07 May 2005 REUTERS/China Newsphoto
Saturday, May 07, 2005
photo
07 May 2005 REUTERS/China Newsphoto
The Impossible Trinity
The foreign exchange market is really an amazing place. It is also the most dangerous and rewarding place to speculate. But disregarding that aspect. it is interesting to see how currencies move against one another and what approaches different governments have in regards to their foreign exchange mechanisms. Each country has the right to decide what exchange regime it will follow and the choices are roughly between fixed, partially fixed and a floating rate. Most of the developed countries like US, UK, Europe allow their currencies to float freely against one another. But this free floating brings in lot of uncertainties for international business and trade, so the developing countries try to have some control on their exchange rate.
Now what exactly in money and what does the exchange rate movements signify. Since money is just paper, all its value comes from the faith that people have in its value. Inflation is something that eats into the purchasing power of money. How stable and strong the currency is depends on the inflation - and indirectly on the faith that poeple have in the central bank of a country. If they think the central bank would not let inflation be too high so that the money in their hand does not lose purchasing power, the currency would be relatively strong. Currency market is forward looking, i.e it inticipates what will happen in the future and incorporates that today. So if people sense that inflation would eat into their purchasing power, the currency will start losing value. This is generally in a longish time frame. Day to day fluctuations for currencies that float freely is just caused by supply and demand. Thinking of currencies as commodities, currencies which are in demand gain value and currencies in less demand lose value. The one certainty with currency markets is that it is nearly impossible to predict which way the currency will move and when. There are so many complex economic, political and financial factors that drive the whole thing.
A cool concept is foreign exchange regimes is what is known as the impossible trinity. (Shown Below)
If a country tries to implement any of the two above, it has to forgo the third. Take the case of India. Say of we want an independent monetary policy and fixed exchange rate. In this case we would need to impose capital control. Why? Say lots of people want to invest in india and start demanding more and more rupees. This will cause the interest rates to rise. But we have an independent monetary policy, so the central bank buys bonds in the market and increases the money supply to ease the pressure. But under this situation it is impossible to maintian a fixed exchange rate cause the speculators see that your currency is appreciating and you are not allowing the value to go up. They will then launch attacks on your currency which you wont be able to defend for long since you have allowed free capital mobility.
Anyways, I found this article on rediff addressing same scenario wrt the RBI policies ..
RBI and the 'dirty trinity'
The "impossible trinity" in monetary policy is achieving three things at the same time: exchange rate stability, free flow of international capital and an autonomous monetary policy (which means the ability to target inflation and/or interest rates).
Now what exactly in money and what does the exchange rate movements signify. Since money is just paper, all its value comes from the faith that people have in its value. Inflation is something that eats into the purchasing power of money. How stable and strong the currency is depends on the inflation - and indirectly on the faith that poeple have in the central bank of a country. If they think the central bank would not let inflation be too high so that the money in their hand does not lose purchasing power, the currency would be relatively strong. Currency market is forward looking, i.e it inticipates what will happen in the future and incorporates that today. So if people sense that inflation would eat into their purchasing power, the currency will start losing value. This is generally in a longish time frame. Day to day fluctuations for currencies that float freely is just caused by supply and demand. Thinking of currencies as commodities, currencies which are in demand gain value and currencies in less demand lose value. The one certainty with currency markets is that it is nearly impossible to predict which way the currency will move and when. There are so many complex economic, political and financial factors that drive the whole thing.
A cool concept is foreign exchange regimes is what is known as the impossible trinity. (Shown Below)
If a country tries to implement any of the two above, it has to forgo the third. Take the case of India. Say of we want an independent monetary policy and fixed exchange rate. In this case we would need to impose capital control. Why? Say lots of people want to invest in india and start demanding more and more rupees. This will cause the interest rates to rise. But we have an independent monetary policy, so the central bank buys bonds in the market and increases the money supply to ease the pressure. But under this situation it is impossible to maintian a fixed exchange rate cause the speculators see that your currency is appreciating and you are not allowing the value to go up. They will then launch attacks on your currency which you wont be able to defend for long since you have allowed free capital mobility.
Anyways, I found this article on rediff addressing same scenario wrt the RBI policies ..
RBI and the 'dirty trinity'
The "impossible trinity" in monetary policy is achieving three things at the same time: exchange rate stability, free flow of international capital and an autonomous monetary policy (which means the ability to target inflation and/or interest rates).
It is 'impossible' for straightforward reasons: if capital is free to move in and out, and the exchange rate is fixed, then money can swing in and out in huge quantities and play havoc with domestic inflation and interest rates -- which then rules out an "autonomous" monetary policy.
This is well known to economists, of course. And it provides a useful framework to understand what Y Venugopal Reddy, the RBI governor, is trying to do through monetary policy. Among other things, it might tell us what is in store as we move through the new financial year.
For a start, Dr Reddy has clearly indicated that the tolerance limit for inflation in India is now 5 per cent, if not less.
Old-timers will recall that the politically tolerable limit for inflation used to be reckoned as 10 per cent, while the long-term average inflation rate for India is around 7 per cent.
The limit today is not set by political compulsions, though. It is set by the fact that the inflation rate in the developed countries is about 2 per cent. If we want to integrate the Indian economy with the rest of the world, then our inflation rate must start getting closer to theirs.
But targeting a tighter inflation limit of 4-5 per cent means that both interest rates and money supply will be used far more frequently to stay within the acceptable inflation band (hence Dr Reddy's introduction of a new quarterly policy cycle).
And it is today's latent inflation that has persuaded Dr Reddy to signal higher interest rates early this week. What this suggests is a strong desire to have an autonomous monetary policy, directed at achieving clear domestic goals.
Take the exchange rate next. The RBI has traditionally tried to hold the "real" (i.e. inflation-adjusted) value of the rupee constant against a basket of currencies.
That undeclared policy still holds, which means that the RBI wants one of the legs of the trinity: stable exchange rates. Yet, the RBI does not always intervene to ensure that the rupee is valued as officially desired.
By one calculation the rupee today is about 4.5 per cent higher than what the "real value" policy would dictate. In that sense, the rupee is allowed to float within limits; as they say, it is a policy of "dirty float".
Then take the third leg of the impossible trinity: capital flows. If the rupee is ruling stronger than what the RBI would like, one reason is the strong capital flows into the country's stock market.
And at the interest rates that exist in the Indian system, even more money would come in and be invested in the debt market -- if the RBI would allow the big institutional players to do this.
But it won't, because this would affect all the variables negatively (as the RBI sees it): it would send the exchange rate even higher, and it would cause problems in managing the money supply (which would impact inflation).
Therefore, the RBI keeps a lid on further opening up to capital account convertibility, frustrating many reformers.
In short, the RBI is forced to have the rupee value float, but it will be a dirty float. It is willing to have some degree of capital account convertibility (FIIs do move in and out of the stock market, and other transactions too have been freed from controls), but within limits and only in some forms -- in other words, partial convertibility.
What it will not compromise on, it seems, are inflation and interest rates -- among other things, because the size of the government deficit translates into a government borrowing level that in some ways supersedes all other considerations.
If that were not there, the RBI would be willing to let the currency and money markets have a freer run, but that is not to be.
So, as someone in the RBI admitted frankly, for the foreseeable future the central bank's policy objective will have to remain the attainment of a "dirty trinity".Wednesday, May 04, 2005
ughh!
The last week of the sem is here .. and I have a take home exam for my stochastic calculus class. Its a pretty tricky exams.. I'll say .... and infact I have been stuck on one problem for 3-4 days now. Imagine trying to solve just one problem for 3 days .. I tried looking everywhere for some hints as to how to go about solving the question, but no luck. The question is an option pricing problem. It goes something like this- There is a security that will pay you $1 after time T if a particular stock price goes below half its initial value before T.... and $0 otherwise. How much will a customer be willing to pay for this security. We have to find a fair price for this derivative. Will take up the fight again tomorrow !!
Tuesday, May 03, 2005
Monday, May 02, 2005
stonehenge
Dont have much time to write today. This is the final week of the sem and work is surely piling up. Hopefully by friday I will be relativily free. If I find time before that, I might write in ..
Sunday, May 01, 2005
China Trade Surplus With West Still Rising ...
Just continuing on from yesterday. Another article that was published in the NYT.
China's global exports soared in the first quarter of this year, allowing the country to rack up huge trade surpluses with the United States and western Europe, according to detailed trade data released late last week by Chinese customs officials..
Chinese exports in the quarter rose to $155 billion, up 35 percent from about $116 billion a year ago.
According to the figures, which were analyzed by Global Trade Information Services in Columbia, S.C., China continues to run a big trade deficit with Asian trading partners like Japan, Taiwan and South Korea, as well as several oil exporting countries. But its surpluses with the United States and Europe are rapidly widening.
China's trade surplus with the United States jumped to $21 billion in the first three months of the year, up from about $12.4 billion a year ago - a 73 percent increase.
The Chinese statistics are different from those released by the United States, which generally show much larger trade gaps. Last year, the United States government said that China had a $162 billion trade surplus with the United States, the largest ever recorded.
In the first three months of the year, China's trade surplus with the seven largest traders in western Europe - Belgium, France, Germany, Italy, the Netherlands, Spain and Britain - rose to about $12.3 billion, up from about $5 billion in the same period a year ago.
Even Germany, which has long run trade surpluses with China because it sells heavy manufacturing equipment to Chinese factories, is now in the red: its $2 billion trade surplus in the first three months of last year evaporated, turning into a $159 million trade deficit in the first months of this year.
I guess there is no end to articles highlighting the Chinese growth and its role in the current global economic scenario. We have a very simple world economic model. China produces, America consumes .. and the rest of the world invests money in the US so that they can consume even more. I read somewhere that if Wallmart was a county it would be China'a seventh largest trading partner!!
Another big issue is the US trade deficit. A trade or current account deficit is accompanied by capital and financial account surplus. So under the present scenario, the rest of the world are lending money to America so that it can consume much more than they can afford. The people who are lending the money believe that the dollar will retain its value and America will always be able to pay back the dollar loans. The majority of these dollars loans are by the cental banks of east asia which have invested most of their dollars into US treasury bonds. The countries with the highest foreign exchange deposits (mostly in dollars) are these very countries i.e China, S.Korea, Japan, Taiwan, Hong Kong. Now the question is that how long will these countries continue to keep on investing their money in the US economy. Bu the problem is that they are stuck in a no win situation. If they indicate that they will no longer buy US bonds, the US dollar will start losing value which will erode the value of their massive savings ..
Another thing I read was that the present value of all US debt obligations is 51 trillion dollars.. and this is way more than the total value of the US economy. In some sense US is bankrupt ... but then people have so much faith in the dollar than they dont care about these facts and believe that the US can pull through .. as it has been doing..
Quoted right from NYT-
We boomers are also preying on children in a more insidious way: We're running up their debts, both by creating new entitlement programs and by running budget deficits today. Laurence Kotlikoff, an economist and fiscal expert who with Scott Burns wrote the excellent and scary book "The Coming Generational Storm," calls this "fiscal child abuse."
The book says that the Treasury Department commissioned a study by two economists of the United States' long-term liabilities, for inclusion in the 2004 federal budget. The study found that the government faces a present value "fiscal gap" - the excess of expected payments over expected revenues - of $51 trillion. That's 11 times our official national debt and also greater than our total net worth, meaning that in some sense we're bankrupt.
I have a few slides here from my multinational business finance class by prof Min Shi.
China's global exports soared in the first quarter of this year, allowing the country to rack up huge trade surpluses with the United States and western Europe, according to detailed trade data released late last week by Chinese customs officials..
Chinese exports in the quarter rose to $155 billion, up 35 percent from about $116 billion a year ago.
According to the figures, which were analyzed by Global Trade Information Services in Columbia, S.C., China continues to run a big trade deficit with Asian trading partners like Japan, Taiwan and South Korea, as well as several oil exporting countries. But its surpluses with the United States and Europe are rapidly widening.
China's trade surplus with the United States jumped to $21 billion in the first three months of the year, up from about $12.4 billion a year ago - a 73 percent increase.
The Chinese statistics are different from those released by the United States, which generally show much larger trade gaps. Last year, the United States government said that China had a $162 billion trade surplus with the United States, the largest ever recorded.
In the first three months of the year, China's trade surplus with the seven largest traders in western Europe - Belgium, France, Germany, Italy, the Netherlands, Spain and Britain - rose to about $12.3 billion, up from about $5 billion in the same period a year ago.
Even Germany, which has long run trade surpluses with China because it sells heavy manufacturing equipment to Chinese factories, is now in the red: its $2 billion trade surplus in the first three months of last year evaporated, turning into a $159 million trade deficit in the first months of this year.
I guess there is no end to articles highlighting the Chinese growth and its role in the current global economic scenario. We have a very simple world economic model. China produces, America consumes .. and the rest of the world invests money in the US so that they can consume even more. I read somewhere that if Wallmart was a county it would be China'a seventh largest trading partner!!
Another big issue is the US trade deficit. A trade or current account deficit is accompanied by capital and financial account surplus. So under the present scenario, the rest of the world are lending money to America so that it can consume much more than they can afford. The people who are lending the money believe that the dollar will retain its value and America will always be able to pay back the dollar loans. The majority of these dollars loans are by the cental banks of east asia which have invested most of their dollars into US treasury bonds. The countries with the highest foreign exchange deposits (mostly in dollars) are these very countries i.e China, S.Korea, Japan, Taiwan, Hong Kong. Now the question is that how long will these countries continue to keep on investing their money in the US economy. Bu the problem is that they are stuck in a no win situation. If they indicate that they will no longer buy US bonds, the US dollar will start losing value which will erode the value of their massive savings ..
Another thing I read was that the present value of all US debt obligations is 51 trillion dollars.. and this is way more than the total value of the US economy. In some sense US is bankrupt ... but then people have so much faith in the dollar than they dont care about these facts and believe that the US can pull through .. as it has been doing..
Quoted right from NYT-
We boomers are also preying on children in a more insidious way: We're running up their debts, both by creating new entitlement programs and by running budget deficits today. Laurence Kotlikoff, an economist and fiscal expert who with Scott Burns wrote the excellent and scary book "The Coming Generational Storm," calls this "fiscal child abuse."
The book says that the Treasury Department commissioned a study by two economists of the United States' long-term liabilities, for inclusion in the 2004 federal budget. The study found that the government faces a present value "fiscal gap" - the excess of expected payments over expected revenues - of $51 trillion. That's 11 times our official national debt and also greater than our total net worth, meaning that in some sense we're bankrupt.
I have a few slides here from my multinational business finance class by prof Min Shi.
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