The 5 Main Factors That Determine FX Rates

by: George Dorgan

The effects of so-called "currency wars" and other central bank actions are small compared to the long-term impact made by five catalysts.

For us, there are five leading factors that are connected with some subsequent indicators. The leading factors are credit or Joseph cycles; current account balances; the financial position of the concerned country; weaker or stronger risk aversion; and the perpetual fact that with time, the difference between richer and poorer nations must become smaller.

"Subsequent factors" like interest rates, (reverse) carry trades and the importance of oil prices only follow the leading factors, but they are by far not enough to explain FX rates. Attempts by Fama and others to use the UIP (uncovered interest rate parity), the real interest rate parity and the purchasing power parity to explain exchange rates could not be confirmed because they got sometimes sustained but often distorted by some of these five leading factors. These distortions did not only occur over shorter periods but over many years.

1) Credit or Joseph Cycles

Credit or Joseph Cycles are boom and bust cycles, especially in real estate. During a boom cycle, higher property values cause consumers to feel more wealthy and to spend more. This leads to increasing local production, especially when the country is a relatively closed economy like the U.S. or Japan. In order to take profit on rising consumer spending, funds and investments are directed to this country (see the asset market model), so stock prices rise. With time, unemployment goes down, wages rise and inflation shows up. In the longer term, this triggers central banks to increase interest rates. If a central bank does not hike rates enough, inflation can persist and the currency depreciates due to negative real rates and funds leave the country again. On the other side, high interest rates prevent local firms from obtaining finance investments at a sufficiently low price.

Credit cycles typically consist of seven years of boom and seven years of bust (or deleveraging), as shown in the following graph from McKinsey. Therefore, they obtained the name "Joseph cycle," from the biblical prophet Joseph that speaks of seven good and seven bad years. It shows that in January 2012 the U.S. had passed 3 1/2 years and another 3 years to go in the bust/deleveraging phase of the credit cycle -- while the U.K. and Spain had maybe even 5 years. Read more about Credit/Joseph cycle, or more generally called "financial cycles" from one of the leading authors, Claudio Borio of the Bank of International Settlement (BIS).

source: McKinsey in January 2012

Even if central banks are supposed to stop excessive booms via higher interest rates, recent credit cycles were actually caused by central banks (read more). Joseph/credit cycles are typically caused by rational expectations, the ordinary investors' expectations about future movements of investments, wages and inflation; real estate prices are the main trigger of rational expectations since inflation came down in the 1990s, while wage and inflation expectations were most important in the 1970s and 1980s.

2) Trade and current account balances

Usually exporters prefer to repatriate foreign profits, caused by a home bias connected with natural risk aversion against the holding of foreign currencies. While local goods are paid for with foreign currency, the latter shows a higher supply and must depreciate.

Some countries like Germany, Switzerland, China and Japan showed consistent current account surpluses thanks to a high savings rate and advantages in productivity. Saving typically happens in the local currency and causes higher amounts of the local currency to persist while monies of countries with lower savings rates are spent and disappear.

Over the very long-term currencies of countries with current account surpluses must appreciate, while the ones of nations like the U.S. or the U.K., that have deficits and a low savings rate, must fall (see more details). High inflation but a weak current account means that money is not saved in the local currency but in a foreign one with lower inflation.

Long-term chart USD/JPY and USD/DEM since 1957, both JPY and DEM with surpluses

During the gold standard and during the Bretton Woods era, countries often accumulated gold with their trade surpluses, which was useless for the global economy, but rather beneficial for the local financial position (see factor 3). With globalization, it makes sense for exporters to take profit of the booming consumer spending of rising nations (see point 5) or of countries that are in a boom phase of the credit cycle, building factories abroad.

In this case profits remain invested abroad, the financial account of the balance of payments shows high capital outflows and leads to a so-called carry trade, often intensified with margin debt taken in the currency of the surplus country. Between 2002 and 2007 this missing capital led to very weak growth of surplus countries like Japan, Germany and Switzerland and the use of the yen and the Swiss franc as the funding currencies of carry trades.

Similarly, a bust of a foreign credit cycle leads to a reverse carry trade: the capital account of the surplus country shows big inflows (see the Swiss balance of payments and the big inflows after 2008).

From the end of the 1960s and with the floating exchange rates, deficit countries paid higher interest rates. This base form of a carry trade helped to counter the "repatriation of profits effect" and limited volatility of exchange rates. On the other hand, it weakens the financial position of the deficit state (see next point), especially if the interest paid is higher than inflation (in the absence of "financial repression"). The concept that countries with high surpluses have lower inflation and pay lower interest rates is reflected above mentioned interest and inflation rate parity.

A main driver of the weak U.S. current account are rising oil prices that take a major part of U.S. imports, while other countries like Switzerland, Germany, Japan and recently, China, are able to profit from shorter distances and/or better (commuter) infrastructure. Other countries with bigger distances like Canada, Russia, Australia or Brazil possess enough oil or other commodities that they can compensate for rising costs of imported oil, these are the so-called "commodity currencies."

3) Availability of funds/financial position and some related FX history

Many less developed countries, but also euro countries like Greece or Spain (but not Italy) do not have enough local capital to boost investments; they need foreign funds. The foreign capital (often called "hot money") leaves such a country far more quickly. This exacerbates risk aversion (see factor 4).

Until 1950, the United States and partially the UK were the countries that had a big capital base.

Development of gold reserves 1955-1971

Consistent current account surpluses help to accumulate capital: During the Bretton Woods era from 1950 to 1971, Germany, Japan and Switzerland were able to transform current account surpluses into big gold reserves and a good capital base, while the U.S. and the UK lost reserves.

source Blanchard, et al. Macroeconomics

Inflation-adjusted growth in these countries was higher, especially inflation was lower. American capital flooded into them, especially when the exchange rates were allowed to float with the end of the Bretton Woods system.

During this period, central banks feared interventions in currency markets because buying foreign monies could be done only with higher money supply, that again fueled local inflation (see why). Monetarist theories with small yearly increases of money supply dominated central banks.

During the first phase of the post-Bretton Woods period, the Swiss franc appreciated by 40% and the German Mark by 30% against the dollar. The appreciation stopped when Volcker increased U.S. interest rates in 1982; the dollar became interesting again as an investment currency.

Emerging markets, especially Latin America, were not able to achieve consistent current account surpluses in the 1970s because their exports were mostly based on commodities ("dutch disease"). The U.S. Fed chairman Volcker won against inflation in 1982 using high interest rates in the U.S. That crowded out investments in Southern America during the 1980s. It led to an era of low global growth between 1981 and 1994, but stronger development in the U.S. and a lost decade in Latin America. Japan, however, improved productivity and was able to increase capital, its international investment position and reserves -- in the form of U.S. treasuries.

The bust of the Japanese bubble led to some more years of slower growth in Asia and other emerging markets, while the technological revolution of the PC helped the United States to grow quite strongly again and attract capital. This capital concentration on the U.S. led to the dotcom bubble in the year 2000.

After the Asia crisis of 1997/1998, state-led economies in China and other Asian countries decided to increase their reserves and their local capital base via current account surpluses and they limited wage increases. With the help of modern communication they were able to repeat the success story of Germany, Switzerland and Japan of the 1960s and 1970s and they did not repeat the same errors as Latin Americans during the 1970s.

Until 2011, the Chinese were in a capital accumulation phase -- that should be followed by a phase of stronger consumer spending (read more).

Capital accumulation phase in China, 1999-2011

The United States remains, despite its weak current account, the country with the strongest availability of funds, last but least because also because the dollar is the world reserve currency.

More on the financial position, wealth and the international investment position can be found here.

4) Risk aversion

The United States not only possesses the largest amount of capital, but contributes a large part to world consumption. High inflation and high oil prices hamper American consumption. By the tradition that caused oil price shocks in the 1970s, markets are strongly driven by the U.S. consumer and U.S. investment houses and so are trading algorithms: a strong U.S. economy helps against risk aversion, while strong Chinese or emerging market growth often pushes oil prices, inflation and market volatility upwards.

Global growth expectations for 2013 are far lower than in 2010 or 2011, but thanks to U.S. improvements, markets shrugged this off, while the strong global growth in 2010/2011 led to a collapse in stock markets in August 2011.

5) The perpetual alignment of rich and poor countries

With time, the difference between rich and poor countries must become smaller. Developed countries must become smarter to maintain higher salaries. Better education for more people leads to technological progress and helps to boost growth, while the scarcity of natural resources hampers it.

Thanks to modern communication, work can be outsourced far more easily than during the "false rise of emerging markets" in the 1970s, this despite increasing oil and transport costs. Therefore, the gap between rich and poor countries must become smaller, while corruption or political insecurities may delay this development.

Between 1950 and 1980, Europe managed to reduce the difference to the U.S. (below both advanced income countries), while since the year 1998, the gap between developed and emerging markets (middle-income nations) has decreased with the consequence that oil and commodities have become a scare resource and an issue for global growth. In recent years, even the 60 low-income countries -- many of them in Africa -- have shown considerable progress, while growth in advanced nations remain subdued.

Looking on the graph below, it seems clear that huge global growth between 2000 and 2007 was not sustainable. On the other side, it demonstrates that the global financial crisis finished in 2009 and that money printing in advanced economies only fueled inflation pressures in low- and middle-income nations. High borrowing rates in China and other emerging markets slowed these economies from summer 2011 on.

The competitiveness issues of many advanced countries in the now globalized economy are solved only with time and rising wages in emerging markets, but not with money printing.

Smaller differences between rich and poor nations does not mean that exchange rates of emerging market countries must always appreciate. On the contrary, countries with current account deficits, rising wages and high inflation, must depreciate with time. One bad example is the continuing depreciation of the Indian rupee, while the Chinese renmimbi has appreciated against the euro since 1996, despite higher Chinese inflation and rising salaries.

Indian Rupee (country with current account deficits) and Chinese Renmimbi (current account surpluses) FX rates against the euro

One important task of currency analysts is to evaluate if the current Brent oil price correctly reflects Chinese, Indian and other developing nations' future growth correctly.

One subsequent factor: Oil prices

An alignment between mid-income nations like China and richer ones like the United States reflected in the Brent oil price has a great influence on trade balances and currencies, while the renmimbi itself is not fully convertible.

Chinese growth rates between 12% and 18% in 2007/2008 combined with low U.S. interest rates drove the oil price up to 150$, while growth of 2-4% let it fall to 30$ a barrel in 2008/2009. The current price of 100$ for Brent oil does it point to a future Chinese growth rate of rather 6% (rather oil and commodity currencies - bearish) or better 8% (oil and commodity currencies - bullish)?

Chinese growth 2004-2013 (source Pictet)

Upcoming new leading factors

Most recently, the increasing trade surpluses of Sweden, Norway, Finland, Germany or Switzerland show that human capital, lower energy consumption and renewable energies have become new important factors in the competition among countries and their currencies, maybe the factor for the next decades (see more).

In the upcoming second part, the reader will understand how FX prices are based on these five factors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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