loans and money

Managed exchange systems such as those with a currency peg or those that try to keep a currency within a defined band are potentially vulnerable to speculative attack. All foreign currency transactions have to go through the central bank, which manages its country’s foreign currency reserves. A speculative attack on a US$ base pegged system usually involves borrowing the local currency and selling it to buy US$. This is usually achieved by using the forward markets. Once the central bank runs out of US$ the pegged system is bound to collapse. Speculators do not act alone and do not have to have the financial resources to bet against the central bank, they are more akin to surfers riding a particularly strong wave.

The foreign exchange market is one of the largest financial markets in the world but it has no exchange. Trades are done by phone or by using computers and it is a 24-hour market. Major foreign exchange centers include London, New York, Tokyo and Singapore. The introduction of the euro seriously reduced the opportunities for foreign exchange traders to make profits as the number of opportunities for cross-currency trades fell.
Trading currencies is arguably one of the most basic trading activities of most large commercial banks. We have already examined ways in which countries can attempt to manage their exchange rates against other currencies. In fundamental terms, however, exchange rates are determined by balance of payment deficits (or surpluses), capital inflows (or outflows) and perceptions of likely future inflation and real interest rates.

This is a particularly useful concept because it deals with that frustrating delay between the change in the exchange rate and the adjustment to the economy. Equally, it deals with both trade and capital flows. Suppose international investors have been buying the equity and fixed income securities of an emerging market economy such as Korea. For some reason, those investors “lose confidence” in the Korean economic story and as a result the Korean won. What does that mean? In practice it means that international investors all try to sell at the same time. However, if investors all try and sell at the same time, chances are their orders will not be filled. The Korean won will fall like a stone, but on very little actual volume.
Classic economic theory suggests that a fall in the nominal exchange rate should lead to a reduction in the current account deficit by making imports more expensive and exports cheaper. However, this assumes that the transmission mechanism from the exchange rate to export and import prices is immediate. We know however that this is not the case. Corporations tend to take a wait-and-see attitude in times of market distress, delaying major price changes until financial and economic conditions become clearer. In economist jargon, as we saw in the monetary approach to exchange rates, prices are “sticky”. Thus, in our example the Korean won may fall without any immediate benefit to the trade and current account balances. This is not completely a hypothetical example because this is exactly what we saw during the Asian currency crisis of 1997–98. Then, a crisis in Thailand focused investor concerns on much of the rest of Asia, triggering a general loss of confidence in Asian assets and currencies. Asian currencies collapsed but on far smaller volumes than the extent of their declines might have suggested. The Korean won collapsed along with the Thai baht, Indonesian rupiah, Philippine peso and at least initially the Malaysian ringgit. Despite this, there was no immediate reduction of Asian trade and current account deficits. Analysts of the Asian crisis will no doubt suggest that other factors were also at work, notably the high importer content within Asian exports. While this was undoubtedly the case, it does not detract from the fact that there was a clear and marked delay between the exchange rate move and the adjustment to the trade balance. For whatever reasons, Korean corporations delayed their price increases.
We can also see this at work from the angle of the exchange rate rather than the trade balance. As an exchange rate appreciates, it causes exports to become more expensive in the currency to which these exports are going and imports from that country to become cheaper. The initial reaction in the trade balance is not negative however. As the exchange rate appreciates, it causes export prices to rise and import prices to fall. This in turn causes the value of exports to rise vs. imports, thus the initial reaction in the J-curve is that the trade balance actually improves. While this is happening, however, the impact of higher export prices reduces demand for those exports, causing falling export volumes. In turn, falling export volumes eventually lead to a fall in the value of exports and thus to a deterioration in the trade balance. The delay between the fall in export volumes and export values and the subsequent impact on the exchange rate is reflected by the concept of the J-curve. That delay factor varies between exchange rates depending on specific export price sensitivity to changes in the exchange rate.