To explain the determination of FX rates in countries with freely fluctuating exchange rates, we now address demand, supply, and market equilibrium in the currency markets.
Since American manufacturers, like Cummins Engine, incur many of their expenses at
domestic manufacturing sites in the United States, American manufacturers tend to require that export purchase orders be made payable in U.S. dollars. This receivables pol- icy requires that Munich buyers of Cummins diesels transact simultaneously in the for- eign currency and diesel markets. To buy a Cummins diesel, Munich customers (or their financial intermediaries) will supply euros and demand dollars to secure the currency required for the dollar-denominated purchase order and payment draft awaited by the Cummins Engine shipping department. This additional demand for the dollar and the concurrent additional supply of euros drive the price of the dollar higher than it other- wise would have been. Thus, the equilibrium price of the dollar as foreign exchange (in euros per dollar on the vertical axis in Figure 6.4) rises. In general, any such unantici- pated increase in export sales results in just such an appreciation of the domestic cur- rency (here the USD).
Similarly, any unanticipated decrease in export sales results in a depreciation of the domestic currency. For example, in 2001–2005, collapse of Boeing Aircraft export sales in competition with Europe’s Airbus contributed to the dollar’s collapse against the euro over that same period (again see Figure 6.1). But this downward FX trend of the dollar assisted Cummins Engine as well as Boeing in stabilizing its sales and cashflows both at home and abroad. With the dollar worth fewer euros, the dollar cost of Ameri- can imports from Mercedes-Benz and Airbus became more expensive, while American exports priced in euros by Cummins and Boeing sales reps across Europe became cheaper. This automatic self-correcting adjustment offlexible exchange rates in response to tradeflow imbalances is one of the primary arguments for adopting a freelyfluctuat- ing exchange rate policy.
FIGURE 6.4 The Market for U.S. Dollars as Foreign Exchange (Depreciation of the Dollar, 2001–2008)
Price of U.S. dollar (⑀ per $)
D0 S2001
S2003
Quantity ($) 1.12
0.93
0 0.770.64
S2005 S2008
Import/Export Flows and Transaction Demand for a Currency
To examine these effects more closely, let’s turn the argument around and trace the cur- rency flows when Americans demand imported goods. The Mazda and BMW dealers would have some inventory stock on hand, but suppose an unexpectedly large number of baby boomers wish to recapture their youth by purchasing sporty BMW convertibles.
Just as Cummins Engine prefers to be paid in U.S. dollars, so too BMW wishes to be paid in euros. Therefore, BMW purchase orders must be accompanied by euro cash pay- ments. How is that accomplished? First, the local BMW dealer in Charlotte requests a wire transfer from Bank of America (BOA). BOA debits the dollar account of the dealer, and then it authorizes payment from the euro cash balances of BOA and presents a wire transfer for an equivalent sum to the Munich branch of Deutsche Bank for deposit in the BMW account. Both import buyer and foreign seller have done business in their home currencies and exchanged a handsome new car. And the merchandise trade account of the U.S. balance of payments would show one additional import transaction valued at the BMW convertible’s purchase price.
If BOA failed to anticipate the import transaction and euro wire transfer request, BOA’s foreign currency portfolio would now be out of balance. Euro balances must be restored to support future anticipated import-export transactions. BOA therefore goes (electronically) into the interbank foreign currency markets and demands euros. Al- though the American bank might pay with any currency in excess supply in its foreign currency portfolio that day, it would normally pay in U.S. dollars. In particular, if no other unanticipated import or exportflows (and no unanticipated capitalflows) have oc- curred, BOA would pay in U.S. dollars. Therefore, unanticipated demand by Americans for German imports both raises the demand for euros and (as theflip side of that same transaction)increasesthe supply of U.S. dollars in the foreign currency markets.
The Equilibrium Price of the U.S. Dollar
In particular, in the market for U.S. dollars as foreign exchange (see Figure 6.4), the sup- ply curve shifts to the right. This shift of market supply represents BOA and many other correspondent banks supporting import transactions by selling dollars to acquire other foreign currencies. The equilibrium price on the y-axis of Figure 6.4 is the price of the dollar expressed in amounts of foreign currency—for example, British pounds per USD, Chinese yuan per USD, Japanese yen per USD, or euros per USD. As the supply of U.S.
dollars increasedS2001toS2008, the equilibrium price of the dollar declined continuously from€1.12 to€0.93,€0.77 and€0.64.
For example, in order for the American imports of Airbus airplanes to increase for 2002–2005, the supply of U.S. dollars in the foreign currency market had to increase.
Thus, the spectacular dollar appreciation of the previous three years (1999–2001) slowed and the dollar began to depreciate (see Figure 6.1). Again, American consumers and companies needed to acquire euros to purchase Franco-German imports. U.S. financial intermediaries supplied dollars in the market for dollars as foreign exchange to acquire the foreign currencies their local American customers (Delta, United, Continental) re- quested in support of these foreign import transactions.
Speculative Demand, Government Transfers, and Coordinated Intervention
The U.S. dollar depreciation of 2001–2008 reflects several factors besides transaction de- mand. FX rates also depend upon speculative demand, government transfers, and central
bank interventions. Speculative demand is very volatile. Transfers can involve either debt repayment (reducing the supply of a currency as a debtor nation takes money out of cir- culation and returns it to the lender nation’s treasury) or foreign aid (increasing the sup- ply of a currency). Government interventions can be coordinated across several central banks or uncoordinated and can be sterilized or unsterilized.Sterilized interventionsin- volve offsetting transactions in the relevant government bond market. For example, the Federal Reserve might sell dollars in the foreign currency markets, but then turn around and acquire dollars by selling an equal dollar volume of T-bonds to Japanese or Chinese investors, leaving the supply of dollars in international exchange essentially unchanged.
What is the proportionate weight of each of these factors in determining the equilib- rium value of a currency? An importantfirst perspective is that only one out offive for- eign exchange transactions supports an import or export trade flow; the other four support international capitalflows. In 2008, for example, the averagedailyvolume of for- eign currency transactions in the 43 largest foreign currency spot markets had a dollar value of $1.005 trillion. The average dailyvolume of world exports was $43 billion. So the dollar volume of foreign currencyflows outstrips the dollar volume of foreign trade flows by 23 to 1. Daily FX rate fluctuations therefore reflect not import-export trade flows but rather international capitalflows, much of which is speculative and transitory.
Because of the sheer volume of transaction, intervention in the foreign currency mar- kets by any one central bank therefore has almost no chance of affecting the equilibrium value of a currency. Take the Bank of Japan, for instance. In June 2009, the central bank of Japan had official reserves of foreign currencies equal (at existing exchange rates) to
$988 billion.16By comparison, China had $1.4 trillion, the European Central Bank had
$49 billion, while the U.S. Federal Reserve had $42 billion in foreign currency reserves.
Suppose the Bank of Japan decided to try to initiate a depreciation of the Japanese yen (JYN) to improve the competitiveness of their export sector. Investing one quarter of their entire reserves or $247 billion, the Bank of Japan’s intervention would be easily over- whelmed by the sheer enormity of the $1 trillion mobile capital awash daily in the interna- tional currency markets. Indeed, the official reserves of all the central banks total only approximately $3 trillion, equal to onlythree day’s worthof foreign currency transactions.
It therefore takes acoordinated intervention by several large central banks with deep reserves to have any real chance of permanently affecting a currency’s value. One such coordinated intervention took place as a result of the Plaza Accords in 1985 when the G-7 nations (the United States, Britain, Japan, Germany, France, Italy, and Canada) all agreed to a sustained sale of U.S. dollars over 1986 and 1987. Figure 6.1 shows that this coordinated intervention was effective in lowering dollar FX rates against the GBP, the JYN, and the DEM.
Short-Term Exchange Rate Fluctuations
The transaction demand determinants of long-term quarterly or annual trends in ex- change rates are fundamentally different from the determinants of day-to-day exchange ratefluctuations. Short-term exchange rate movements from week to week, day to day, or even hour to hour are determined by arbitrage activity in the international capital markets and by speculative demand. Sometimes current events set speculators offin sup- port of demanding and holding a currency (a long position), and sometimes the reverse (a short position). Behaviorally, each speculator tries to guess what the others will do, and much herd-like stampeding behavior based on volatile investor expectations often ensues.
sterilized interventions Central bank
transactions in the foreign exchange market accompanied by equal offsetting transactions in the government bond market, in an attempt to alter short-term interest rates without affecting the exchange rate.
16International Monetary Fund,International Reserves and Foreign Liquidity, various issues.
Arbitrage is the act of buying real assets, commodities, stocks, bonds, loans, or even televisions, iPods, and sandals cheaply and selling them at higher prices later. Arbitrage activity is triggered by temporary violations of arbitrage equilibrium conditions, which equalize, for example, real rates of return on 90-day government bonds (adjusted for any differences in default risk). When such conditions do not hold, opportunities for ar- bitrage profits exist, and arbitrage activity will appear quickly, proceed at huge volume, and continue until the relevant arbitrage equilibrium conditions are reestablished. Again, the sheer magnitude of thefloodtide of $1 trillion per day of international currencyflows quickly closes (within hours or even minutes) the window of arbitrage profit opportunity in FX trading. If the buying and selling prices and terms of delivery can be arranged si- multaneously, then the transaction is one of pure arbitrage. If the second transaction is delayed, we often call the activityspeculation.