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Since the European Central Bank announced a trillion euro quantitative easing programme, and the Federal Reserve an end to its very low interest rate regime, the euro has fallen sharply, touching a 12-year low against the dollar. Pundits in India continue to worry about the impact of a rise in US interest rates: will it lead to a flight of portfolio capital from the country?
The accepted assumption is that the rise in USD interest rates will attract capital to that country, as it will get a higher return on bonds.
Some comments:
“Low and negative nominal yields in Europe encourage flows into US fixed income”, (Mohamed EL-Erian, Chairman, President Obama’s Global Development Council, Financial Times, March 10);
“the steep rise in the dollar, which has fallen below $ 1.10 against the euro, was the consequence of the diverging monetary policy paths of the Fed and the European Central Bank” (James Bullard, head of the Federal Reserve of St. Louis, FT, March 24);
“income-seeking investors will be tempted to switch their money from Europe to America” (The Economist, March 21);
Henny Sender of the Financial Times was surprised: “Only in India could a 25 bp rate cut precede currency strengthening” (FT, February 11).
But are there such clear links to interest rate hikes and exchange rate appreciation – and vice versa? After all, if markets are efficient, surely market prices are based on fundamentals? The only theory of exchange rates is that they should equate the purchasing power of the two currencies in their domestic markets: a corollary is that higher inflation should lead to depreciation of a currency. If the Federal Reserve is considering raising rates later in the year, it is because of worries about inflation going up: and, on fundamentals, the dollar should fall, not rise! (Incidentally, the US has a large deficit while the euro zone recorded a surplus over 2014.)
On the other hand, in the era of large, cross border capital movements, it is capital inflows and outflows which influence exchange rates more than mundane issues like trade deficits and surpluses. But is the cause and effect relationship between higher interest rates attracting foreign capital sound? It can as well be argued that prospects of higher interest rates should lead to capital outflows rather than inflows: after all higher interest rates are a bear influence on equity and bond prices, and expectations of higher interest rates may well drive capital out! Will this always be counter balanced by capital inflows in the pursuit of higher income and speculative “carry trades”?
Research by Bank for International Settlements economists suggests that the two most successful trading/speculating strategies are:
1) “carry trade” or borrowing/shorting low interest currencies to invest in/buy a higher interest currency; and
2) “momentum trading” or buying an appreciating currency and selling a depreciating one, which further strengthens the trend, in a classic feedback loop.
In other words, does speculation rather than economic fundamentals determine exchange rates? Sadly, in a $5 trillion a day foreign exchange market, this seems to be the reality. As Nobel Laureate Robert Mundell, the propounder of The Impossible Trinity once argued (The Wall Street Journal, October 18, 2010), “The whole idea of having a free trade area when you have gyrating exchange rates doesn’t make sense at all… All this unnecessary noise… just confuses the ability to evaluate market prices…..What economic function did the exchange rate changes among these islands of stability fulfil? Except for stuffing gift socks of hedge funds, the answer is none." Bank treasuries are reporting a sharp increase in income in Q1 of 2015, thanks to volatile exchange rates.
In believing in the virtues of liberal capital flows and market determined exchange rates, are we overlooking the basic purpose of the foreign exchange market: to serve the real economy by facilitating balanced trade in goods and services? Closer home, while some economists, policy-makers, inflation hawks welcome the proposed independent public debt management agency in order to eliminate “financial repression” (ie lower interest rates than market-determined ones), few seem to criticize the “repression” of the real economy through ever-fluctuating and, in our case, overvalued, exchange rates.
