Exchange Rates and their effects take centre stage (The Euro,Yen and Sterling)

16th July 2010 by Shaun Richards

As equity markets have calmed down a little since their gyrations of late June and early July exchange rates have taken centre stage. These have not achieved the same amount of publicity as they did a month ago which in some respects is revealing. You see the weakening of economic figures coming out of the United States has led to her currency falling. Putting this another way the Euro as an exchange rate has rallied quite considerably against the US dollar. This has many implications but I notice that many news media and newspapers have effectively ignored this rally, I guess it does not fit the story they want to tell. Back on the 7th June this exchange rate fell to as low as 1.19 but yesterday it rallied 0.02 to above 1.29. You’d think a rally of nearly 8.5% would be news. Indeed a rally in the US dollar of this amount would have been but not in the Euro it would appear.

Effective Exchange Rates

One way of looking at a currencies position overall is to look at an effective exchange rate which is an attempt to calculate a theoretical exchange rate which represents a countries trading pattern weighted to the currencies of the countries it trades with.

The Euro

The Euro has had an interesting pattern since it began. It fell to 80.96 back in October 2000 and its high has been 115.8 on the 18th December 2008 and its average has been 100.10 since its inception in 1993.

If we look at what has happened in recent years we can see that the strength of 2008/09 was a factor in the problems of the euro zone in 2010. For the weaker peripheral countries such as Greece, Ireland Portugal and Spain the currency strength contributed to a competitiveness problem. Now if we look at the recent fall in the Euro which started on the 26th October 2009 at 115.17 and hit a low of 99.86 on the 8th June 2010 one can see that it should have helped with this problem. If look at the figures over the past year we have seen the Euro on this basis fall by 8.1%. The rally since the 8th June has taken us back up to 102.6.

The Economic Impact of this

The first thought I had when looking at these numbers was that they put the recent fall in the Euro into context. If you look at its recent fall it only just fell below its average since inception. So some of the screaming headlines look at little overdone as 99.86 is only just below 100.1 which is its lifetime average. Indeed some of the railing at speculators by Europe’s politicians looks rather over-done too.

The actual fall in the Euro exchange rate would have been a benefit to the euro zone at a time it needed it as her exports should have become more price competitive just as a time when price competitiveness was and indeed is a problem. Just when the euro zone desperately needs some economic growth to help with its fiscal deficits the Euro was doing its best to help. I always thought many of the headlines and indeed statements from Europe’s politicians and officials to be curious as the “wolf pack” were in fact in this instance helping Europe adjust. I notice that Wolfgang Munchau in the FT once called the leaders of the euro zone financial illiterates well in this instance they deserve that title in my view. As Germany was most likely to be the nation that benefits from such a move and the peripherals less likely to do so then the “internal problems of the euro zone would have been exacerbated but this is likely to have been a small price to pay for the euro zone growing more quickly overall.

Actually  the rally in the Euro’s exchange rate that has taken place recently is not as unfavourable as you might think. If you look at the numbers I have quoted above you see that the rally against the US dollar (8.5%) is much larger than the general rally (2.7%). As many commodity prices are priced in US dollars this means that the rally will be anti-inflationary whilst only have a small impact on competitiveness.

The Japanese Yen

One country that can seem almost obsessive about exchange rates is Japan. The reason for them being more talked about there is simply because Japan is such a large exporter. Also if you look at her economy and see her struggle to increase her internal consumption over the past twenty years then you can see that Japanese hopes for the future depend on exports.I have written several articles on her problems with domestic consumption and its corollary of disinflation and at times deflation.

Here the pattern is not the same as for the Euro the Yen has been strengthening against the US dollar since the 18th June 2007 when the US dollar bought 124.16 Yen whereas it only buys 87 right now. Japan’s exporters have had a difficult time dealing with this and the recent general fall in the US dollar will not help. For many countries a rise against the US dollar has the impact of reducing inflationary pressure but remember Japan is mired in disinflation so she is the one place in the world that will not welcome this. So exchange rate movements since the middle of 2007 have been something of a curse for Japan. On an effective exchange rate basis Japan did get some relief in early 2009 when her currency fell including for a few months against the US dollar but unfortunately for her the more recent trend is up.

Japan and her consumption tax

Recent weeks have produced something which to my mind is slightly curious from Japan. The new government of Nakato Kan established an early priority of reducing Japan’s fiscal deficit and its (enormous) national debt. This is welcome news although it is a massive task as her national debt is over 200% of her Gross Domestic Product and is only sustainable at all because Japan is a nation of savers. If she was like the UK for example the bubble would have burst long ago.

Mr Kan’s Democratic Party of Japan (DPJ)government called for increasing taxes in the run up to the July 11 upper-house elections as part of his effort to reduce the fiscal deficit which is not usually a good strategy to seduce voters! However it was at least a welcome contrast to the recent UK election where political parties dodged the subject. He argued that more tax revenues could bolster social welfare programmes, in turn helping to lift Japan out of its prolonged economic malaise and boosting living standards. Old Liberal Democrat Party policies such as massive public works and deregulation have failed, he felt, leaving the nation saddled with vast public debts which he planned to try to control.

Sadly this honest approach did not work well with the electors and the election was something of a set-back for Mr.Kan. However his plan for a consumption tax has found a supporter in the International Monetary Fund. It feels that Japan should start raising its consumption tax from 5 per cent next year to help restore its fiscal position. It has called for a gradual rise to 15%  “over several years”.


If you read my previous articles on Japan you will see that a constant theme and problem in Japans economic history has been a lack of domestic demand. Those at the Bank of Japan have probably pulled their hair out so many times in frustration at their inability to influence this that they may well have none left. So a plan to tax consumption is at best very curious. I cannot help but feel that a hike is likely to further suppress weak domestic demand and run the danger of plunging the economy back into recession. If we look for a guide from the past then a rise in the rate from 3 per cent to 5 per cent in 1997 was quickly followed by a harsh downturn.

So if this is a cunning plan I fear that it is likely to be a “cunning plan” of the sort constructed by Baldrick in Blackadder. For those who wonder why I supported a rise in a consumption tax in the UK but do not in Japan it is quite simple. We are natural consumers and are more likely to shrug it off. This is not the first time that I have accused the IMF of having a rigid “playlist” or a one size fits all policy. I am afraid the one size does not always fit all.

UK Sterling

The battered UK sterling has managed quite a decent rally recently. I was personally grateful for this as I got just under 1.20 when I bought some Euros for my holiday a fortnight ago which compared with 1.10 last year. Although the 1.50 of 3 years ago has long gone! After falling below 1.10 in March we rose to a high of nearly 1.23 at the end of June,although we have since slipped back to 1.19 as the Euro has strengthened in July. Against the US dollar after a low of 1.43 on the 18th May we have now rallied to just above 1.54.

Some may remember the stir in the press and other news media when we went below 1.50 which has not been repeated as we have gone above it. Rather one-sided you may feel and you would be right.

Economic implications

The recent rally in sterling is likely to have a weakening influence on our balance of payments. This is not in itself particularly helpful as it will impact on our economic growth just as we badly need some. However the move so far has been relatively small (for a small open economy anyway…).

However there is a much more helpful effect. As many commodity prices are denominated in US dollars then the rally against the US dollar will help to reduce our inflationary tendencies which have been a problem throughout 2010. Indeed as our Monetary Policy Committee continues to fail to take action on this front it would appear that this particular rally may well turn out to be rather beneficial and be the best hope of an improvement we have. There is a further irony in this as Mr.Posen who is a member of this committee has given speeches recently which have suggested that the MPC feels that our exchange rate is less of an influence on inflation and the UK economy than the Bank of England has suggested in the past. But these days the Bank of England seems to undergo intellectual contortions rather regularly in what I consider to be an unhealthy fashion.

Further Thoughts

In the area of exchange rates the the euro zones politicians did deserve Wolfgang Munchaus description of “financial illiterates” as they attacked what were favourable exchange rate moves.

The IMF is again applying policies for a pre-set playlist. If you look at it another way you could say that it operates with something of a similarity to a cult.

Seeing Japan also began to take up the austerity banner provokes a line of thought that has troubled me over the past few weeks. Whilst austerity individually is a good thing for many countries the world is running quite a risk with so many trying it at the same time.

19 thoughts on “Exchange Rates and their effects take centre stage (The Euro,Yen and Sterling)”

  1. Jonathan Treloar says:

    Do you think Ireland may have been wise to get its austerity in first?

    1. Hi Jonathan
      It certainly gave Ireland credibility in financial markets as opposed to say Spain and Portugal which had to be in effect forced into it. Indeed in many respects Ireland’s response to her problems have been exemplary. However the fact that she stole a march in terms of timing may not be much of a gain as her problems were so severe in terms of her property sector that it will take years to improve and fix I feel.

      I finished my article in the way I have today to make the general point that individually many countries should embrace austerity but there are second and third order effects of so many doing it at the same time. There is kind of an echo of the competitive devaluations of the 1930s in this…

  2. Ian says:

    Isn’t it possible that if Japan were to announce, say, that consumption tax will increase from 5% to 15% in a series of steps over the next 5 years that this would stimulate spending by households?

    1. Hi Ian
      There have been suggestions of this. But if you take that line then you have to explain what happened in 1997 when this last went up as in essence Japan’s economy then went down. Of course there are always (in economics) other factors but it is not an inspiring precursor. Also I do not hear much talk of this ahead of the rise in VAT in January 2011 in the UK and we are more natural consumers than the Japanese. So at best it will be a small short-term influence I think and it will have long-term negative effects.

  3. Graeme B says:

    Two suggestions to remedy Japan’s currency and population deflation:

    1. take rate of deflation for the year (or 6 months?) and purchase this amount of JGBs, in terms of % of GDP, for cancellation.

    2. income tax breaks for children – say 5 or 10% per child up to some large maximum per child.

    do you think these are outrageous enough to cause a run on the Yen?

    1. Hi Graeme
      I like the idea of the Japanese trying to engineer a run on the Yen! In many ways it would suit them and many of the problems that other countries would face from it do not apply to the Japanese. For example they would actually welcome some inflationary pressure. How do you do it though? It seems mostly outside the ability of politicians as the bar for stupidity with them is set so low….Also there is always the danger with this sort of thing of generating something that you cannot control.

      Encouraging child birth might be worth a try but of course there are many other factors in such decisions and how much impact tax breaks might have is pretty much unquantifiable I think.

      1. Graeme B says:

        Creating a gentle run would be the trick… I figured that small, regular monetization of debt would fit the bill – assuming a rate of deflation of ~1%, it would still take more than 100 years to make all the existing government debt evaporate. They could even argue they were just counteracting deflation.

        I still think that tackling the demographic issue is the key to solving the problem long term though. Income tax breaks would be a little bit of mischievous social engineering, encouraging the middle classes and the wealthy to have children rather than the poor (not that any government in its right mind would want to admit this).

  4. Drf says:

    Hi Shaun,

    I am not sure that the old chestnut about lower exchange rates giving an export advantage is true. In the first place for a country like the UK materials, energy, components, sub-assemblies, minerals or other elements have to be imported to produce most of the exported products. A low exchange rate increases the net cost of these imports to the producer, which reduces the resultant profits they make per unit. In addition, in an already saturated and increasingly competitive global market, which depression exacerbates, it becomes like chasing of a pot of gold at the source of a rainbow, to generate more volume at the expense of profit and yield.

    Thus in such times as these there is every argument for lower volume but greater per unit contribution being the advantage. In any case government spending overseas is always a significant factor in the ongoing balance of payments deficit. Anthony Nutting did significant objective analysis of this weakness some years ago. The significant spending on the wars in Iraq and Afghanistan has contributed a great deal to this imbalance.

    So as one with quite intensive experience of involvement in net export costings and profits I must express my considered and established opinion of the fallacy of this viewpoint, that a lower exchange rate generates more net export-derived income for the country overall, and that more volume at a lower contribution automatically means more profit. Like many other fallacious and dangerous ideas which have become the present left-wing norm with semi-neo-Keynesianism, I feel this argument needs to be examined properly in terms of the real evidence.

    1. Hi Drf

      I think it is yet another area where conventional economic theory needs some revision in my view. It is an area where algebra,probability functions and economics combine to give a false view of reality. For example just because you can draw a continous mathematical function for export price elasticity and mathematically calculate an expected increase in exports for a 1% change in your exchange rate does not mean that this will happen in reality. I feel that you also need to factor in how volatile exchange rates are, and also realise that for some products it would take a reasonably sized move to make any real difference.

      As Greece is a common subject in economics these days I think that she is a case in point. Whilst favourable moves in her currency will help, as in essence she does not produce that many tradeable goods the effect would be small. Her main tradeable “product” is tourism and it not very likely that a 1,2,3,4 or 5% move would make any difference to that whereas 10% or 20% might. So for ages on a currency depreciation you would get a small effect and then a much bigger one.

      So I agree the subject is more complicated than it is often presented as and in reality can be opaque and hard to predict with any precision…

      1. Drf says:

        Hi Shaun, glad you agree that this subject is more complicated than usually presented. A great deal more examination of the real detail is really necessary before making the glib pronouncements which most modern economists seem to now make on this issue.

        Of course that is usually mainly to support a particular political leaning rather then an objective properly quantified economic analysis, inevitably because to take action to avoid an exchange rate collapse would almost always result in politically damaging consequences to an incumbent government.

  5. Shireblogger says:

    Exchange rates : interesting to consider this against the fact we have near zero interest rates in UK/US/Jap, slightly higher rates in Eu, deflation in Jap,inflation worst in UK,US and Eu inflation stable-ish. When monetary expansion ends, what then for sterling.

  6. Mr.Kowalski says:

    Shawn.. the Euribor ?

    1. I know
      It is 0.861% now for the 3 month version and its rise is a clear sign of the stresses in the European banking system. There was news this week that Spanish banks are borrowing more and more from the ECB meaning that they like their Iberian neighbour Portugal’s banks cannot get funding elsewhere.

      I get the feeling that the bank stress tests may well follow the usual pattern for euro zone measures of calming things down and even improve things for a day or two until markets spot the flaws. I wonder if they regret now introducing the idea….

  7. seanbroseley says:

    We need to find another planet to trade with so that we can all improve our balance of payments.

    1. Do you not have the feeling that if we traded with the man in the moon, the clangers, or little green men that somehow the UK would manage to be in deficit!?

      1. SeanBroseley says:

        Undoubtedly planet Zog would have an educated but cheap labour force and we’d be sunk.

  8. Richard D says:

    Hello there. I have been reading quite a bit on econonic matters recently, to try to educate myself and help decide better where to invest my hard earned. I have followed your blog for a few months now and must say I find it very readable and interesting, even if I can’t follow all the economics yet.

    One thing which puzzles me is why, given japan’s apparently dire
    economic situation, is why the yen is so strong. If I remember correctly the trend used to be around 200 to the pound, now it’s around 140. Japan depends on exports, major markets in recession, etc (or is it the poind so weak vs the yen) Is it affected by the carry trade like the swiss franc ? Thanks

    1. Hi Richard and welcome
      Actually my first thought on reading your question is whether Japans situation is dire. There are respects in which it is (disinflation/deflation, relative size of her national debt, population trends, lack of domestic consumption growth). However she also has strengths it terms of her manufacturing capacity, exporting and her peoples tendency to save. Of course the saving tendency is the flipside of her lack of consumption.
      The reason for my listing them is that if you list all the main currencies around the world they have weaknesses. The way I rationalise it to myself is that it is currently a height contest amongst pygmies (with no offence meant to pygmies). So I think it is the fact that Japan has strengths which has supported the currency since 2007 (and before). The idea of an exporting nation having a strong currency used to be used by Germany before she joined the Euro so it is not so unique and there are elements of such a strategy in the way the Euro has at times behaved.
      It is quite possible that the Yen has been boosted recently by the unwinding of carry trades but because she is a bigger economy has probably weathered it better that the Swiss who to my mind have real problems. Usually countries hit trouble because of a weak currency but the Swiss may be about to hit real problems because theirs is so strong…..
      This year flights to perceived quality have swamped other factors in many markets and Japan in an economic sense has probably benefitted from this. As to when this will change is difficult to predict precisely as her problems are slow-burning and it is almost impossible to know when the “thought-bubble” will burst. Many so-called experts have shorted the Yen but have been wrong and personally rather than sit and wait I would rather join a move that is beginning if I get the chance.
      Exchange rates can ignore economic fundamentals for quite a long time.
      As to levels when I worked in Tokyo in the early 1990s 260 sticks in my mind as an exchange rate so we have nearly halved and yet they still export and we have a balance of payments problem, there is food for plenty of thought in that in my view.

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