Bob Munro looks at the implications of the sliding dollar
Financial journalists have recently been strongly speculating that the US dollar will continue to slump, taking sterling back above the $2.00 level, a position not seen since the ERM-deutschmark tracking days of the early 1990s. Putting aside the obvious delight of the UK's importers, weekend New York shoppers and families jetting off to Florida theme parks, should the nation's exporters of goods and services be concerned? Is this journalistic hype? Or is there a more fundamental change going on in the world's currency markets?
Decade: in reviewIf we examine the most recent ten years of sterling/dollar rates, from 1993-2002, the range was $1.37-$1.73 (figure 1). Many treasurers' perception that the rate was simply fluctuating around $1.55 is borne out by this statistic. During this period, the range on any one year averaged 18 cents (12.3%), leaving anyone with sterling/dollar exposure, buyers and sellers of dollars, a substantial headache.However, if we go back further to look at the period from 1973-1992, not only did sterling/dollar trade in a substantially wider range, $1.04-$2.60 (figure 2), but the average range in any one year leapt to 35 cents. Figure 3 illustrates clearly that in historic terms, the sterling/dollar rate has been in a period of relative hibernation in the past decade.A return to historic volatility would leave commercial currency exposure twice as important to those concerned and potentially ruinous to those who neglect the problem.To put it in hard cash terms, if sterling/dollar were to rise 35 cents, or 19%, from current levels, a company selling $10m back into sterling could receive up to £900,000 less than if rates stayed still. For companies with different levels of exposure, as they say in the US, you do the math.
Vital questionsThe key questions are: is this level of volatility likely to return; and is the sterling/dollar rate headed back above $2.00? To answer these questions it is useful to ask what drives the foreign exchange markets, what factors determine the rates and why are the currencies so inherently volatile?Economic textbooks might tell you the currency exchange rate between two countries is determined by the relative strength of the economies.The stronger economy with the more buoyant stock market might attract the greater inflows from abroad. The US economy during the dot.com boom might be the best example of this. Funds flowed into the US stock market, boosting the dollar to ever-higher levels, particularly against the euro.However, post-bubble, although the stock markets have since fallen across the globe, the US economy remains far healthier than the anaemic Euroland version, yet the euro has reversed its fall against the dollar and set new highs in recent months.To further disprove the 'relative strength of the economies theory', consider the fall of sterling against the euro from EUR1.75 to below EUR1.40 over the three years to 2003, during which time the UK economy easily outshone Euroland. Further evidence can be found with almost every currency pair post-Bretton Woods(1).The current vogue is to blame the fall of the dollar on the massive US trade deficit running at over $40bn per month. However, further investigation reveals that the deficit was 'at record levels' and 'unprecedented' for many years, whilst the dollar climbed steadily. The Japanese yen provides another example of a rollercoaster performance of a currency whilst the trade account clocked up ever increasing surpluses. Shouldn't the yen have been on a one-way ticket to the stratosphere all the time?Obviously, the theory of economics is a much more complex picture than painted here, and in the real world the currency exchange rates will be affected by a myriad of economic conditions. Attempts to combine all of these factors are often presented as a 'fair value' or a 'purchasing power parity' for a particular currency pair. One recent fairly typical study suggested that both sterling and the euro were approximately 20% over-valued against the dollar. Does this mean the dollar is about to climb substantially, back to the fair value suggested? Well it could, but historical studies show that currencies often stray even further from these theoretical values and can remain out of kilter for years before swinging just as wildly back the other way.It could be said that any combination of the economic theories or valuations will prove to be correct over time, but in the commercial environment timing is everything. By the time the exchange rate matches the economically forecast rate, a company could have gone out of business. In other words, as a forecasting tool they are next to useless.Of course, we also know that governments, or their agents, also attempt to manipulate their currencies. If we leave aside the pegs imposed on restricted capital flow currencies, the track record of governments of free-floating currencies is very poor. Most economists acknowledge that intervention, either monetary or verbal, is futile in the end. The Bank of England will be pleased to confirm this privately.So we have established that economic fundamentals offer very few clues about the likely direction of exchange rates and governments would be well advised to keep their distance. We also know that exchange rate markets are incredibly volatile. Could this volatility be a clue to why economic analysis fails us?
Volatile animalThe exceptional volatility can be easily explained by the nature of the participants in the foreign exchange markets. You might imagine that the massive increase in world trade since 1945 has created a market which sees a daily turnover of over $1.5trn per day. But whilst world trade was the catalyst, it has been the growth of the speculator from within global financial institutions that has transformed the foreign exchange market into the giant, complex and extremely volatile animal it is today.If we go back to the economic textbooks again briefly, the foreign exchange markets present an example of an almost perfect market: cheap and easy access, perfect price information and no real monopoly influence. The opportunity to speculate in such a market offered the early participants, particularly the banks, a useful additional source of revenue. However, the lure of speculative profits quickly tempted any number of diverse financial institutions such as hedge funds, pension funds, mutual funds, investment vehicles and virtually every bank in the world to join the party. The result is that the business of the traditional commercial end user is swamped by the speculative activity. It is estimated that less than 3% of the market's daily turnover is now based on commercial trade for goods and services.The result has been that the volatility which made the currency markets so attractive to the speculators has been fanned by the flow of new entrants and the growth of sophisticated derivative products. These major financial institutions thrive on the daily volatility and now spend millions just managing their increasingly complex foreign exchange risk.The genuine end user, importing or exporting goods and services, does not usually have the same resources to manage this type of volatility.Indeed, in most cases the underlying business is complex and risky enough without the added burden of exchange rate risk.So where does this leave the average commercial user of foreign exchange?If we return to the example of a seller of dollars, worried by the press headlines, our brief look at the historical context shows there is the potential for a return both to rates above $2.00 and additional volatility in the coming months and years.
He who hesitates ...Doing nothing is not an option. An adverse move in the exchange rate means that at best, a company could find itself at a serious competitive disadvantage, at worst, out of business altogether. Remember, we have established that exchange rates do not automatically return to their fair value or their previous mean within a few years, so most companies will not be able to ride out the foreign exchange pain. Of course, a favourable currency move could result in a windfall profit but that is no reason to put the company's hard-earned conventional profits at risk.The answer has to lie in a sensible risk management policy. The overall trend cannot be bucked but, if an adverse trend can be identified, hedging your currency risk can slow the damaging effects, preserving the competitive position in the underlying commercial market and giving the business time to adjust to the new environment. To identify the trends we need to turn back to the speculative market.Whilst it is true to say that speculators may be using any number of the diverse economic indicators to make their investments in the market, the majority are simply trying to identify which clearly established trend they should join in order to profit from the continuation and extension of that trend. Of course, if enough speculators reach the same decision, the trend extends anyway. This is the herd instinct in action.The study of trends or human behaviour in any market is often distilled into the study of price movement charts, so-called technical analysis. It is this analysis which occupies the minds of much of the speculative market.By implication, if a company has access to good technical analysis, the trends in the foreign exchange markets may become a little clearer and an appropriate hedging programme could be initiated.And it is not just the obvious long-term trend - for example current dollar weakness - that needs to be identified. It is the quarterly, monthly or even weekly trends - the normal ebbs and flows, or wave patterns - within larger trends, which can provide opportunities to cover currency exposure. Timing is everything.That is not to say that this is a perfect solution. Technical analysis is far from foolproof and certainly not the self-fulfilling prophecy some people assume. However, it often gives some level of guidance when economic fundamental analysis continues to confound.Even when you have a clearer idea of the forthcoming trend, the key to a successful hedging policy is to think of it in terms of the probability of the currency forecast being correct and managing the risk. If the worst happens, is the company protected? Can the company afford to wait and take advantage of the trend?Are we going to be disciplined enough to make the difficult decisions if the rate starts going against us?Our dollar seller should indeed be worried by the headlines but the very worst thing he should do is panic, or perhaps even worse, bury his head in the sand. What he needs is some honest trend assessment, an ongoing risk management policy and some decisive action. No one can buck the trend in the market, but by taking pre-emptive action you might just be in business long enough to be worried by the next sensational headline on a Sunday morning.
Reference(1) The Bretton Woods Project was set up as an independent initiative by a group of British non-governmental organisations to promote increased transparency and civil society participation in World Bank and International Monetary Fund initiatives. Further information is available at: www.brettonwoodsproject.org.