Statement by Glenn Stevens, Governor: Monetary Policy Decision
At its meeting today, the Board decided to leave the cash rate unchanged at 3.0 per cent.
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During 2012, there was a significant easing in monetary policy. Though the full impact of this will still take further time to become apparent, there are signs that the easier conditions are having some of the expected effects: the demand for some categories of consumer durables has picked up; housing prices have moved higher; there are early indications of a pick-up in dwelling construction; and savers are starting to shift portfolios towards assets offering higher expected returns.
“The depreciation of the yen definitely is a drag on the ability of other Asian currencies to appreciate,” Ramin Toloui, global co-head of emerging markets portfolio management at Pacific Investment Management Co., which oversees the world’s largest bond fund, said in a Jan. 30 interview in Singapore. “Certain countries that are part of the production chains into Japan may be in a more beneficial position than countries that are direct competitors.”
Determinants of Exchange Rates Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics, the relative importance of these factors is subject to much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-Push Inflation Versus Demand-Pull Inflation.)
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. (For further reading, see What Is Fiscal Policy?)
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For more, see Understanding The Current Account In The Balance Of Payments.)
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
(Reuters) - South Korea's threat to impose a broad tax on financial transactions is the first sign of deepening concern in Asia that speculation of competitive currency devaluations is prompting investors to head for the exit.
Until then, and because investors had not shown any big signs of concern, Asia's reaction to the tensions centring on the yen had been passive, comprising an asymmetric mix of jawboning and light currency intervention.
The selloff in Seoul markets this week turned into a warning sign. Foreign investors posted their biggest daily stock selloff in 16 months in South Korea and pushing the won, a currency that best serves as a proxy for Asia, to a three-month low.
The risk is that the threat of policy action will prompt more market selling, pushing currencies down yet further and raising investor fears of the competitive devaluations that policymakers are trying to avoid.
"Korea is going to be the first domino, and it's that domino effect that the yen's depreciation clearly risks," said Rob Ryan, currency and rates strategist at RBS, referring to the increasing likelihood that Korea announces some form of currency control measure soon.
"The real trigger has been the equity market reaction and the outflows from Korea. I think the concerns over intervention are a little overdone just yet, but clearly it is a big risk if the yen continues to weaken."
Concerns about competitive currency devaluations are the result of easy monetary policies in advanced economies, including the United States.
The latest focus of attention is the yen, which has weakened nearly 12 percent against the dollar since mid-November as the government and the Bank of Japan ramped up efforts to lift the country out of a recession and years of deflation. The Bank of Japan last week doubled its inflation target to 2 percent and agreed to an "open ended" commitment to buy assets.
South Korea has understandably been the most vocal of Asian policymakers on the subject of the yen.
Heavyweight Korean exporters such as Samsung Electronics Co (005930.KS) and Hyundai Motor Co (005380.KS), which compete directly with Japanese electronics and auto companies, have seen their competitiveness eroded as the won increased in value from as low as 15 per yen to near 11.8 over the past six months.
Foreigners have sold a net 1.8 trillion won Korean stocks this month. The stock market .KS11 is down 3 percent so far this year. Foreigners have been buying Taiwanese stocks, but those volumes are far lower than they were in 2012.
"The recent wave of quantitative easing policies has created an unprecedented situation and makes it necessary (for affected countries) to adopt a paradigm shift in response," South Korea's Deputy Finance Minister Choi Jong-ku said in Seoul this week.
The Korean government will tell state-controlled firms to refrain from borrowing abroad and will further tighten rules on banks' currency derivatives trading to ease volatility in foreign exchange markets, Choi said.
Seoul was opposed to imposing an outright levy on financial transactions, such as the Tobin tax being debated in Europe. But it would consider similar measures should speculation in the won intensify over time, he said.
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