)
One of the currently accepted wisdoms of currency markets is that prospects of higher interest rates in an economy attract capital, appreciating the currency: this is the ostensible reason for the rise of the US dollar against the euro and the yen over the last year or two. Many commentators and policy makers in India also worry about whether the expected rise in US interest rates later in the year could lead to capital flight, putting downward pressure on the rupee. I have been wondering for a long time about the root of the supposedly strong relationship between rising interest rates, capital flows and currency appreciation.
Perhaps the origin of the “logic” goes back to the Gold Standard era which collapsed in the inter-war years. As will be recalled, in that era, countries did not have independent monetary policies: the money supply was determined by the amount of gold with the central bank, and the only way to attract foreign capital and ease money was to increase interest rates offered by the central bank on gold deposits. Thus, there was a positive correlation between interest rates and money supply.
Is the gold standard era logic equally valid in today’s circumstances when central banks can create (or destroy) domestic money in circulation through monetary policy, administered interest rates and/or open market operations – not by attracting foreign capital, or driving it out? In fact, in today’s global economy, a strong case can be made that prospects of rising interest rates should drive capital away from an economy than the other way round: they directly reduce prices of bonds, and are also a bear factor for equity prices. Logically, therefore, existing investors in bond and equity markets would sell their holdings and transfer capital to economies with little prospects of rate increases – and the capital flight should depreciate the currency.
Even the IMF seems to subscribe to the relationship between rising interest rates attracting capital inflows. In its report on the US economy released earlier this month, it cautioned that the Federal Reserve’s “carefully prepared” move to raise interest rates later in the year could trigger “significant and abrupt rebalancing of international portfolios, accompanied with market volatility and damage to financial stability around the world.” It also emphasised that “monetary policies are driving most of the currency movements, as the US Federal Reserve prepares to raise rates while the European Central Bank and Bank of Japan maintain their monetary stimulus.”
Or is it the gigantic level of short term speculation in the currency market (and not interest rates) that is really the driving force underlying the movements in market-determined exchange rates? After all, currency markets trade $5 trillion a day, more than a hundred times the volume of daily cross-border trade requiring exchange of currencies. And, much of this speculation or proprietary trading is essentially short term. As one research report by the Bank for International Settlements evidences, the two most popular strategies are momentum and “carry trades”: the first means following a trend in prices (buying US dollar when it is appreciating) and the second involves shorting a low interest currency to go long in a high interest currency. In theory neither should work were markets to be “efficient” in arriving at prices close to equilibrium values, changing randomly around it: for restoring PPP equilibrium, currencies of high inflation/interest rate economies should depreciate against low inflation/interest rate currencies. But the success of both strategies, momentum and carry trades, suggests otherwise. As The Economist argued in its Economic Focus (December 12, 2009), “If markets were truly efficient, carry trades ought not to be profitable because the extra interest earned should be exactly offset by a fall in the target currency. That is why high-interest currencies trade at a discount to their current or ‘spot’ rate in forward markets.” Carry trades and other speculative activities often “drive exchange rates a long way from their fair or ‘equilibrium’ values”.
In that case, will international monetary co-operation help reduce the de-stabilising effects of the global financial “non-system” favoured by the IMF? As Keynes argued a long time back, "Speculators may do no harm as bubbles on a steady stream of enterprise. But…when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”
E-mail: avrajwade@gmail.com
