FX Markets: $4.7 Trillion Per Day?

For the uninitiated, when economists refer to FX, the abbreviation doesn\’t mean \”special effects\” or \”Federal Express\” or \”Fighter, Experimental.\” It means \”foreign exchange.\” Morten Bech discussed \”FX volume during the financial crisis and now\” in the March 2012 issue of the BIS Quarterly Review. BIS stands for Bank of International Settlements, an organization whose members are central banks and some international organizations, which among other tasks holds conferences, collects data, and facilitates some financial transactions.

In particular, BIS produces the Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, which comes out every three years. The most recent version found that FX trading activity averaged $4.0 trillion a day in April 2010. Yes, that\’s not million or billion per day, or trillion per year, but $4 trillion per day.  I\’ll say a bit more about the implications of that remarkable total in a moment, but Bech\’s main task is to look at the underlying data for the three-year survey and thus find a way of estimating the FX market at semiannual or even monthly intervals. Bech writes:

\”By applying a technique known as benchmarking to the different sources on FX activity, I produce a monthly time series that is comparable to the headline numbers from the Triennial going back to 2004. Taking stock of FX activity during the financial crisis and now I estimate that in October 2011 daily average turnover was roughly $4.7 trillion based on the latest round of FX committee surveys. Moreover, I find that FX activity may have reached $5 trillion per day prior to that month but is likely to have fallen considerably into early 2012. Furthermore, I show that FX activity continued to grow during the first year of the financial crisis that erupted in mid-2007, reaching a peak of just below $4.5 trillion a day in September 2008. However, in the aftermath of the Lehman Brothers bankruptcy, activity fell substantially, to almost as low as $3 trillion a day in April 2009, and it did not return to its previous peak until the beginning of 2011. Thus, the drop coincided with the precipitous fall worldwide in financial and economic activity in late 2008 and early 2009.\”

Here\’s a result of Bech\’s work. The horizontal axis is years; the vertical axis is the size of the FX market. The green line plots the results for 2004, 2007, and 2010 from the Triennial Survey. The red line uses the benchmarking technique to create a semi-annual data series, and the blue line builds on that to create a monthly data series. The vertical lines refer to August 9, 2007, when the first really bad news about the financial crisis hit world financial markets, and September 15, 2008, the middle of what was arguably the worst month of the crisis.

As Bech points out: \”The FX market is one of the most important financial markets in the world. It
facilitates trade, investments and risk-sharing across borders.\” In that spirit, his result interest me in several ways.

First, I\’m always on the lookout for ways to illustrate the effect of a global financial crisis in ways that don\’t involve trying to explain interest rate spreads to students. Seeing the size of the foreign exchange market contract by one-quarter or so in late 2008 and early 2009 is a useful illustration. There are four more graphs for illustrating the financial crisis in this blog post of last August 3, and two more in this post of May 17.

Second, it\’s useful to compare the size of foreign exchange markets at $4.7 trillion per day to the size of world trade. World exports were about $15 trillion for the year of 2010, according to the World Trade Organization. Thus, only a tiny part of the foreign exchange markets are involved in financing imports and exports. Instead, by far the most important part of the foreign exchange markets involves international financial investing. This insight helps to explain why FX markets are so notoriously volatile: they are a financial market where international capital markets are continually rushing in and out of currencies. The volatility suggests that those who are involved in international trade might often do well to lock in future values for foreign exchange in futures and derivatives markets–and of course, part of what makes the FX market so big is the efforts by all parties to hedge themselves against large movements in exchange rates.

Over time, there does appear to be a tendency for foreign exchange rates to move in the general direction that reflects their purchasing power–the so-called \”purchasing power parity\” exchange rate. In the Fall 2004 issue of my own Journal of Economic Perspectives, Alan M. Taylor and Mark P. Taylor review \”The Purchasing Power Parity Debate,\” and find that such movements do occur over the long-run, but they proceed slowly, over a period of several years, and in the meantime exchange rates are buffeted by changing investor sentiments and current events.

Feldstein, the Euro, and Optimal Currency Areas

Martin Feldstein has an essay in the January/February 2012 issue of Foreign Affairs on \”The Failure of the Euro\”  (it\’s not available free on-line). I found it especially interesting because Feldstein is a long-term skeptic on the euro and explained his skepticism the Fall 1997 issue of my own Journal of Economic Perspectives,
in   \”The Political Economy of the European Economic and Monetary Union: Political Sources of an Economic Liability.\”  (Like all JEP articles from the current issue back to 1994, it is freely available on-line courtesy of the American Economic Association.) But while Feldstein is a long-time skeptic on the euro, his argument has shifted slightly over the last 14 years.  

Here\’s Feldstein\’s critique from the 2012 article: \”The euro should now be recognized as an experiment that failed. This failure, which has come after just over a dozen years since the euro was introduced, in 1999, was not an accident or the result of bureaucratic mismanagement but rather the inevitable consequence of imposing a single currency on a very heterogeneous group of countries.\”

Feldstein has long argued that the euro is best understood not as an economic policy, but as a step toward an attempted political unification of Europe. In both the 2012 and 1997 articles, he quotes a comment from German Chancellor in 1956, after the U.S. forced England and France to abandon their attack on the Suez Canal. As quoted in the JEP article, Adenauer said: \”France and England will never be powers comparable to the United States and the Soviet Union. Nor Germany, either. There remains to them only one way of playing a decisive role in the world; that is to unite to make Europe. England is not ripe for it but the affair of Suez will help to prepare her spirits for it. We have no time to waste: Europe will be your revenge.\”

The Treaty of Rome launched the European Common Market a year later. But it wasn\’t until the Maastricht treaty in 1992 that a common currency became part of the project. In retrospect, it\’s obvious to point out that lots of countries have extensive trade with low trade barriers–say, the U.S. and Canada, or the countries of Europe circa 1995–without any particular need for a common currency to facilitate such trade.

The potential difficulties with a common currency have been widely discussed among economists at least since the work on \”optimal currency areas\” by Robert Mundell and others back in the 1960s. When countries share a currency, they also share a one-size-fits-all monetary policy. Some countries might prefer lower interest rates to stimulate their economy, some might prefer higher interest rates to hold down inflation; but with a single currency, the countries all get the same monetary policy. Thus, countries must find other ways to adjust.

This theory suggests four key factors: if a group of nations has these four factors that affect economic adjustment, a single currency may work well; if it lacks these factors, the single currency may turn out badly. The four factors are: 1) fiscal transfers to and from a central government, overall moving funds to where the economy is doing less well; 2) geographic movement of families and companies away from areas where the economy is doing poorly to where it is doing better; 3) flexibility in prices and wages so that areas doing poorly see prices fall and become more attractive locations for business, and vice versa; and finally 4) that the economies of these different geographic areas move more-or-less in unison, so that economic differences across the regions don\’t require these other adjustments to do too much.

The United States, for example, scores pretty well on these four categories, which is part of what makes a single currency workable and beneficial. Europe doesn\’t score especially well on any of these four categories. Thus, the euro was an attempt to put the cart before the horse: instead of first creating a European economic and political structure where a single currency would work, the idea was to first create the single currency, and then follow up later with the needed economic and political structure. As a result, the euro created a situation in which national economies suffering difficult times, like Greece, no longer had an independent monetary policy to help, and also didn\’t have many other methods of adjustment. Perhaps not surprisingly, they turned to another short-term method of soothing their economic pain: large domestic budget deficits.

However, the euro\’s troubles in the last year or so did not arrive in the way Feldstein envisioned back in 1997. Back then, he was concerned that the new European Central Bank might not be very independent of political pressure,and thus would allow a higher rate of inflation to emerge along with an ongoing depreciation of the euro as a way of stimulating European exports. Back in 1997, Feldstein discussed the rules that as part of belonging to the euro, countries would have to limit their budget deficits. While he discussed the likelihood that these rules would not be strictly enforced (and that arguments over the deficit limit rules might even derail the euro negotiations), he did not seem to envision that the runaway levels of government debt in Greece and elsewhere would cause the euro to tremble. At that time, Feldstein was relying on another part of the treaty–the part which banned the European Central Bank from bailing out member states. That provision is being bent, although not yet totally abandoned, in the present crisis.

What actually happened, as Feldstein explains in the 2012 article, is that the European Central Bank did stay tough on inflation. As a result, countries around the periphery of Europe that had long experienced high interest rates–from fear of future inflation and instability–now found that they could borrow at low interest rates. Households borrowed and poured much of the money into housing; governments borrowed more and poured the money into everything. But bond-buyers seemed to ignore the provision in the euro treaty that there would be no bail-outs.  In the U.S. economy, it is accepted as a fact of life that some U.S. states and cities will need to pay higher interest rates when they borrow, because their finances are in dodgier shape. But
debt levels rose in Greece, Ireland, Italy, and Spain, they treated debt issued by these countries as if it had the same risk level and thus the same interest as debt issued by, say, Germany or France. When investors finally took notice of the greater risks, and started jacking up the interest rates they demanded on additional borrowing, severe overborrowing had already occurred.

At this point, there\’s no good way out of the euro tangle.  For example, one set of proposals are that Europe should now take steps toward a meaningful fiscal union, where countries like Greece would get funding from the rest of Europe in exchange for tight oversight of their future government borrowing. But ordinary Germans don\’t want to send money to Greece, and ordinary Greeks don\’t want Germany controlling their country\’s budget. Having the European Central Bank print euros to buy all the dodgy debt would flatly contradict the euro treaty provisions against bailing out countries, and would leave the ECB holding a bunch of financial securities that are unlikely to pay off.

Meanwhile, European banks hold large amounts of the bonds issued by governments, so any agreement for the governments to default on a substantial portion of their debts means that Europe\’s banks will be badly underwater. (In a way, this is similar to how U.S. banks were underwater when they thought they were holding safe mortgage-backed financial securities, but then those securities turned out not to be safe.) In facing the risk of these losses, European banks are trying to build up their capital ratios by holding down on lending, which slows Europe\’s economy more.

But more fundamentally, the euro has linked together quite disparate economies--like Germany and Greece–with a common exchange rate. In a post last November 18, I called this \”The \”Chermany\” Problem of Unsustainable Exchange Rates.\” Just as China\’s long-term refusal to let its exchange rate relative to the U.S dollar move (much) has contributed to enormous ongoing trade surpluses for China and corresponding trade deficits for the U.S. economy, the locked-in common currency (in effect, a fixed exchange rate) between Germany and Greece has locked in large trade surpluses for Germany and large trade deficits for Greece.

Feldstein concludes his 2012 essay: \”Looking ahead, the eurozone is likely to continue with almost all its current members. The challenge now will be to change the economic behavior of those countries. Formal constitutionally mandated balanced-budget rules of the type recently adopted by Germany, Italy, and Spain would, if actually implemented, put each country’s national debt on a path to a sustainable level. New policies must avoid current account deficits in the future by limiting the volume of national imports to amounts that can be financed with export earnings and direct foreign investment. Such measures should make it possible to
sustain the euro without future crises and without the fiscal transfers that are now creating tensions within Europe.\”

Back in the 1990s, I was dubious as to how the euro would actually work long-term. As a practical matter, I find it hard to believe that the EU will be able to enforce limits on government fiscal policies or on total volumes of trade across countries. I find it hard to believe that the needed economic adjustments when a country has slow productivity growth, like Greece, will happen through changes in wages and prices, or geographic mobility of people, or fiscal transfers. The euro will probably hobble on for awhile, because breaking up is hard to do. But it will probably hobble from one economic crisis to another until its underlying economic and political context has been fundamentally changed. 

After Japan\’s Quake, the Intervention to Stabilize the Yen

In the aftermath of the dreadful earthquake and tsunami which hit Japan on March 11, 2011, I completely missed that there was an international intervention to stabilize the exchange rate of the Japanese yen. Fortunately, Christopher J. Neely tells the story and offers useful context in \”A Foreign Exchange Intervention in an Era of Restraint.\” Here are some highlights of what has happened, and what lessons can be drawn: 

Foreign exchange intervention has become rare for the G-7 countries
Back in the late 1980s and early 1990s, many major central banks stopped frequent intervention in exchange rate markets, as shown on the figure. In fact, there have been only three exchange rate interventions for these countries since 1995: an intervention after Japan\’s quake in March 2011, an intervention soon after the start of the euro in September 2000, and an intervention in the yen after East Asia\’s financial crisis in 1998. 

The FX intervention after Japan\’s March 2011 Quake
 Japan\’s currency started falling sharply after the earthquake. Here\’s how Neely describes what happened:  \”Nevertheless, the G-7 finance ministers and central bank governors held a conference call on the evening of Thursday, March 17 (Friday morning in Tokyo) and decided to conduct a coordinated intervention to weaken the JPY. The G-7 issued a press release containing the following text:

 In response to recent movements in the exchange rate of the yen associated with the tragic events in Japan, and at the request of the Japanese authorities, the authorities of the United States, the United Kingdom, Canada, and the European Central Bank will join with Japan, on 18 March 2011, in concerted intervention in exchange markets. As we have long stated, excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability. We will monitor exchange markets closely and will cooperate as appropriate (G-7, 2011).

 Figure 7 shows that the yen reacted immediately to the intervention announcement, surging
almost 4 percent within the hour against the USD …\”

As Neely reports, the total intervention was about $10.4 billion. Notice that the yen starts stabilizing when the announcement is made, and then moves to a certain level and more-or-less sticks at that level for awhile. The volatility of the yen foreign exchange rate diminishes a great deal.

What did the 1998 exchange rate intervention look like?
Neely describes the background to the 1998 intervention this way: \”The June 1998 intervention also followed a financial crisis, the 1997 Asian exchange rate crisis in which international capital fled many developing Asian countries, such as Thailand and South Korea. In early June 1998, the main macroeconomic concern was that the yen was unusually weak and weakening further, which made goods and services from other Asian countries less competitive with Japanese goods and
services and harmed those countries’ recoveries. Policymakers probably feared that a falling yen
might cause China to devalue the renminbi (RMB), possibly sparking competitive devaluations, inflation, and instability throughout the region.\”

The pattern of the 1998 intervention is qualitatively similar to the 2011 intervention: that is, a reaction just before the announcement is made, a movement to a new level, and volatility is stabilized.

What happened in the September 2000 intervention? 
Neely sets the stage: \”On January 1, 1999, the ECB began conducting a common monetary policy with a new currency, the euro, for the 11 original nations of the European Monetary Union (EMU). From its inception, the euro tended to depreciate against the dollar, falling from about 1.18 USD/EUR on the inception date to less than 0.85 USD/EUR in September 2000. Doubts about the policies of the new central bank probably contributed to this weakness. At the same time, the U.S. economy was slowing—it would officially enter a recession in March 2001—and the strong dollar/weak euro was perceived as detrimental to U.S. exporters. In addition, the Japanese feared that an overly strong yen would price Japanese exports out of the European markets. Against this backdrop, the ECB, the United States, and Japan decided to intervene to support the euro on September 22, 2000.\”

Again, the qualitative pattern is the same: the exchange rate takes a jump, but then stabilizes at a new level with diminished volatility.

What are the overall lessons?
 Neely summarizes the lessons this way: \”Since 1995 most advanced governments/central banks have used intervention only very sparingly as a policy tool. Examination of coordinated interventions during this period shows that intervention is not a magic wand that authorities can use to move exchange rates at will. It can be a very effective tool in certain circumstances, however, to coordinate market expectations about fundamental values of the exchange rate and calm disorderly foreign exchange markets by reintroducing two-sided risk.\”

Those who are talking about pressuring China to adjust its exchange rate vs. the U.S. dollar have a reasonable case to make. But they would be wise to take to heart the practical issues here. Foreign exchange rate intervention can stabilize a disorderly  market in a short-run situation where everyone is betting the currency will move in only one directly, but is not a magic wand to move exchange rates at will.

When Milton Friedman Blessed Foreign Exchange Futures Markets

Leo Melamed tells the story of “Milton Friedman’s 1971 Feasibility Paper” in the Fall 2011 issue of the Cato Journal

“In 1971, as chairman of the Chicago Mercantile Exchange, I had an idea: a futures market in foreign currency. It may sound so obvious today, but at the time the idea was revolutionary. I was acutely aware that futures markets until then were primarily the province of agriculture and—as many claimed—might not be applicable to instruments of finance. Not being an economist, the idea was in need of validation. There was only one person in the world that could satisfy this requisite for me. We went to Milton Friedman. We met for breakfast at the Waldorf Astoria in New York. By then he was already a living legend and I was quite nervous. I asked the great man not to laugh and to tell me whether the idea was “off the wall.” Upon hearing him emphatically respond that the idea was “wonderful,” I had the temerity to ask that he put his answer in writing. He agreed to write a feasibility paper on “The Need for Futures Markets in Currencies,” for the modest stipend of $7,500. It turned out to be a helluva trade.” 

The same issue publishes Friedman’s 1971 paper, “The Need for Futures Markets in Currencies,” for what I think is the first time. Friedman writes: 

\”Bretton Woods is now dead. The president’s action on August 15 [1971] in closing the gold window was simply a public announcement of the change that had really occurred when the two-tier system was established in early 1968. … The U.S. is a natural place for the futures market because the dollar is almost certain to continue to be the major intervention
currency for central banks and the major vehicle currency for international transactions. Exchange rates will almost surely continue to be stated in terms of the dollar. In addition, the U.S. has the largest stock in the world of liquid wealth on which the market can draw for support. It has a legal structure and a financial stability that will attract funds from abroad. It has a long tradition of free, open, and fair markets. It is clearly in our national interest that a satisfactory futures market should develop, wherever it may do so, since that would promote U.S. foreign trade and investment. But it is even more in our national interest that it develop here instead of abroad. As Britain demonstrated in the 19th century, financial services of all kinds can be a highly profitable export commodity.\”

Boone and Johnson on the euro situation

Peter Boone and Simon Johnson have written an insightful and well-informed essay, \”Europe on the Brink.\” The whole thing is well worth reading, but here are a couple of points that especially struck me.

What are the immediate financing needs for European countries? \”The ability to refinance or roll over debt is a much clearer concept, and it is this need for liquidity that breaks nations and pushes them into default. Figure 2 shows rough estimates of the financing needs for some euro area countries over the next year to cover debt falling due plus the budget deficit. There is wide variance in amounts due, ranging from 7 percent of GDP for Austria to one–third of GDP for Greece. Because all these nations are running budget deficits, none of them can source this financing from their revenues.\”

The European Central Bank is already providing financing to sustain various European nations through its payments mechanism. \”The ECB operates a payment system that nets out transactions across borders. When, for example, there is more money flowing out of Irish banks into German banks, the Irish central bank incurs a liability to the Bundesbank. The Bundesbank claims on Ireland could be repaid by the Central Bank of Ireland, for example by selling holdings of gold or other valuable assets, but this is not done. Instead, the balances continuously build up and they become
financing to the Irish banking system. Figure 3 shows the current status of this financing at the end of 2010. It illustrates that the Bundesbank is the largest creditor to the system, being owed €340 billion, while the central banks of GIIPS are the largest debtors. The total credit to GIIPS is €336 billion, which is more than the combined value of all the bailout packages to Greece plus the European Financial Stability Facility, the rescue fund backed by euro area nations. The credits are provided with no approval required from national parliaments or budgets, and there is an implicit assumption that all will be fully repaid. These correspondent account balances are critical to the functioning of the euro system. If some central banks decided they would no longer accept claims from another central
bank—let us say, hypothetically, the Bank of Ireland—this would effectively end the euro area. If euros held in Irish banks become less useful than euros held in German banks, the price
of the two will diverge.\”

Emerging nations get into international financial crises because they need to borrow in a currency that is not their own. As a result, when it comes time to repay and a crisis is near, they cannot print additional money, and their central bank cannot act as a lender of last resort in the currency in which they have borrowed. In a real way, nations of Europe that have borrowed in euros find themselves in this same position: that is, they have borrowed in a currency, euros, which they themselves do not control, and where the central bank controlling that currency is unwilling to act as their lender of last resort. Boone and Johnson write:

\”The problem the euro area faces is that creditors lent money to banks and the sovereign under the assumption that they would all be supported fully during periods of trouble. Led by Germany, the euro area is now switching from a “moral hazard” regime to new arrangements under which all nations must fend for themselves. The stated reason is that these nations will otherwise spend too much and become insolvent. … It becomes increasingly likely that no lender of last resort exists in the euro area, making it more like a typical emerging market than a developed nation. Emerging markets succumb to defaults because they borrow in currencies which they cannot print. The defaults occur when the nation runs out of foreign currency with which to make payments on its debt. Such nations typically have low debt levels relative to income and modest short–term debt, compared with the 85 percent debt/gross domestic product average in the euro area. If the Germans get their way, we should compare euro area deficits and debt levels to emerging markets, not to other developed nations with their own printing presses and domestic debt.\”