The Foreign Exchange Market After the Float

The Foreign Exchange Market After the Float

67 Economic Analysis and Policy THE FORE IGN EXCHANGE Vol. 15 No. 01, March 1985 ~~RKET AFTER THE FLOAT JON STflN mRD Sen i o r Lecturer in Econ...

2MB Sizes 5 Downloads 57 Views

67

Economic Analysis and Policy

THE FORE IGN EXCHANGE

Vol. 15 No. 01, March 1985

~~RKET

AFTER THE FLOAT

JON STflN mRD Sen i o r Lecturer in Economi cs Un ive r s it y o r Quee ns lnnd St . Luc i a , 4067 .

I tITRQDUCT I Otl Wnen 1 started to write some notes f or thls paper I was iw.pressed by the ve r y dramatic events which had tak en place in foreign exchange markets dur ing Feb ru a ry a:ld this st 1 Tn~ d a memory or some lines in Oscar \,ilde ' s play :i'ne importance oj" Being Ernest . You mny re membe r whe n tII ss Pri sm , tut o r to CecUy , saId : Ceci l y , you 'I i ll r e ad your Politi cn l economy in my absence . The c hapter un tlla Fa l l of the Rupee yo u m:!y omi t . I t i s somewha t too se nsation;:\l . Even these met.111ic problems have tl u.l i r melod ramati c side . Eve n if I wished, which I do no t, I don't think thaL J \wu l tl he a!lle to llvold di sc ussin& these II"Q dern dlly mc l od r am.1 t ic events or to avoid m;,ki ng some COllVll('nt on t hem. Ilowevcr , before 1 r(Hlch U"It point tilClrCl is some preliminary g r o und ,,'h1ch JDust neces!w rily be co ve red . I propose to pro ceed In the (01 lowing W.1y . First , I wi ll br ing o ut the sign ificance of the decisions to float and t o r emove exchange controls becau!Je the ;lssocl,1tl'.d decisions (whlcn have c:ade tile A\lstralian fJO Ilt "the c\e;mest in t ill'. "'0 rid") , will have the g r eatest lo ng term impact on t he Austnl l inn do ll
THE EFFECT OF THE DECISIONS TO FLOAT Th..! decision to fl oat the Aus tt lll i an do ll n f t :lken i n December 1983 , IUld th e co nSClque n t changes implemented dur i ng 1981" i nvolved three disti n ct t:hangcs to t ile elltern:!l account: I.

l'htl fir!:lt 1Ind ,ro,:\l obvious ''',is tI,e de1.: lfil o n relllt i ng to the nonl in g rat e : the Australinn Government li nd its mo net l1 ry a ge nc i es , particularly th e Rese rve Jiank , I-:ould not intervene In the f o r eign exchange market to determin e . or to "ttempt to defend , o n ;I sustained bnflis , a pnrtl c ula r c xdHlnUe rate alt ho ugh tile Reserve a:lIlk r e ta ined the right to inte rvene.

2.

The cxchnnge con tr o l s which hnd been in force since t he Second Ilnrld \~a r were relJoOved, COlIIl'lete ren/val was not effected until during 1984 .

J.

Th e Aus tralian fo r eign exch:mge r.l
7no effects oj" thesc decisions have beel1 to aHOL) irr:porte1"'s and cXPOl'tC1'8 wtlimited opportunity to lead cmd lag payr."£l1tn al1d receiptD in and out of l.uDt1"'alia and jor expo rtem to ,.old e:.:port l'CcciptIJ or:~f;hoT'C. 1.8 I.J(1U

68

Economic Analysis and Policy

Vol. 15 No. 01, March 1985

/.ustl"Olian ~sidents rtave az.n.::,st unlimited opportWlity to hold internationaUy diversified portfolios . CHANGt:S III INTERMTIOHAl FINANCIAL MARKETS In the last 25 years international fin ancial markets have developed subs t .mtlally due to the elimination of regulati ons , the response o f financial institutions to r egulation and to ge nuine financial innovation in intenlational fi nancial markets . The landmarks in this expansion o f international finoncial markets have been as follolls: the retu r n to co nvertability of European currenc ies in the late 1950s, tile progreflslve elimination of exchange co ntrols on capita l account trn nflm:: tJons, t,]C developments In co mputer nnd telecommuniC
FLOAting exch.mge rates - although m
(b)

inter national financial markets, such as the Eurodollar market, which are ef fectively beyond the control of any ont10nal mone t n r y author i ty or i nde ed any supra-not Ianni lIuthority .

(c)

Ktll'id flntlncial innovation In monetnry n'ld bunking practi ces .

(d)

The internation .. lisation of b;lnking :md the development of off- .. hor .. hnnklng "pnr,....... whl.-h, 11k" th .. lr el>nerlr. coun tl>r""rr, the Eurodollar market,' lIt:e effectively free from moneta r y co ntrol .

(e)

As II result, the r e are s ub stan tial and increasing flows of f(nllndll l c apital between economics r eHectins the emerge n ce of international portfolio diversification on a growing And substantial scale.

(£)

As an empirical observation, there Is of exchange rates and int erest rates .

;I

h Igh degree of volatility

The Importmlt economic resu l t of these chonges hilS been thllt the .11'prollflnte fr
69

Economic Analysis and Policy

Vol. 15 No. 01, March 1985

A small open economy is u price taker in WQ-rld markets , l.e ., t he foreign cu rrency price o f exports and Imports are determined in world markets ; together with these pri ces the exchange rntc determines thl! domestic currency r etu rns to expo rter s nnd the domestic currency price of imported goods . III copica l markets, and in the capitol account o r the bnlnnce of payments, a 5111.11 1 open economy is also a price taker so that dOl1lCstlc Interest rates c onnot vary from i n ternutionally dl!tl!rmined rates. Mo re precisely the difference should not be greater than the covl!rl!d interest differential. There arc twO important propositions which emerge rrom this frumcwork. First, under fixed excha nge rates, a smull open economy cnnnot control the stock of high powered money unless j t engages a ste rilisati on programme to o(Csot capir,!} Hovs. Second, under a floating exch ange rnte a smJt the sole source or cha nge in the stoc k o f high powered money is from domestic sou rce s because the excilunge rate is the price which oquiliilrates the demand for, and supp ly o f, foreign exchang('.

CHANGES (N FORE I GN EXCHANGE MARKETS In order to understand how foreign exchange markets oper,1te today it Is necessary to e:o;al1line the m.1jor developments In foreign exchange marktlLS In the 19108 lind 19805 . The ma jor factor!> on which 1 will co ncentrate are fl r st, the ri se of rhe I~ew York fore i gn exchange market, secon
The grO""1n& internatlonnlization of the US economy . The trnde/CNI' ratio increilsed in the US econollY. :md ns well there a re now IlIOre foreign ban ks in th e USA and more US banks opera tin g OVl!rse
(2)

The increased volatility of exchllnge rate s created the potentinl for large gsins and l osses in foreign ('xchanRe dealing. Commercial 11l1nks focussed more d irectly on the importAnco of curre ncy eXPO!lures. II growing numiler o f banks tre llted their trading operations as the opportunity to mnke profits !IO that 1ncollC from foreign exchange tradin g became £I n impor tant source of commcrcinl bonk I!ar n ings. The management of money nnd foreign e xcha nge became a ll integral port of Ullanci(li operations and plannin g for large corporations ,1nd led to n mo re active presence in the fo r eign eXc!longe market.

(3)

Changes in t r .1ding practices nnd co nvention!;, such as direct dealing between US b,lIlks, iotegrnted New York into the glob1l 1 fo r e i gn exch nnge marke t.

Trading volume in the New Yo r k market increased by over 40 per cent 1980 to 1983 ;md some factors whi.c h accoun t for this rise arc: ( 4)

f -r o~

l)eregula t i on o( the US capito l market wh i ch led to n shsrp increase

Economic Analysis and Policy

70

Vol. 15 No. 01, March 1985

in forr!ign e xchange trading by non-b.:mk finan cia l i nstitutions. ( 5)

Japan relaxed foreign exchange cont rols as had the United Kingdom earlier. Howeve r there were some facto r s which limited activ ity in the eflrly 1980s. These include:

(6)

The worldwide recession and gl ob.ll debt crisis which slowed o r reduced trade volumes.

(7)

N.my mul.ti.lliltiollals felt le ss need to hedge following changes 1n foreign exchange accounting rules in the US.

INCREASE IH TURNOVER IN FOREIGN EXCHANGE HARKETS The globa l fo r e i sn exchange mark lH in 1985 has a da i ly turnover of Someth1'1g in excess o f SUS 200 billion which exceeds t r ade volume by A r .. cto r of app r o xi mate l y 20 to )0. The relative importnnce of individual foreign exchange ma r kets is indicated by turnover figu r es : in the New York market turnover now appl:"oaciles SUS 40 billion A day , very simila r to that o f London; the Tokyo ma r ket is approximately half the size of London ' lnd l,ew Yurko 'i' urn ov('r In Singnpo r e Is app r oximntely half the Tokyo figure while th e Cnnlldian foreign exchange m;u-ket ' s turnover is Ilbou[ [our-fifths o f the Singap ore flb'H e. Turnover 11118 Increased by npproxim.1.tely 75-80 per ce,l t since the l 1)te 1970", ;llthough it Is probable that g r owt h in the 19805 hns been at a slower r ate Lhun In the 19701'1 .

CH,4JiGES IJl PRACHCES IN THE FORE IGN EXCHAtIG[ MARKET The rU l:" eign exc h;mge mal:"k('t hdS been m..1. r ked by the IIharp Inc r e .. se in inte r -bli nk dealing. Tile Fede r al Reserve Bank of ~e\~ York estimates that inl(!r-bu nk tl:"ading lUIS increm;ed in recen t years beyond what Is strictly attributable to (ncre.wed vol uml;! of customer bWliness ; perhaps as much ilS half of thi'! increase in f ore i g n excha nge turnover between 1977 and 1980 is ;lccounled for by "pure" inter-bank pos i tioning. In 1980 it is thought thnt interbank t r ades exceeded c ustomer deals by f"ctor of 20 COnljl;t l:" cd with 10 in 1977. There are severnl reasons for this ch'lIlge In the char{lcter o f the 'Il:lrket. I'lrflt, US bmlk>l a r e now principals trading 011 their ololn nccount re rvi ces for th eir cus to me r s on a broker b"sls . Second, Increased c.ompe tit! ve activity has led to more llctive posit i on taki'1g. Third , more volatile exch,:onge rates have led to rapid inter-day trad ing at the ex pense of Ion/(, term jJosltloning. 3.

Over I"ecen t yell r s . .. growing number or co mme.rcial bnnks have ta ken substantial positioll!> i n foreign exc hange In response to expected chrmr,ell in exchange rates and in inte r est nlte di ffer entials; such position s are generally held fo r li mited time inte.rva l s. Such a [1:"'Jding pa t tern offe r s 1) more competitive se r vice to customers ilud tllkell advant age of p r ofit opport un lt i es avaLl'lble in fluctuatins e xch
71

Economic Analysis and Policy

Vol. 15 No. 01, March 1985

exchange options trading, both in th e over- the -counter market and in orga ni1:ed trading o n a number of stock ex changes together with the introduction oC c urrency future s t r a ding on the IMl-I in Chicago , hilS accelerated these trends . Unf o rtunately I don't hav e t h e t ime today to d iscuss these interest i ng develol)lIICnts. The incre ase in exc han ge rate vo latility aln ce 1973 h as made it nec essary in many economic activiti es [0 make dec i s ion s r ega r din g the future co urse of exchange r(t t es a nd t his involves making predi c tions abou t the fut ure rate. The genera l evidence sugges t s that a ccurate predi c ti ons of chan ges in foreign excha nge rates have been , and continue t o be, r a re. The general ex per i e nce suggests: 1.

that forecasts of spot rnt es based on f o rward rales arc Imprecise ;

2.

models based on fun da!IICn t al factors ar e poor predictors of a c tual exchange rate IilOvements j

3.

t hat the use o f forward rotes a s a predictor of future spo t rates ge ne ra tes imprecise for e ca s t s ; ;md

4.

iong t e r m p r edi ct Jon" o f futu r e Sl'ot riltes are more inllccurllte til e lon ger the predi ction period.

The ove ral l outcome h" s been that den t e r s in the foreign exchnnge mnrket have found It prudent to at tem pt to achieve thei r profit gooli s over t he very silort l erm . The very sho r t te r .. has t o be meusu r ed on II scn l e of hours and minutes. This has lend to lin emphnsis on r ap id "in and o ut" i'il'ot tr"n6I1ctLolHl . \o:e C'JIl note that rnpid "in and out" requires highly sop histicated co mput er equipment to show th e buying a nd se lli ng quotetl orre t'ed in the ma r kee , tn r eco r d t r ansactions th a t have been CArr i ed o u t , to Ulld.lte cont inuously the deale r' s position in all cu rr e ncies and to r eo;;eivc market . eo;;onomic a nd polhical data and news. Rapid lnte r -day tradin g i s not without its prob lems wh i ch include t he possibi lity of IllIyment e rror s lind defa ult s , and heavy transac ti ons costs . An import.1llt r esu lt of the willingness of b:mks to hold pos iti o n" for l e ngth of time is that this ca n by itself magniry c rrnti c o r onc-way rnt c mo veme nts in exo;;ha nge. r ' ltcs . Under these cl r c uC1 s tances imhn l a nees In dCfMnd/sullply condi tio ns a r e not o ff set by changes in buffe r stocks of f o r e i gn exchange but nre rapidly t r ansfer red to chllnges in rat es . Th is hnl': bee n nccentuated by th e co nve r gence of tradin g styles of deale r s so that s ha rp c umu lat ive I)Ovcme nt s in the market can dcveloll very quickly. ~J lly

In o rde r to exp lain t he oper llti o nlO of the fo r eig n exchange Il\o1rket we can use t he following stylised dcsc rlption of what we c an refer to IlS the wholesale or dealer spot market. Othe r co nsiderOltio ns apply to the. retn il ma r ke t s organ i se d by banks f or dufts , travellers c heques a nd {ore l gn notes ; a8 l indi cated beCo r e I do no t consid er fopward, options, swap and future 1D1Irkets . Major catngo rie s of dealer s are first, markBt makers , second , dcaZe r8 actirl9' as b1'Oker8 foY' cl.iCrlts iL n d thi r d , 8peciaZiaed brokers . The market cons i sts of a s mall pe r cantagc of dealers who lire market maker8 i.e ., dealers who will provide bUY/llell quotes on r equest and who are prepnre d to deal , up t o tha conventional transact i on limit in the marke t, to trade

72

Economic Analysis and Policy

Vol. 15 No. 01, March 1985

either way
THE AUSTRALIAN FOREIGN

EXCH~~GE

MARKET

The Australian foreign exchange market . iong the sole preserve of the trading banks operati'lg as the agents of the Rese r ve Bank of Austr.11ia, whose experl.ences defending .1 fixed exchange rate have over the lnst decade been less thiln succe,o;sful, has undergone sign1ficant change ,o;ince December 1983 and wi l l continue to change significantly. The trading bunks now operate on their 0\0]11 account and are not underwritten by the Reserve B1lnk ilnd are able to offer extended services in the fon:~ign exchange fje l d to their cl i ents . The t r ading banks have been joined in the market by a large number of non-b1lnk dealers, the SUl t US of some of which mny change as a re:clult of the decision to licence 1 6 new foreign banks in Austr;llia , while the Treasurer has indicated an open ended commitment to allow new dealers to enter the market subject to their meeting prudential req ui rerneuts. In so fOIl' .1!.l an outside observer can determine, there 1,,; oniy a small number of de,. lers 'Includi.ng non-bank dealers (it has been suggested that this figure is as low as Six to eight) who 'lctively adopt a market maker r ole . The Australian market, as one would expect, is r ela t ively thin where small tr a nsactions cml have a disproponiou,,'te effect on the rate . I would think it a reasonable propOSition to put tlmt the Australian market is still digesting the changes made in 1983 Hnd 1984 and would further think that the performance of the market iast month, although rather disorderiy at spec! flc instances, wa s not unduly disturbed, given the trading conditions which prev.dled through globa l foreign exchange markets. It wiii take some time for the business community to become fully m>are of the opportUeposure , for interniltional

Economic Analysis and Policy

73

Vol. 15 No. 01, March 1985

por t folio diversification and for tradi ng in the ncwer ins tr uments in the f oreign exchange market . Consequently it would be rCHsonable to expect greater development and diversification of the Au stra l i,1n foreign exchange market i n 1985, a process 14h1ch may be
THE AUSTRALlAIl

EXCIiAl~ GE

RATE - 1985

The fact that we now have a f l O
home very clearly and dramatically in the last two months to all Austr
If we revert to my pl.'evious discllss i o n of a smnll open eco nomy, i t becomes clear that in a Hmall open economy , wo r ld eve nt s wi l l necessnrily dominate domestic ac t ivity . With this b a ckgrou n d in pl
74

AUSTRALIAN FOREIGN EXCHANGE MARKET

Economic Analysis and Policy

DAILY QUOTE (HIGH) SUS/SA

83 82 81 8. 7.

*•

78

>-

77

0

0

Vol. 15 No. 01, March 1985

Z w u

7.

~

7' 7. 73 72

71

7. JAN 85 SOURCE : AUSTRALIAN FINANCIAL REVIEW

FEB 85

75

AUSTRALIAN FOREIGN EXCHANGE MARKET

=

,

300

250

200

Economic Analysis and Policy

DAILY TRADING RANGE (SUS/SA)

i"z a

Vol. 15 No. 01, March 1985

~

150

..

,

50

o

z JAN 85 SOURCE: AUSTRALIAN FINANCIAL REVIEW

FEB 85

76

Economic Analysis and Policy

Vol. 15 No. 01, March 1985

1.

As we might expect from the previous discussion , tur nove r tn the market has increased substantially due to a sharp increase in tnter-bank dealing .

2.

Against the SUS, and $A declined by about 15 per ce nt in the period {rolD the beginning o f 1985 to mid-~Iarch and by a s light ly les~er percentage i n trade weighted terms.

3.

The m.1 rket was highly volatile in February .,nd, although the mnrket steadied in Mnr ch , it still dlsplnyed clear evidence of volatility. In February, the dally rnnge over which th e $A traded inc r e,}sed dramat i cally r eaching an unprecedented 350 point range on one dny. The dny-to-dIlY fluctuillions against the SUS have been drllmatic ; swjngs of two per ce nt hllv e been conuoon; a day-on-dllY change of over five per ce nt hal> been recorded nnd in one two-day Ileriod the $A vnrl ed by over ntne per cent, 1.1.' . , up and down.

HO'..l TO INTERPRET THE CHANGE IN THE EXCHNIGE RATE in view of the developments in, nnd lltruc ture of . the foreign exchnnge II\I1 r ket It bccnmc clc.1r Chnt mnny a! the explanations of the chllnge in the Austral inn doilnr have been , to put It mUdly, less than nd equate . In a mnrket dominated by trnnsactions arising frolll portfolio re-adjustment, nnd in which the trading horizon 1s ext remely sho r t , day-to-dIlY and week-toweek ami month-to - month va d ations do not, and cmmot, tell UB anything about the economy ' !; comparative advantage, relative economic perform.,nce or long lcrlll econolllic perfonnance or long terlll economi c prospects . In a highly orgnnized asset IlI.lrket, I>llch nil the foreign exchange market , It is cxtremely difficult, and that again is putting it mildly, to sepllrate out rnnd om fnctors from short term di seq uillbriUIII; moreover exchange rates clln d1ve r g
77

Economic Analysis and Policy

Vol. 15 No. 01, March 1985

unfilled need for structural ad j us tment in the Australian economy but this re-adjustment has predated the float and i ll required wh atever exc hange rotc or whatever the behaviolJr of the exc hnnge rnte under eithe r exchange rnte regime.

POllCV ISSUES IN FOREIGN EXCHANGE MARKET Let .e address mysel f to t wo questions:

1.

Sho uld we retain a floating e xcha nge rate?

2.

Shou ld the Reserve HlInk intervene In the market in an attemp L to Iron o ut the day- t o-d ay swings?

The sho rt answer to the ( 1 rst of these questions Is yes nnd no to the second. The log i c of the decisi on to float is that the exc hange f atll I,. no longer a polIcy obj ective nor is it an instrument of poli cy : it Is now a floatIng economic vadable. The effects of a fl oating rate \~ill , as we oliey . I en n see no reason , save t hat of the s uperior ca pital position of the B;:mk , to suppose thilt thl:' Ret!erve Blink ca n do better in speculntl.ng ag., in st the mll r ket th;m eHn otln:> r dealer". In the co nditions whi c h prevailed in the mn.rket last month, tryi.ng to slIK){lth dnt Iy flu c tuations surpassed the lilbours of lIercules liS II test of strength and e ndurance. Certainly those "urOI.ean central banks which attempted the task have withdl:".awil li c king their wounds. "'Uho ut wishing to appear unpatrioti c , 1 cllnnot believe we have a central bank o f heroic and godlike ststure.

A LOOK AT THE FUTURE Any comment on the fu ture of the Aust r alillll e xchange rille requi.res ;m explanntion of the s tfength and fl'Lure coun,e of the US do l. l.ar . lis 1 have explai ned, 1 would attribule the strength of the US dollllr to two major factor s : 1.

A sh i ft in portfolio preference vhic h recognises the value of assets denominated in US dollars; this, 1 think, was the haUlI\3rk of a perraanent shift.

2.

A current evaluation of the US economic performance . nnd prospects , liS be ing very 6t l:" ong .

I would think that there has been some overshooting and some correction of the r ate will occ ur. I would "lso think that , on present i.ndlcations, th e cxpectutions regarding the future performilncc of the US economy ure fully in corporated In the exchange r.1tO, so that continua ti on o ( the good news by itself will not boost t he exchange rate flJrth el' : for thnt to oceul:" even stronger economic news is required .

Economic Analysis and Policy

78

Vol. 15 No. 01, March 1985

J \'/ould think also that the persistence of a US exchange rate at ;myth ing like current levels will set in t r
In addition, the long standing "farm loan" problem \'/ill not be ,111eviated by difficulties in exporting fm·m products , The strength of the US doLLnr wi l l contribute to further problems f or third world debtor notions ilnd the fragile arrangements to reschedule debt repayments c llrrently in force Clln be predicted to come ,mtl er fu r ther strai n. US flnlHlciill inl;tltutions ;J[e unlikely to be nble to hide problem lo"" s in their balance shee t s bec;llIse regulatory agencies, (ollowing the criticisms o[ their actions in the Continen ti lll Illinois rescue ,
CONCLUSIONS 1n r el8tion to the Austrnlinn foreign cxchan gc lIIarket, T 140uld expect:

~1iss

I.

thilt there \,/111 be furthe r developments during 1985. particulnrly in response to needs for hedging and incrensed international portfolio dlversificution;

2.

the ma r ket wUi con tinue to be vo l i.ltl1e ;

3.

some improvement of the Australilln dollar ngni_nst the US tlollllr can be eXllected; ilnd

I. ,

the dOn1('stic economy will continue to come t o experience difficulty In coming to g r ips with the fa c t tlwt the exchange rute now flo;lt R.

I'erhaps could co nclude by reminding yo u of \11Hlt Cecily said after I'rlsm ' H Inst r uctio n: Cecily (picks up books :lIld throws them bilck on (h£! t ab l e): Ilorrlr.l Polltic