Exchange rates are gaining new weight




Toronto Star


It is easy to assume the world of so-called “high finance” has little impact on your everyday life. One is constantly bombarded with news about financial instruments that seem esoteric and without real world impact. While some prices, such as the price of money — interest rates — directly impact all of us, others, such as exchange rates, seem of limited import. If we are travelling abroad, the currency exchange rate gets our attention, but otherwise daily news reports on rates make little dent on our memory in the same way as a weather forecast. Indeed, on most occasions there is little happening in exchange rate markets that matter to us. The recent decline in the yen exchange rate amid Japan’s ballooning debt crisis changes all that. Exchange rates are usually determined by investors weighing cyclical factors. Standard questions to determine exchange rates include: Are the external accounts of a country deteriorating relative to other countries? And what is the likely path of interest rates in various countries? Capital flows between nations impact exchange rates based upon such important but mundane considerations. Today, however, there are much larger factors, more structural in nature, which influence exchange rates. These factors overwhelm the importance of cyclical factors. With debt-to-GDP ratios near record highs across much of the developed world, investors are wondering just how such high debt levels can be reduced. The high inflation necessary to make it easier for debtors to service debt has been created, but as a consequence interest rates have risen to dangerously high levels. Ultimately, the relief of debtors can only come if interest rates can be reduced. What might governments need to do to prevent investors from ditching bonds and in this process push interest rates to levels that threaten their solvency and the solvency of the private sectors? If their answer is to compel savers to buy government bonds at low yields, the government is overstepping a key private sector right — the right of an individual to own only what they want to own. And in a country where the government gets more involved in allocating the savings of its people, some savers are likely to move their money to nations where that doesn’t happen — which can have a major impact on the exchange rate. It is unlikely that all developed governments would force savings institutions to buy government bonds as part of the process to “inflate away debt.” Some countries with particularly high debt levels need to act quickly to depress interest rates. When such action is taken, the ensuing redirection of capital will produce major exchange rate volatility. The recent decline in the yen exchange rate reflects the reality that Japan, the country with the world’s highest total debt-to-GDP ratio of 417 per cent, is likely to impose such a measure upon it savers first. Given its high debt level, Japan cannot live with interest rates materially above even their current very low level. Their attempt to keep bond yields low and inflation high is spooking investors who are selling yen to move savings elsewhere thus depressing the Yen exchange rate. Who wants to a hold a nation’s currency when its central bank, faced with high inflation, acts to both depress interest rates and create new money as it buys even more government bonds? In pursuing such a policy, Japan is creating an exchange rate crisis. If policymakers wish to prevent a decline in the price of their government bonds while also preventing a collapse of their exchange rate, they will need to adopt another policy. The only policy that might work to stabilize the price of both is to force their savings institutions to sell foreign investments to buy Japanese government bonds. This policy would encourage both the purchasing of yen and Japanese government bonds. The key question then is what damage mass liquidation of foreign currency bonds by Japanese investors might do elsewhere? A steady large selling of Canadian Government bonds would place upward pressure on bond yields but also mortgage rates in Canada. If Japan forces its savings institutions to stop funding foreign governments and increase their funding of the Japanese government, then suddenly Japan’s exchange rate problem turns into an interest rate problem in other countries. Exchange rates matter. They matter for exports and imports and investments. However sometimes they matter for more existential things. Now they matter because the most indebted country in the world is facing an exchange rate collapse unless it can force or persuade its savings institutions to repatriate capital. This exchange rate reality creates a forced selling of other countries government bonds and puts upward pressure on interest rates elsewhere. Japan will not be the only country to have to resort to such measures but, given the slump in the yen exchange rate, it does look like it will be the first. When it acts it will signal to global investors just how alien the new world financial order is compared with the past few decades. By putting upward pressure on other countries government bond yields it may force those nations to pursue similar policies. The financial earthquake that sees investors restricted in their freedom to chose their investments looks like it has an epicentre — Japan.