Foreign Exchange Market History, Future Trends & Roles Of Central Banks

1.Write a 1000-word essay on “Foreign exchange market history, the future trends and roles played by national central/reserve banks in the foreign exchange markets”.

2.For the second tasks you are required to use the exchange rates given in the Excel file (sources: https://www.rba.gov.au/statistics/tables/#exchange-rates) BAO3402_Group_assignment_Data 2018S2.xlsx”. The file is available in VU Collaborate

You are required to:

a)Plot the given FX rates using appropriate charts (line or XY). Identify the significant movements of the FX rates. Explain probable factors, which can have caused the identified movements in FX rates.

b)Calculate daily FX rate changes for each currencies ;

Calculate the annual average (for 2013,2014,2015,2016 and 2017 separately) of daily FX rate change and the annual standard deviation of the daily FX rate changes (for each calendar year)

Foreign exchange regimes in the history

Foreign exchange regimes in the history

International trade policies subscribed to the use of gold and silver before 1875. However it was soon perceived that this led to difficulties with the rise and fall of prices when there was a rise or fall in demand and supply. It was then that the gold standard was first informally introduced. The standard was first formally then introduces in the 1900s with the signing of the Gold Standard Act by the then US president, William Mckinley. However this came to end as the US faced financial crisis during the World War 2. This was owing to the fact that as the European powers continued to produce surplus money which exceeded their gold reserves to fund the war, the US ended up having to expend large volumes of their own gold. This obviously created a disparity in trade leading to the US to make private ownership of gold as illegal. Following the end of the war, the US dollar was upheld as the international reserve currency with agreement of 45 countries, establishing the Bretton Woods regime (King, Osler and Rime 2013).

Meanwhile, the International Monetary Fund (IMF) came into existence in 1947, to play the role of a supranational entity which would promote global cooperation and trade, and to guide and aid developing nations in monetary matters. It was following this that the Bretton Woods regime came in 1971 to an end as with increased trade by the US led to shortage of US dollars in other countries and US failed to meet the demand for the volume of dollars. This was followed by a brief period of one year where the Smithsonian agreement came into effect, according to which the new standard rates were fixed on the basis of the devalued value of the dollar. Finally in 1976, the world saw the introduction of the first paper based currency regime, when the IMF abolished gold in totality as a reserve asset as per the Jamaica Agreement and formally established the floating exchange rate regime.

Foreign Exchange Rate Systems

Exchange rate systems can be categorized as per the degree of its “fixity” or “flexibility”. Currently, there exists a total of 9 kinds of rating systems as per the policies of the governments of the countries. These systems are primarily monitored and controlled by the monetary authorities of the respective countries. These 9 regimes can be broadly divided into 3 groups as per the degree of “fixity”.

Foreign Exchange Rate Systems

Fixed arrangements are those which have a fixed standard exchange rate, either against a specific value, or with respect to another currency such as the US dollar which are called dollar pegs. Examples of such arrangements would be the CFA franc zone, which is truly fixed, the European Union is another example, referred to as a currency union where the member countries share the same currency. Another kind of fixed regime is a currency board, where the total asset reserves are kept in a foreign currency equivalent to the local monetary base, by the monetary authority (Cooper 2014). This is what the British and French did during the colonization age in their colonial territories.

Intermediate arrangements in comparison to the fixed arrangement regimes, involve adjustable “pegs”. Such arrangements periodically or as per convenience tend to adjust or change the standard rates or pegs. The rate regimes, adjustable pegs, crawling pegs, basket pegs and target zone or bands fall under this category or exchange rate regimes. Adjustable peg systems periodically modify their pegs, basket peg on the other hand fixes the peg as a weighted measure of a set of foreign currencies. Crawling pegs engages in changing the currency rate through devaluating the currency serially. Countries employing target zone system have a pre-determined threshold margins, the breach in which prompts the monetary authority to reset the current rates to suit the needs of the time (Born, Juessen,  and Müller  2013).

Floating exchange rates can be categorized into 2 groups, namely free floats and managed floats. The free float system allows the market forces to freely influence the exchange rates. The managed float system on the other hand, has the provision of the authorities to take steps and intervene whenever the situation is seen to go against the desired direction.

Currency wars

It is well understood that relative value of currency is a key aspect which is said to influence and act as an indicator of a country’s economy. The fall of value of currency implicates the failure of the country in maintaining living standards and high inflation. However currency wars such as the ongoing one between China and US stands testament to the fact that often countries may want to devalue their own currency. This is because a cheaper currency value can be used as a tool to boost exports and this would also mean that the price of imports would increase which would go on to increase aggregate demand, all of which contributes to growth in the economy (Blanchard   2016). Therefore, the competitive advantage that a cheaper currency brings.

Currency wars

National monetary policy options

As per the Mundell-Fleming trilemma or impossible trinity, out of the policies of open capital markets, monetary independence and pegged exchange rates, only 2 can be implemented at a time. This was validated whenever a body tried to implement all 3 together, like the Bretton woods system which was operating smoothly till monetary independence became a significant factor in the policy leading to its demise. This was primarily because the move demanded the authorities to take control of the capital market leading to a breakdown of the policy (O’Rourke   2014). 

Central bank’s intervention in the foreign exchange market

A central authority such as the national bank or reserve bank may intervene in the exchange market in 2 ways. It was choose to exercise its powers of laying down regulations and restrictions, through its control of interest rates, control of outstanding credit by means of credit ceilings or through implementing directed lending, hence directly controlling the market or it may take a more subtle indirect route (Engel 2014). The authority instead of interfering in the market by setting up parameters, may instead choose to control the market by prompting signals to the market. These can be achieve via open market operations such as selling or buying financial instruments like treasury bills, commercial pares and central bank notes in the primary and secondary market. Another approach to indirect control is via enabling lending facilities which involves rediscounting the assets of high quality. Yet another way is to implement reserve requirements, wherefore it is made mandatory for all the banks to keep a specific part of their portfolios in the central bank (King, Osler and Rime 2013). 

The choice of the authorities to exercise direct or indirect control policies however lie solely with the kind of outcome that is felt to be more aligned with their strategy. Direct control is simple to execute and helps the authorities to control the credit aggregates, both distribution and cost. It is also seen that fiscal cost if implementation is low for such policies. Although, this also come with the addition price of ensuring efficient resource allocation. This can lead to a situation which is unfavorable for new financial institutions due to the heavy reliance on the existing banks for determining credit ceilings. It also has the risk of financial repression by economic powers of all of its competition, overhanging of liquidity and even disintermediation leading to flow of fund into the informal, unregulated market (King, Osler and Rime 2013).

National monetary policy options

Indirect control on the other hand has been seen to facilitate intermediation via the formal sector. The indirect control policy allows for more flexibility in policy, making the introduction of smaller but frequent modification easier, so that the authorities may be able to respond to situations more readily.

International trade and exchange rate control

A typical kind of control that the central banks or a government monetary authorities may seek to exercise it that of the foreign exchange resources. Such policies intercept and regulate the dealing of exporters and importers. This allows for the authorities to control the amount of foreign currency flowing into the nation and thereby control the exchange market conditions. Practices such as import licensing and making the foreign transactions exclusively through the central or reserve banks so that the amount may be monitored (Neely and Weller 2013). This however may end up restricting the importing business and hence are deemed as non-tariff barriers.

The historical values of the foreign exchange rates of the currencies, US Dollar (USD), Euro (EUR), the Japanese Yen (JPY), Chinese Yuan (CNY) and Malaysian Ringgit (MYR) between January 2013 and January 2018 were analyzed with respect to the Australian currency. The exchange rates of the USD was seen to show a decreasing trend. However the values are seen to be following an increasing trend with a low positive slope when focusing since 2016, which seems to be stabilizing.  The overall exchange rate has however decreased since 2013. In fact it is observed that the value of the AUD fell below that of the USD since May of 2013. The value of 1 AUD seems to be around 0.8 USD since 2017.

Figure 1: Historical Exchange Rate of USD compared to AUD

The exchange rate of CNY with respect to AUD was seen to follow a downward trend. This implies that either there is an increase in the value of currency of AUD has decreased or that the value of CNY has increased. However it can be seen that from the exchange rates that 1 AUD has decreased from a little above 6 CNY to about 5 AUD over the period. The currency exchange rates seem to have gone back to a stable trend since.

Figure 2: Historical Exchange Rate of CNY compared to AUD

The exchange rate has been to remain ore or lee the same across the period, showing a dip around 2016 but then again increased to suggest that the rates have not changed much at the end of the period. The exchange rate is however quite high with 1 AUD being equivalent to around 90 JPY.

Central bank’s intervention in the foreign exchange market

Figure 3: Historical Exchange Rate of JPY compared to AUD

The value of the EUR is seen to be greater than the AUD. However the plot of the historical exchange rates show that the rate values have shown a low sloped downward trend. This means that either the AUD has increased in value of the EUR has decreased, however the decrease is very slow. The rates however stabilize by the end of 2013, during which there was a dip of 0.8 to 0.7.

Figure 4: Historical Exchange Rate of EUR compared to AUD

The value of MYR is seen to be historically lower than that of the AUD. The rates however are seen to be increasing since 2015 after a period of slow decrease till before that. The overall change from before and after the period is seen to not be large. The value of 1 AUD is seen to be equal to be around 3 MYR at the end of the period.

Figure 5: Historical Exchange Rate of MYR compared to AUD

The annual average change in daily exchange rates of the five currencies with respect to the AUD are given in the table as follows. The annual average of daily change in the rates for US are seen to be negative but very close to zero except in 2017 which was also close to zero.

Table 1: Average of Daily exchange rate change

Table 2: Standard deviation of exchange rate change

The value at risk is the measure of expected loss, which in this case assumed a 95% confidence interval. The following table contains the computed values of VaR for the overall period for each of the currencies. This could affect foreign direct investment as higher VaR would discourage foreign trade (Hayakawa, Kimura  and Lee 2013).

Table 2: VaR for each of the currencies.

The maximum and minimum value of the foreign exchange rate changes are given im the table as follows

Table 2: Maximum and minimum change in rate

The currencies USD, JPY and EUR showed an overall decreasing trend, this can be owing to higher inflation than. This can also be said to impact CYN, however it could also be impacted owing to the lower interest rates imposed by the central monetary body of China, leading to lower exchange rates (Engel 2014). The MYP however seemed to be more or less constant if not show a slight increase in exchange rates. This could be owing to either lower inflation or higher interest rates in Malaysia. 

References

Blanchard, O., 2016. Currency wars, coordination, and capital controls (No. w22388). National

Born, B., Juessen, F. and Müller, G.J., 2013. Exchange rate regimes and fiscal multipliers. Journal of Economic Dynamics and Control, 37(2), pp.446-465.

Cooper, R.N., 2014. Exchange rate choices.

Engel, C., 2014. Exchange rates and interest parity. In Handbook of international economics (Vol. 4, pp. 453-522). Elsevier.

Hayakawa, K., Kimura, F. and Lee, H.H., 2013. How does country risk matter for foreign direct investment?. The Developing Economies, 51(1), pp.60-78.

King, M.R., Osler, C.L. and Rime, D., 2013. The market microstructure approach to foreign exchange: Looking back and looking forward. Journal of International Money and Finance, 38, pp.95-119.

Neely, C.J. and Weller, P.A., 2013. Lessons from the evolution of foreign exchange trading strategies. Journal of Banking & Finance, 37(10), pp.3783-3798.

O’Rourke, K.H., 2014. A tale of two trilemmas. In Enacting Globalization (pp. 287-297). Palgrave Macmillan, London.