TCS Daily

Exchange Games

By Christopher Lingle - October 25, 2004 12:00 AM

China's refusal to allow its currency to respond to market forces has attracted unwanted criticism. It is almost certain that Beijing's fixation on pegging the yuan with the dollar appears on the agenda of any international meeting that addresses economic issues.

Of course, China is not the only sinner. For their part, generations of Japan's corporate and political leadership have revealed a preternatural fear of a rising international value of the yen. At the same time, South Korea's financial and monetary authorities have been very active.

Indeed, virtually every country following an export-led growth strategy follows the same path. An artificially-low currency is seen as aiding local exporters in maintaining their global price competitiveness and allowing foreign currency reserves to rise.

Ironically, the increasing foreign exchange reserves become part of the problem that lead to costs that almost certainly outweigh the presumed benefits. In particular, most of the remedial steps lead to creating public-sector debt instruments that lead to substantial interest payments.

It turns out that export-led growth and currency intervention are logically inconsistent from an economy-wide perspective. In defending local currency from appreciating, import prices of capital goods and raw materials are kept higher while local facility investments becomes sluggish. However, artificially-low foreign exchange values kept import prices of consumer products and capital goods high. This adds to upward price pressures on the domestic economy that lower the real income of workers.

A hidden loss from defending a targeted exchange rate is measured by differences between interest paid on the bonds and what was generated with the foreign currency bought by the government.

Government actions to keep local currency weak against major currencies cause more foreign currencies to flow into the domestic banking system. In response, the central bank issues bonds to absorb the excessive liquidity from the financial system and thus relieve upward price pressure of the economy.

To this end, the Bank of Korea (BOK) issued monetary stabilization bonds worth 124.7 trillion won as of the end of August to stabilize the currency market by adjusting the level of money circulating the local banking system.

Seoul paid a total of 3.1 trillion won ($2.7 billion) in interest payments for the foreign exchange stabilization bonds from January through August this year. But it has been revealed that of this amount 1.8 trillion won was lost due to speculative positions taken in overseas foreign currency derivatives markets.

Deputy Prime Minster Lee Hun-jai recently admitted the government used foreign exchange derivatives markets to hold down the value of the won against major foreign currencies. As head of the Ministry of Finance and Economy (MOFE), he said that the MOFE had made speculative plays in the non-deliverable forward (NDF) market last year in response to large inflows of speculative funds into the currency markets. It would appear that the government thought that two wrongs would make a right...?

These losses keep mounting. Losses in 2003 from managing the foreign exchange stabilization bonds amounted to a loss of 880 billion won.

As it is, export-oriented economic policies contribute to the decision for governments to intervene in foreign currency markets that tend to push up domestic consumer prices. At the same time, forays into foreign exchange markets usually lead to increased volatility in currency markets since speculators will sniff out profit opportunities created by the interventions.

It might be helpful to trace the impact of monetary policy on foreign exchange markets to see what steps are taken to avoid appreciation of a currency. If the central bank or finance ministry wishes to hold down the international value of the domestic currency, foreign currencies are purchased. Money markets will see an increased supply of the domestic currency in money markets combined with increased demand for the foreign currency so that the value of the former tends to fall relative to the value of the latter.

It is expected that a relatively weak currency will allow producers to sell more exports. Yet the overall impact depends upon the source of the funds used to intervene in foreign exchange markets. When drawn from existing currency supply, liquidity will be reduced in the financial system. In response, central banks tend to seek to maintain sufficient liquidity by purchasing government bonds.

The increased demand for exports leads producers to seek loans from commercial banks that can lend at lower interest rates due to the loose monetary policy. Initially, exporters experience increased profits. But eventually domestic prices begin to rise under pressures of the bidding war to control access to inputs.

When prices of domestic goods and services to rise there will be a decline in profits earned from exports as well as domestic sales. These rising prices end the illusion that growth can be created from thin air by loose monetary policy and export-led growth.

Attempts to manipulate foreign exchange valuations are not only fruitless, they are pointless. History is replete with examples where markets overwhelmed government attempts to impose a change or fight against pressures that determine the relative values of currencies.

Over the past year, the yen has risen relentlessly against the US dollar despite massive interventions from Tokyo. Meanwhile, Japan's record reserves suggest that its capacity to export was not hurt by a strengthening currency. Meanwhile, Beijing's position has inspired howls from protectionists to block its exports while its own macroeconomic situation has been destabilized, most evidently by high and rising prices. And now South Korea is beginning to catch a whiff of the stale odor of stagflation.

Christopher Lingle is Global Strategist for eConoLytics.


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