they can. There are various ways they can hedge the currency risk.
There is a forward market in currencies as well as a spot market. In the spot market currencies are bought and sold for immediate delivery – in practice, delivery in two days’ time – whereas in the forward market they are bought and sold for delivery in the future. You will see that the Financial Times table of the value of the pound against major currencies lists a spot price and prices for delivery in one month and three months and one year.
The forward price relative to the spot price reflects the interest rate differential between the countries concerned. Suppose, say, you hold sterling and are due to pay for goods in Swiss francs in three months’ time. You are worried the value of the Swiss franc will rise, in which case you will have to pay more in sterling terms. So you might buy Swiss francs today for delivery in three months’ time, which means you are locking in to a known exchange rate.
Suppose also that you can deposit money in Britain to earn 6 per cent and in Switzerland to earn only 2 per cent. For three months you have the benefit of the higher sterling interest rate, whereas if you had bought the Swiss francs immediately you would have been depositing the money at the lower Swiss interest rate until it was needed. So the price you pay for the Swiss francs for delivery in three months will be higher than the spot price by an amount that reflects this interest rate advantage – in other words, at the three months’ price you will get fewer Swiss francs for your pounds than at the spot price. But if the currency you want to buy forward offers higher interest rates than in Britain, the forward price will be lower than the spot price (at a discount rather than a premium). Forward exchange rates are shown in the Financial Times, together with the annual interest rate differential they reflect.
In practice, hedging strategies in the foreign exchange markets may be a great deal more complex than simply buying or selling a currency forward, though this illustrates the principle. Currencies may be swapped, too (see Chapter 17) and banks offer a range of OTC currency hedging products. Currency futures may also be bought on certain financial futures exchanges and OTC currency options are traded in London (see below).
Foreign exchange is dealt in by the major banks and by specialist foreign exchange brokers, with the dealers operating from the screen-cluttered trading floors familiar from many film and television reports. Dealing is via these screens and telephones: there is no central marketplace.
London, conveniently placed to provide continuity between Tokyo and New York in the time zones, is the largest foreign exchange market. A Bank of England survey of 253 banks and securities houses and 10 brokers in 1998 estimated the average volume of the London market at $637 billion per day, with US dollar/sterling and dollar/deutschmark business accounting for 49 per cent of the total. As much as 65 per cent of that $637 billion represents forward business, mainly swaps, the remainder being spot (immediate delivery) transactions.
Was there really $637 billion of cross-border trade per day that required currency transactions in London? Of course not. More than four-fifths represented dealing between banks. Dealing with non-financial institutions was only 7 per cent of the total. Business with other financial institutions accounted for 9 per cent. Direct business with customers is thus a relatively small proportion of the total and the volume of speculative activity is high. However, each trade-backed transaction may in practice require a number of separate transactions on the exchanges as banks deal to ‘lay off’ the risk they have taken from the customer. Arbitrage (see glossary) evens out temporary disparities between rates for different currencies and ensures that interest rate differentials are reflected in forward rates. Currency dealers justify the vast speculative activity with the argument that it results in a highly liquid market in which necessary trade-backed transactions can be carried out with ease. In addition to foreign exchange itself, there is massive $171 billion daily trading in over-the-counter (OTC) derivative products. The market for interest-rate derivative products is about 2.5 times the size of that for currency products, though the latter were growing faster.
While the economists at the banks may seek to make rational forecasts of likely trends in a particular currency, the dealers have a much shorter-term view, taking advantage of temporary swings and anomalies. In the absence of rational reasons for currency swings, they may enlist the help of chartist techniques (see Chapter 7a) which indicate likely trends or turning points purely on the basis of chart patterns and profiles. It may add to the volatility of the market if large numbers of participants react to the same chart signals simultaneously.
Exchange rates are obtainable at most of the investment or personal finance websites. The main source for more general information on foreign exchange is the Bank of England website at www.bankofengland.co.uk/, which also has a special section on the euro, and there is a UK government site on preparations for the euro at www.euro.gov.uk/. Most countries in the euro zone have their own euro sites, but the official European Commission site is at europa.eu.int/euro/. The value of the euro relative to other currencies is, of course, the concern of the European Central Bank at www.ecb.int/. Incidentally, the Internet is littered with organizations trying to persuade you to have a punt in currencies or their derivatives. Be a little wary.
