Forex Trading Strategies Blog

The US, Euro zone, Japan and some of the most developed economies of the world have been through a phase of extremely low interest rates. These nations lowered interest rates for a prolonged period to boost demand and spur economic growth.

Technically speaking, low interest rates over prolonged periods provide cheap credit and increase the money supply in the economy and logically this should spur inflation. However, this has not happened and strangely enough, low interest rates and low inflationary rates have been strange bedfellows in these nations for over a decade.

To understand this relationship, let’s study the causes of inflation. Inflation can be categorized into two categories, ‘cost push’ and ‘demand pull’. Cost push inflation occurs when costs of inputs rises and leads to higher prices of consumption products. Hardened global crude prices are a common cost push factor. Demand pull inflation occurs, when excess demand in the economy or euphemistically put, excess money chasing les goods, pulls prices up.

Low interest rates leading to cheap credit and excess money supply should have resulted in demand pull inflation. However, this has not been the case.

The chief reason being cited for this anomalous coexistence is nothing but the mantra called globalization. Had the economies functioned in isolation like in the pre-global period, low interest rates would certainly have sparked inflation. However, the two low cost production bases,

China and India have contributed immensely to keep prices of goods down and have allowed the paradoxical coexistence of low inflation and low interest rates.

China’s major contribution has been the lowering of production costs of manufactured products, while India has helped reduce the costs in the service industry, with a large number of business processes being outsourced to India.

To read further on this topic, click here

The new US Fed chief notched up interest rates in the US further by 25 basis points taking them to 4.75%. He did this to keep inflation under leash and has hinted that rate increases are likely to continue. This hike is in continuance with his predecessor’s interest rate policy and is the 15^th successive increase in interest rates. Allan Greenspan began hiking rates from their 1% level in mid 2004.

The British pound lost ground to the US dollar on this news as also the announcement of an increase in the UK’s current account deficit. The US interest rates, now at 4.5%, are higher than the UK's. With further likely increases in US interest rates in the future, experts feel that the US dollar is all set to overtake the British pound in the coming years.With this hike the gap between the US and Australian interest rates also narrowed and the US dollar rose against the Australian dollar as well. The Australian Dollar slipped to a three year low of US 70.2 cents.

While the US economy has shown no signs of slowing down, the successive interest rate hikes have dampened the US realty market. Experts have termed the sustained boom in this market as a bubble waiting to burst. Hardened property prices had led to a lot of borrowing against homes. These borrowings have sustained consumer spending and the economic boom in the US.

The US Fed will have to be cautious, while planning further hikes as any further increase in interest rates can prick the property bubble and destabilize the US economy.

To read further on the Fed’s latest hike, click here.

Economics has classified exchange rate systems into three broad categories, fixed system, pegged system and flexible system. In reality, several offshoots of these systems have developed over time. Macro economic crises in countries have also led to a system where there are no exchange rates.

This phenomenon is termed as the dollarization of an economy and usually happens when a country looses faith in its own currency due to severe macroeconomic mismanagement and adopts another country’s currency as its own. Usually the US dollar is the preferred currency in such cases, hence the term dollarization. This arrangement is also termed as ‘no separate legal tender’ as the country has given up its own legal tender or currency in favour of the US dollar.

The case of ‘no separate legal tender’ may also exist in a monetary union like the EU, where member countries give up their legal tenders in favour of a common currency.

Fixed Rate Systems

Under a fixed rate system, a variety of arrangements are being followed by different countries ranging from a currency board to a fixed rate system.

The currency board is usually backed by a legislative commitment and the nation undertakes to exchange foreign currency for the local currency at a fixed rate and vice versa. Under this system, the country looses its independence over its monetary policy as it issues local currency to the extent of its foreign reserves. This form of system helps control inflation and can be very beneficial for a country that has been through a macroeconomic crisis. Argentina follows a currency board arrangement for its currency, the Peso.

The traditional fixed rate system is not as rigid as the currency board. It allows periodic adjustment of the exchange rate and permits countries to follow independent monetary policies. However, if countries following this system, follow profligate monetary policies resulting in indiscriminate inflation, the economic backlash can be severe. The collapse of the South East Asian economies is attributable to this phenomenon.

Both the above mentioned systems are adopted with the objective of providing exchange rate stability and encouraging foreign investment.

Pegged Rate Systems

Under the pegged rate system, countries peg the value of their currency to a single currency or a basket of currencies, while also allowing a narrow fluctuation margin of 1% to 2%. Another variant of this system allows periodic adjustments in the exchange rate and is termed as the ‘crawling peg’. The Bahamas and Marshall Islands have pegged their currencies to the U.S. dollar; Niger and Senegal to the French franc; and Bangladesh, Czech Republic and Thailand to a basket of select currencies. Under the pegged system, a country’s central bank maintains the value of the currency through frequent interventions of buying and selling foreign exchange to maintain the value of the local currency or through changes in interest rates or a combination of both. Raising interest rates leads to inflow of foreign currency for investment in the country and helps the local currency to appreciate and vice versa. This exchange rate system provides considerable discretionary power to the country over its monetary policy compared to the fixed rate mechanism.

The Managed Float

This currency system is one step behind the fully flexible exchange rate system and is followed by countries that have strong and stable macro economies backed by sound financial institutions. Under this arrangement the currency of the country is allowed to float towards its market value and not maintained by the central bank. The central bank intervenes in the market to cushion any major fluctuations in order to protect the interests of importers and exporters. India is a prime follower of this currency system. Other countries include Pakistan, Taiwan and Venezuela.

>The Flexible Exchange Rate System

>Finally, countries with the strongest currencies follow a fully flexible exchange rate system, where the value of the currency is freely established by market forces. Interventions by the central bank are infrequent and occur only in the case of wild fluctuations.

To read more about exchange rate systems, click here.

China’s central bank has stated that it will not reduce its dollar holdings for the present levels when it revamps its currency mix for its forex holdings. China’s forex reserves have now crossed $819 billion and it is widely believed that around 70% of these holdings are in US dollars. This high level of exposure to the US dollar can spell doom for China if the US dollar were to depreciate. On the other hand, if China were to reduce its dollar holdings it will have to sell that currency. This will lead to a drastic jump in the availability of the dollar in forex market and cause the currency to depreciate.

At the same time we are aware of the fact that China uses its massive dollar reserves to prop the US dollar by investing in US federal securities. China is also facing intense pressure from the G8 to allow its currency to float and appreciate to its true value. If China were to move to full convertibility in a jiffy, its need to hold dollar reserves will decline, which will have a major impact on the dollars value.

An appreciation in the Chinese Yuan combined with deprecation in the US Dollar, will reduce China’s export competitiveness to the US substantially and slow down its economy. We all know that China’s spectacular growth is key to global economic stability at this point of time and disturbing this will bode unfavourably for the global economy.

Thus, it is a catch 22 situation for China and it will have to be very careful in its forex management and take a very gradual approach towards full convertibility.

Click here to read more about China’s forex strategy.

We have all read about China’s huge forex reserves vis a vis its highly undervalued currency and the US Dollar being overvalued in the face of the nation's huge current account deficit. According to traditional economics, for both these nations, the situation is unsustainable, and correction in their currency values is imminent.

A problem with economists is that they tend to rely too heavily on text book theories, and sometimes do not move with time to adapt these theories to a changed world. Most of the theories on the current account deficits and currency values were written when economies were still isolated and markets were not as yet so global.

Let’s study how investment and production work within the boundaries of an economy. The savings that the nation generates get ploughed back in the form of investment and it becomes a virtuous cycle. A healthy banking system facilitates this cycle, setting it onto a high growth path.

However, with the onset of globalization, things can begin to look different. China has accumulated a lot of savings in the form of forex reserves. China uses these reserves to buy US Government treasury instruments. This helps China keep the value of its currency low and at the same time keeps interest rates in the US low. Low interest rates fuel consumption growth.

US that is fulfilled to a great extent by China. Production in China is also driven by US MNCs that bring in technology and capital. In a way the US is acting as an efficient bank for the bi-economy set up. So the relationship can be termed sustainable and the two currencies can continue their anti-theory trends.

To read further on this, click here.

It has been widely expected that the Bank of Japan (BoJ) is set to end its loose monetary policy regime and begin hiking interest rates gradually. However, a new statement by the Japanese Prime Minister Koizumi has reversed the market’s expectation. The PM’s statement suggests that he feels that it may be too early for Japan to start raising interest rates.

This along with corporate news that General Motors might sell its entire 20 % stake in Suzuki led the Yen to weaken against major currencies like the US dollar and the Euro. This sale would have meant that a huge amount of US dollars would be exchanged for the Yen so that GM could withdraw its investment. Thus, this transaction will exert a downward pressure on the Yen.

Japan has been running a zero percent interest regime for sometime now and the country’s central bank had hinted last month that it is planning to reverse this trend. The Yen had appreciated on this news. But, with the Japanese PM portraying a different point of view, the Yen is likely to display a confused trend until the BoJ announces its next interest rates on Thursday, March 9.

To read more on this, click here.

Have you ever wondered how a corporation like General Motors is on the verge of closure or why Delphi  has declared bankruptcy? Is it the competition from Japan or China that is leading to this state of affairs or is there is a hidden reason that does not meet the naked eye?

The auto industry in the US contributes nearly 4% to the GDP. The industry has lost over 200,000 jobs since 2000 and nearly 2.5 million other manufacturing jobs have been lost since 2001. In effect, these jobs are flying to other pats of the world, which have taken over the supply of these manufactured products.

If this had happened in a fairly and squarely, it is acceptable as the US has created more jobs in the services sector. However, these happenings can be linked to a phenomenon called currency manipulation and the two main culprits are the second and third largest economies in the world ie. Japan and China.

Japan and China have kept their currencies highly undervalued so that their exports are priced relatively cheaper as compared to domestic manufacturing products in the US. Japan has spent over $420 million in the last five years to keep the value of the Yen artificially low. It has been estimated that Japan’s currency is nearly 36% undervalued as compared to the US dollar. This implies that a car imported from Japan for $20,000 has a hidden subsidy of $2,400 to $7000, to the disadvantage of US auto manufacturers.

China on the other hand, has fixed the value of its currency through a governmental diktat. Its currency is undervalued at 15% to 40% giving its manufacturing sector a huge unfair advantage over America’s industry.

Thus currency manipulation by other nations is hurting theUS economy substantially and the government needs to take action and force these countries to revalue their currencies.

The Indian economy has grown from strength to strength and has become the fourth largest economy in the world in terms of purchasing power parity. The country’s economy is growing at a robust 8% per annum and its foreign exchange reserves have swelled to $140 billion form $ 59 billion in 2002.

The country had set out a road map to full convertibility a few years back and with its recent growth, its Harvard educated finance minister, P Chidambram, is planning to pre-pone the time frame for full convertibility.

One of the major impediments to achieve full convertibility is taming the country’s fiscal deficit. Chidambram has expressed confidence in achieving the target for the fiscal deficit to desired level of 3.5% of GDP supported by the strong economic growth.

However,India being a multiparty democracy, such decisions take time and are usually arrived through a consensus in a truly democratic manner. Chidambram has been trying to initiate a parliamentary debate on convertibility, but is having to wait as the supporting political parties have not turned around on the issue.

To read more on India's convertibility plan, click here.

The Japanese central bank, Bank of Japan, in a statement early February, said that it plans to pursue its zero percent interest rate policy, which would imply a weaker Yen, especially after the US having raised its interest rates. However, in a recent statement, the Bank stated that it may be open to ending the easy monetary regime and may raise interest rates.

Japan seems to be in a catch 22 situation. Its economy is not in the best of shapes. So if it raises interest rates, any chance of rapid revival would be doomed. If it doesn’t raise interest rates, its currency will slip.

In economics it has been said that the currency of a country is like a stock. It reflects the health of the economy. Thus, if Japan’s economy is not in the best of shapes, a softer Yen is only revealing the truth. And, a softer Yen may actually help Japan with its exports as they would get cheaper.

More on the Yen, from the International Herald Tribune.

While China had been facing tremendous pressure form G7 to revalue its currency and put it on a float, their stance softened after  China undertook token adjustments and introduced a narrow trading band.

The French issued a new statement that the Yuan’s value is the sovereignty of China and it may be better to approach the subject in an informal way rather than exert formal pressure.

While, certain lawmakers in the US have threatened to introduce legislation that will erect trade barriers against China, the Bush administration is completely against the idea.

It’s the complex nature of the global economy that is making nations shy of taking a firm stance on the issue. Disturbing the equation by revaluing the Yuan could slow down the Chinese economic rate of growth as its exports would become dearer. That could prove to be disastrous for global economic growth, so why take chances.