Explain why the value of a currency may fall in a floating exchange rate system.
In a floating exchange rate system, the value of a currency is determined by market forces of supply and demand in the foreign exchange market. Several factors can lead to a fall in the value of a currency:
Changes in Relative Interest Rates: If a country's interest rates decrease relative to those of other countries, it can reduce the attractiveness of holding that currency and lead to a decrease in its value. Investors may seek higher returns in other countries with relatively higher interest rates.
Economic Performance and Outlook: Market participants closely monitor a country's economic performance and future prospects. Factors such as low economic growth, high inflation, political instability, or fiscal imbalances can negatively impact the value of the currency. Investors may sell the currency, leading to its depreciation.
Trade Balance and Current Account: A country with a persistent trade deficit or a deteriorating current account balance may experience a decline in its currency's value. A trade deficit means that more goods and services are being imported than exported, resulting in a net outflow of the currency.
Market Speculation: Speculative activities in the foreign exchange market can also contribute to currency depreciation. If traders anticipate a fall in the value of a currency based on economic indicators or market sentiment, they may sell the currency in the expectation of buying it back later at a lower price.
Market Intervention: In some cases, central banks or governments may actively intervene in the foreign exchange market to influence the value of their currency. Intervention to sell or buy the currency can impact its value in the short term.
It is important to note that currency depreciation can have both positive and negative effects on an economy. On one hand, it can make a country's exports more competitive, stimulating economic activity and potentially improving the trade balance. On the other hand, it can increase the cost of imports, leading to higher inflation and potentially reducing consumers' purchasing power.
The value of a currency in a floating exchange rate system is determined by a complex interplay of economic factors, market forces, and investor sentiment. The relative strength or weakness of a currency reflects the market's assessment of a country's economic fundamentals and its position in the global economy.
It won’t blow up the financial system, but it will be scary writes The Economist
Over the past decade owning a house has meant easy money. Prices rose reliably for years and then went bizarrely ballistic in the pandemic. Yet today if your wealth is tied up in bricks and mortar it is time to get nervous. House prices are now falling in nine rich economies. The drops in America are small so far, but in the wildest markets they are already dramatic. In condo-crazed Canada homes cost 9% less than they did in February. As inflation and recession stalk the world a deepening correction is likely—even estate agents are gloomy. Although this will not detonate global banks as in 2007-09, it will intensify the downturn, leave a cohort of people with wrecked finances and start a political storm.
Listen to this story.Enjoy more audio and podcasts on iOS or Android.
The cause of the crunch is soaring interest rates: in America prospective buyers have been watching, horrified, as the 30-year mortgage rate has hit 6.92%, over twice the level of a year ago and the highest since April 2002. The pandemic mini-bubble was fuelled by rate cuts, stimulus cash and a hunt for more suburban space. Now most of that is going into reverse. Take, for example, someone who a year ago could afford to put $1,800 a month towards a 30-year mortgage. Back then they could have borrowed $420,000. Today the payment is enough for a loan of $280,000: 33% less. From Stockholm to Sydney the buying power of borrowers is collapsing. That makes it harder for new buyers to afford homes, depressing demand, and can squeeze the finances of existing owners who, if they are unlucky, may be forced to sell.
The good news is that falling house prices will not cause an epic financial bust in America as they did 15 years ago. The country has fewer risky loans and better-capitalised banks which have not binged on dodgy subprime securities. Uncle Sam now underwrites or securitises two-thirds of new mortgages. The big losers will be taxpayers. Through state insurance schemes they bear the risk of defaults. As rates rise they are exposed to losses via the Federal Reserve, which owns one-quarter of mortgage-backed securities.
Some other places, such as South Korea and the Nordic countries, have seen scarier accelerations in borrowing, with household debt of around 100% of gdp. They could face destabilising losses at their banks or shadow financial firms: Sweden’s central-bank boss has likened this to “sitting on top of a volcano”. But the world’s worst housing-related financial crisis will still be confined to China, whose problems—vast speculative excess, mortgage strikes, people who have pre-paid for flats which have not been built—are, mercifully, contained within its borders.
Even without a synchronised global banking crash, though, the housing downturn will be grim. First, because gummed-up property markets are a drag on the jobs market. As rates rise and prices gradually adjust, the uncertainty makes people hesitant about moving. Sales of existing homes in America dropped by 20% in August year on year, and Zillow, a housing firm, reports 13% fewer new listings than the seasonal norm. In Canada sales volumes could drop by 40% this year. When people cannot move, it saps labour markets of dynamism, a big worry when companies are trying to adapt to worker shortages and the energy crisis. And when prices do plunge, homeowners can find their homes are worth less than their mortgages, making it even harder to up sticks—a problem that afflicted many economies after the global financial crisis.
Lower house prices also hurt growth in a second way: they make already-gloomy consumers even more miserable. Worldwide, homes are worth about $250trn (for comparison, stockmarkets are worth only $90trn), and account for half of all wealth. As that edifice of capital crumbles, consumers are likely to cut back on spending. Though a cooler economy is what central banks intend to bring about by raising interest rates, collapsing confidence can take on a momentum of its own.
A further problem is concentrated pain borne by a minority of homeowners. By far the most exposed are those who have not locked in interest rates and face soaring mortgage bills. Relatively few are in America, where subsidised 30-year fixed-rate mortgages are the norm. But four in five Swedish loans have a fixed period of two years or less, and half of all New Zealand’s fixed-rate mortgages have been or are due for refinancing this year.
When combined with a cost-of-living squeeze, that points to a growing number of households in financial distress. In Australia perhaps a fifth of all mortgage debt is owed by households who will see their spare cashflow fall by 20% or more if interest rates rise as expected. In Britain 2m households could see their mortgage absorb another 10% of their income, according to one estimate. Those who cannot afford the payments may have to dump their houses on the market instead.
That is where the political dimension comes in. Housing markets are already a battleground. Thickets of red tape make it too hard to build new homes in big cities, leading to shortages. A generation of young people in the rich world feel they have been unfairly excluded from home ownership. Although lower house prices will reduce the deposit needed to obtain a mortgage, it is first-time buyers who depend most on debt financing, which is now expensive. And a whole new class of financially vulnerable homeowners are about to join the ranks of the discontented.
Dangerous properties
Having bailed out the economy repeatedly in the past 15 years, most Western governments will be tempted to come to the rescue yet again. In America fears of a housing calamity have led some to urge the Fed to slow its vital rate rises. Spain is reported to be considering limiting rising mortgage payments, and Hungary has already done so. Expect more countries to follow.
That could see governments’ debts rise still further and encourage the idea that home ownership is a one-way bet backed by the state. And it would also do little to solve the underlying problems that bedevil the rich world’s housing markets, many of which are due to ill-guided and excessive government intervention, from mortgage subsidies and distortive taxes to excessively onerous planning rules. As an era of low interest rates comes to an end, a home-price crunch is coming—and there is no guarantee of a better housing market at the end of it all. ■
It looks very much as though 2015 will be a good year for the world economy, after all – and, if it is, that will be thanks to the fall in the oil price. It won't be good for everyone and we have already seen the pressure it puts on the Russian leadership – though, before you conclude that sometimes there is natural justice in the world, remember that the people who are hurt are not leaders such as Vladimir Putin. Other oil- and gas-exporting countries are damaged, too, and I think we will see further fallout in unpredictable ways. But the net impact is strongly positive, more so than most commentators at present acknowledge. The winners far outnumber the losers.
If that sounds overly optimistic, consider this. We have a lot of experience of sudden increases in the price of oil but very little of sudden falls. Oil has tended to go up in big jumps and come down in small, incremental notches. We know that, when the oil price suddenly doubles, this gives world growth a huge blow. The global recessions of the 1970s, the early 1980s and 2008 were all triggered by an oil-price shock. So if oil gives the economy a blow on the way up, surely it must give a corresponding boost when it is on the way down?
How much of a boost? It would be nice to have a ready-reckoner on the lines that x per cent off the oil price would lead to a y per cent rise in growth. But that isn't possible. First, we don't know what the oil price will do in the months ahead. And, second, the fall in price can come about either from an increase in supply or from a broader trend of deflation around the world. If the former, the lower oil price is undoubtedly positive; but if the driver is general deflation (and in Europe and Japan inflation had plunged before the oil-price fall), the argument is more finely balanced.
There is a spectrum of views on this. Here are a couple, from each end of the scale. The more cautious comes from HSBC, which has just put out a paper emphasising deflationary concerns. It notes that the world is saddled with high levels of debt and that years of very low interest rates and quantitative easing have failed to get credit growth moving. It concludes: "It's increasingly difficult to ignore the echoes from Japan."
At the optimistic end is Berenberg Bank, which reckons that lower oil prices will increase demand in Europe and America by at least 0.5 per cent over the next 18 months. It acknowledges that there are losers and that the damage to Russia may spill over into Germany and Italy. But the conclusion is upbeat: "Cheaper oil, if it lasts, should provide a persistent tailwind to growth for oil consumers over the next few years even beyond the short-term boost to real incomes."
My feeling is that the fall in the oil price comes just in time to sustain and broaden an uneven recovery. Continental Europe and Japan have been the two main laggards in the developed world and both depend heavily on imported energy. If the price drop adds 0.5 per cent to eurozone growth next year, that would be enough to double the performance of 2014. We must be aware that cheaper energy cuts headline inflation and it is quite possible that this will go negative early next year in the eurozone.
But the problems of the eurozone go far beyond simple deflation, for they concern the rigidities imposed on Europe by the single currency and the lack of structural reforms, especially in Italy and France. In any case, underlying inflation will pick up once cheaper oil has worked through the system; meanwhile, the dip will nudge the European Central Bank to have yet another shot at boosting demand.
And for Britain? As a net importer of oil, we are a net beneficiary. This is bad news for the North Sea oil industry and for the Scottish economy, but the UK as a whole is a modest winner. If Europe perks up a bit, we become a bigger winner thanks to higher exports. British consumers are clear winners, as we have seen, and the idea that the economy can have another year of 3 per cent growth, maybe a bit more, seems a decent bet. Next year's uncertainties are political, not economic.
We can, as a country, make a mess of things. We know how to do that. But whereas for most of the past five years we have been butting into a global headwind, now we have a tailwind. And that is a huge change that I don't think we fully appreciate.
