Central Banks and Currency Controls

Introduction
Any International Finance textbook contains a good chapter on currency regimes (or systems). Bekaert and Hodrick (2009) dedicate Chpater 5 to this issue. Eun and Resnick (2009) have a shorter discussion (p. 54) as do Kim and Kim (2006, p. 86).

A 1913 law establishing the Federal Reserves Bank (the Fed or FRB) charged it with four functions:
1. Assure stable price levels
2. Assure stable sustainable economic growth
3. Minimize (non-frictional) unemployment
4. Assure stable exchange rate for the U.S. dollar (USD)

This last task, also called, central bank intervention in currency markets. To fully understand the intervention process by the Fed, I request you read an excellent brief FRB publication titled "U.S. Foreign Exchange Intervention".


Exchange Rates Systems (a rough description)
To what purpose and how do central banks intervene? There are several basic exchange rates regimes or systems that are maintained by central banks' actions:
i. Floating exchange rates that allow a country's exchange rate (mostly against the USD) to float freely as determined by supply and demand. All major central banks allow their currencies to float (e.g., USD, GBP, EUR, JPY CFH). As you can learn from the above recommended FRB publication, the FRB is committed to intervening to "counter disorderly market conditions" that remain undefined.
ii. Fixed (or pegged) exchange rates. Under this regime, the central bank intervenes daily to keep the value of its currency constant against another currency. Bahrain, for example, fixed the value of its dinar to the USD at a rate of 2.65957 USD/BHD.
This means that the central bank of Bahrain will sell and buy US at this rate.
iii. Managed floating rates. Under this system a country's central bank intervenes occasionally not in order to counteract disorderly market condition but to manipulate the value of its currency with some economic objective in mind.


How does a country choose a system?
It is difficult to give a general answer to this question but here are a few thoughts:

A central bank should allow its currency to float freely if it wishes to control interest rates in its country. In sum: it gives up objective number four in the above list in order to manage objectives 1 and 2. To understand this, assume the U.S. had pegged its currency against the EUR at a rate of 1.5 USD/EUR. If U.S. consumers' demand for European goods increases, importers convert USD into EUR to finance the purchase of goods in Europe. This may push the exchange rate to above 1.5:1 (higher supply of USD causes it to weaken). To bring the exchange rate back to 1.5:1 the FRB must generate additional demand for the U.S. currency by raising interest rates. Higher interest rates cause European investors to shift their money into U.S. investments. To do so they must convert their euro into U.S. dollars. This resulting higher demand for the USD should move the exchange rate back toward towards 1.5:1. Higher U.S. interest rates may however cause a decline in the U.S. economic activity as well as elevate unemployment.

Why peg a currency? There are several possible situations where a country might prefer this regime:
a) The case of China: The Chinese government adopted a growth agenda that is based on exporting goods to the rest of the world (but mainly to the U.S.). To achieve its goal it had to make sure that its export products are reasonably cheap for U.S. consumers. It (non-officially) committed itself to an exchange rate that undervalued the yuan. This meant that Chinese exporters who sold their products for USD had to yield these dollars to the People Bank of China for approximately 8.2 CHY/USD. To do so, the People Bank must print yuans and inflation may (and did) raise its head. Luckily enough, Chinese citizens are very thrifty and they use this excess yuans to purchase Chinese government securities (this is called yuan sterilization)
b) A country that pegs its currency to the USD (for example) must offer the same interest rates as in the U.S. (otherwise: a money machine can be build to take advantage of the arbitrage opportunities inherent in any discrepancy). This mechanism disciplines the country's central bank. It cannot print as much money as it wishes because this will lower its interest rate below that of the U.S.

Why choose a managed float?
a) The Chinese example: After may years of maintaining its currency on (approx.) 8.2 to the dollar, the Chinese government decided to slowly enhance its value. You can see the graph in a WSJ article dated January 23 ("U.S. Stance on the Yuan Gets Tougher"). This was accomplished by gradually changing the official exchange rate. Note however that the process stopped in mid-2008. Following the start of the financial crisis in the U.S., a decline in U.S. demand for Chinese goods motivated the Chinese government to stop appreciating the yuan.
b)The Russian Example. Russian consumers and foreign investors in Russia dislike large fluctuations in the value of the ruble. Consumer don't like it when the price of a Mercedes in Moscow goes up by 20% in a week. Likewise, a German investor who invests in a St. Petersburg shopping mall may want to know that when time comes to sell the investment, she will be able to convert her rubles into euros at a reasonable rate. For all these reasons, the Russian central bank acts to reduces exchnage rates volatility by intervening in currency markets ("Russia Signals a Halt in Ruble Devaluation" The WSJ, January 23)

Connecting newspaper articles with class material

"There is only one alternative to the dollar" in the January 5 Financial Times is an interesting discussion of the fate of the USD as reserve currency. I find the following quote interesting:

If the US stimulus policy revives the economy by spring or summer, the dollar could rally further. The risk posed by US policy comes from potential market concerns about monetary policy becoming inflationary. The current growth rate of the Fed’s balance sheet is totally unprecedented.
A similar sentiment has been expressed in yesterday's WSJ (did you come across this?)

As discussed in the Relative Purchasing Power class discussion, if the inflation rate in the U.S. will exceed that of other countries, exchange rates should reflect this difference through a depreciated dollar. It is possible though that the Fed will react by raising interest rates. This, according to the Interest Parity Relationship should result in a stronger dollar. So, should we expect the USD to depreciate (high expected inflation) or to appreciate (higher interest rates)? Who knows.

What is Money?

One of you guys called my attention to "When It Comes to Cash, A Thai Village Says, 'Baht, Humbug!'" from today's Journal. This article touches upon the question of what makes money money. This gives me the opportunity to refer you to an interesting article by Hal Varian in the New York Times from way back ("Paper currency can have value without government backing". Professor Varian is in my opinion one of the most erudite economists in the U.S. You might also want to read his article in today's Journal ("Boost Private Investment to Boost the Economy"). It makes for a good commentary about the limited effect that government has on the current economic situation.

International Diversification

I suggested in a recent email message that you avoid reading Chapter 13 in Bekaert and Hodrick. This chapter is tedious and its main points can made in a much briefer manner. Serendipitously, an article from today's WSJ titled "Swimming with the Currency " is very helpful. The article touches upon several points

First, when investing in a foreign investment, the rate of return in terms of the domestic currency (say USD) is affected by both the performance of the investment in the foreign asset (stock or bond) and the performance of the foreign currency itself (see my December 17 email message). Let me pick an example from this article relating to results of investing in the Brazilian stock market (the Bovespa index). During 2008 the Bovespa declined 41% in local prices and the Brazilian real lost 55% of its value against the USD. This means a total loss of 73.45% (compute!!!)

The second important point in this article is what it calls geographical diversification. Modern portfolio theory tells us that the more assets you include in your portfolio, the better are the risk-return opportunities. If you remember the mean-standard deviation capital market line, this means that the slope of this line is steeper when more assets are included. In short, don't attempt to outperform your domestic market by investing in foreign stocks. Do so in order to mitigate domestic market's variability. Hopefully, when your domestic market performs badly, foreign ones might mitigate this loss.
A few additional observations about international diversification:
1. The lower the correlation between the rates of return between the domestic and foreign markets, the better are the diversification opportunities. See page 465 for a tabulation of the historical correlations between various economies (Exhibit 13.5). Which countries seem to be good vehicles for international diversification?
2. Although you can't see it from Exhibit 13.5, these correlations tighten over time. Because we live in a global economy, all local economies are interrelated and are becoming more so with time.
3. What is the meaning of a "foreign" company anyhow? Is Toyota a foreign company? a huge part of its production and sales take place in the U.S.

The third important concept in this article is called translation exposure which is completely ignored by Bekaert and Hodrick. Here is the gist of this concept. According to GAAP (Generally Accepted Accounting Principles) U.S. corporation should consolidate the financial results of their subsidiaries --including foreign subsidiaries). When a the currency of the foreign subsidiary appreciates against the domestic currency, the subsidiary's assets appreciate. This appreciation enhances the parent corporation's income for the year. Obviously, the opposite might happen and profits could be dampened.

Money supply and the Fed's Actions

Many of you elected to use the December 18 article titled "Japan Looks Set to Follow U.S. Rate Cut". Several of you had difficulty conceptualizing the mechanism of the money supply. As stated by a class participant:

The article mentions that as part of the “quantitative easing” approach, the Fed may consider buying U.S. Treasuries to create funding for new programs. I am not clear how the U.S. federal government purchasing its own securities provides additional funding in a real sense.

To clarify this issue I will guide you through the following steps:
1. Economic activity is promoted by banks extending credit
2. When credit is granted by a bank, it create a "deposit" available to the borrower for check writing.
3. Banks are limited by reserve requirements (stipulated by the Fed) as to how much credit they can extend. Currently, for every 10 dollars in deposits the bank must hold a reserve of one dollar. The more the reserves available to a bank the more deposits (and hence credit) it can create.
4. When the Fed buys securities from dealers, it pays them money that is automatically deposited in their bank accounts.
5. This extra money constitutes new (and therefore additional)reserves that enable banks to lend more (see point 3 above) by creating new loans (deposits).
6. Because bank deposits constitute a component of the money supply, we say that by purchasing securities the Fed helps increase the money supply or the quantity of money.
7. Note that if banks refuse to use the new reserves to grant new loans (as they currently do) , the money supply may not grow.