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.

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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.

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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.