Tuesday, October 21, 2008

Run On Several Currencies

The Swedish krona again fell to new lows against the euro and the dollar, with the decline being particularly dramatic against the dollar.

But it could be worse. Although the South Korean won have stabilized somewhat in recent days after the dramatic plunge last week, several other smaller currencies are experiencing dramatic declines. The South African rand has lost more than a quarter of its value against the U.S. dollar in just little more than a month, while the Brazilian Real and the Mexican Peso have both lost roughly a fifth of their value in just about 5 weeks.

To a large extent, these dramatic declines are the result of the fact that these countries are commodity exporters. But given the decline of currencies like the South Korean won (which is a big importer of commodities) and the Swedish krona, it seems that there is also a general flight of capital away from currencies perceived (whether justifiably from a fundamental perspective or not) to be risky.


Blogger VVi11y said...

What about the argument that a significant cause of the movements in the forex market is due to the highly leveraged positions of the hedge funds being unwound?

11:20 PM  
Anonymous Stuart said...

To see the dollar rally given the exploding debt of the US is almost Orwellian. I can't help but envision the mother of all balloons about to pop.

4:36 AM  
Anonymous Anonymous said...

Kopenhagen in Denmark is 30% more expensive then Malmö in Sweden, just a couple of miles away in a verry similar country?

The Swedish Krona is undoubtedly severly undervalued!


8:33 AM  
Anonymous Anonymous said...

why then sweden's currency is cheap while denmark's not? what's the explanation?

2:53 PM  
Blogger Flavian said...

A Big Mac costs 29,50 danish crowns in Copenhagen and 38,- swedish crowns in Sweden. The exchange rate is at the moment 1,35 swedish crowns per danish crown leaving the danish hamburger 4,8% more expensive than the swedish hamburger.

To that comes that only very few countries are more expensive than Denmark.

I do not argue that currencies can deviate from purchasing power parity, they do, but the theory of purchasing power parity would rather indicate that scandinavian currencies are generally overvalued against those of all countries except Switzerland.

Since Denmark is the Scandinavian country with the best record as far as domestic price stability is concerned I would rather say that the Danish Crown is the safest bet among scandinavian currencies and that the Swedish Crown could and probably will depreciate even more.

4:34 PM  
Blogger stefankarlsson said...

vvi11y: yes that is probably a partial explanation.

stuart: I agree with you that the dollar rally is absurd considering the fundamentals and that it will therefore eventually collapse. But as long as the factors (mainly central bank intervention) driving the current rally remains in place, the rally will continue.

Anonymous: the explanation of why the Danish krone is more stable than the Swedish krona is very simple: they peg their currency to the euro, Sweden does not.

Flavian, as I've told you repeatedly before, there are other goods than Big Macs in the world, and Big Macs are among the least relevant since they are among the least tradable.

5:23 PM  
Blogger Flavian said...

My interest in Big Macs is related just to the fact that it is nearly untradable and therefore reflects the price level of a country extremely well.

Tradable goods tend to cost approximatly the same all over the globe, but untradable goods usually deviate a lot.

Untradable goods therefore tend to reflect the domestic price level very precisely.

If you would use other and supposedly more advanced methods than the Big Mac index you would probably also come to the conclusion that Denmark is an expensive country.

5:45 PM  
Blogger Flavian said...

I am also convinced that the real meening of the theory of purchasing power parity is that under a system of truly fixed exchange rates the world would have a uniform price level for UNTRADABLE goods.

The price level for tradable goods is of course approximatly uniform even under a system of floating exchange rates.

5:49 PM  
Blogger stefankarlsson said...

Flavian, the point (again, as I've explained before) is that there is no reason to believe that non tradable good will be equal. The only reason to believe that goods price will affect exchange rate is to the extent they will affect supply and demand of a currency in trade transactions. But if such transactions can't be made because the goods aren't tradable, then it won't have an impact.

There are different versions of PPP theory. The earlist one did not make any distinction between tradable and non tradable goods, but that version is wrong for the reason that I just explained plus explain below. The newer ones which take that into account are more accurate, but still incomplete because they overlook capital market flows.

6:13 PM  
Blogger Flavian said...

My argument is that under an international gold standard countries with a real exchange rate below PPP would have a higher demand for credit but due to the fixed rate system interest rates would tend to be similar all over the world.

The result of that would be an inflationary boom in countries with real exchange rates below PPP relative to those with real exchange rates above PPP.

That would lead to a uniform price level even for untradable goods.

During the hey-day of the European Exchange Rate Mechanism one could observe that the price level for untradables was almost identical in Germany and the Netherlands with the result that there were no tensions between the guilder and the D-mark, whereas there was tension between the Danish Crown and the D-mark/Dutch Guilder Bloc due to the fact that untradables were more expensive in Denmark than in Germany/the Netherlands.

I would not be surprised if there is a uniform price level in Ecuador and El Salvador. Both countries use the US dollar as their official currency and therefore the law of one price ought to apply even to untradable goods.

However it is beyond doubt that El Salvador and Ecuador have a great deal lower price levels than the US.

6:29 PM  
Blogger stefankarlsson said...

"My argument is that under an international gold standard countries with a real exchange rate below PPP would have a higher demand for credit"

And just why would they have a higher demand for credit?

10:52 PM  
Blogger Flavian said...

I believe that the main reason is the fact that it would be more profitable to produce tradables in low cost countries than in high cost countries with the result that demand for credit would be higher in low cost countries than in high cost countries.

Still I clearly have the impression that this is something I will have to study more closely.

But in short I think it is obvious that the equilibrium interest rate would differ from country to country and that the de facto monetary union of the gold standard would tend to make interest rates uniform all over the world with the result that actual interest rates would be too low in boom regions and too high in regions suffering from recessions.

Therefore recessions would get sharper as well as booms fueled by slightly inflationary monetary conditions.

As soon as I have more time I will start to re-read Goschens book on foreign exchange markets.

Another thing I will study more is classical and austrian interest rate theory to see where they differ and where they are in accordance with each other.

12:42 AM  
Blogger stefankarlsson said...

"believe that the main reason is the fact that it would be more profitable to produce tradables in low cost countries than in high cost countries with the result that demand for credit would be higher in low cost countries than in high cost countries."

No, it wouldn't. Had you read my earlier reference to you about Balassa-Samuelsson, you would have seen that the point there is that the reason why price levels are higher in poorer countries is that productivity levels are relatively similar in non-tradable sectors while differing a lot in tradable sectors. But as wages within a country is relatively similar this causes unit labor costs to be higher in non-tradable sectors in rich countries (causing the price level to be higher) but in the tradable sectors it will not be higher (meaning it won't be more profitable to produce there meaning in turn there won't be higher credit).

9:42 AM  

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