Bah! Humbug! What can a mere quarter-percent hike in the Federal Reserve Bank’s interest rate do to markets? It seems so small a change as to be trivial.
For two years prior to Janet Yellen’s appointment as Chair in January 2014, her predecessor, Ben Bernanke, and the business press speculated on the timing of a rate hike with casuistic verbal contortions that kept the markets guessing. Finally, the agony was over on December 16, 2015. After almost a decade, the Fed raised short-term interest rates by . . . a mere one-quarter percent.
But what was the agony all about? The millions of words in the media, the roiling of markets worldwide?
A Multiplier Effect on Bond and Exchange Markets
Even a one-quarter percent increase can have a much larger impact on bond markets and foreign exchange rates. The math examples below abstract from many other market considerations, including the time value of money, the length of the bond when the principal amount would be returned, and forward exchange rates, but will suffice to explain the multiplier effect in simple terms.
BOND MARKET EXAMPLE
Imagine that Investor A owned, prior to December 2015, a bond yielding 1.5% and that a new Investor B purchased, after December 2015, a bond yielding 1.75%:
Investor A: Before December 2015, a $10,000 deposit would have been yielding the owner 10,000 (.015) = $150 per year in interest.
Investor B: After December 2015, with a quarter-percent interest rate increase, a new investment of $10,000 would yield $10,000 (.0175) = $175 per year.
With bonds being traded in the market, which now expects a 1.75% return (as against the old 1.5% return), Investor A’s bond could now lose value by up to $1,250. This is because after December 2015, an investment of only $8,571 would yield 8,571 (.0175) = $150 in interest per year.
The face value of Investor A’s investment of $10,000 would therefore be devalued in the bond market (by other new or later investors like Investor B, who are now targeting a 1.75% return) to as low as $8,571.
Hence a mere one-quarter percent interest rate jump could devalue a bond by as much as 14 percent: (10,000 – 8,571)/10,000 = 0.1429, or a drop of up to 14.3 percent in face or resale value.
EXCHANGE MARKET EXAMPLE
Imagine that Frenchman Pierre had invested, prior to December 2015, in US bonds. Assume for simplicity’s sake that the exchange rate prior to December 2015 was €1 = $1.10.
Before December 2015: A €10,000 investment by Monsieur Pierre would have converted into dollars 10,000 (1.10) = $11,000, which Pierre used to purchase US bonds yielding 1.5 percent annually (this return compares favorably with similar-grade investments in Europe):
[11.000 (.015)] = $165 in interest annually.
$165 converted back into euros would yield 165/1.10 = €150 . . . or an expected 1.5% yield for investor Pierre.
After December 2015: If exchange rates remained the same, Investor Pierre would continue to receive the same $165, or €150—a 1.5% rate of return in interest.
However, many other new investors, such as Monsieur Quentin, could earn a 1.75% return after December 2015 if the exchange rate did not change and remained at €1 = $1.10:
An investment of €10,000 (1.10) = $ 11,000.
$11,000 (0.0175) = $192.50 in interest.
$192.50 converts back into 192.50/1.10 = €175, assuming exchange rates do not change.
HOWEVER . . .
Seeing the higher returns available after December 2015, yet other French investors, such as Monsieur Raymond, and a great many many others, would be eager to participate in the game. As a first step, in order to invest in the US bond market, euros have to be sold (supplied to the exchange market) and dollars purchased (or demanded in the foreign exchange market). Foreigners cannot invest in US dollar instruments unless they first exchange their own money for the US dollar in the foreign exchange market. This collective extra demand for the US dollar, from a host of foreign investors, would drive up its exchange rate. Recall that the world has a trillion dollars equivalent, or more, in liquid assets looking for a higher return. Billions of euros are ready to be sold and dollars demanded, each day, if the prospect of a higher return exists. Collective higher demand for any free-floating currency such as the US dollar can drive up its value in milliseconds or minutes, from €1 = $1.10 to say €1 = $1.0209. (This 1.0209 new exchange rate is only an example—one among many scenarios of a stronger dollar.)
Hence, after the dollar strengthens in the exchange market:
An investment of €10,000 (1.0209) = $10,209 from the currency conversion at the new exchange rate.
$10,209 (0.0175) = $178.66 in interest earned.
Assuming the dollar remains at the appreciated (stronger) exchange rate, $178.66 converts back into 178.66/1.0209 = €175, which is the same targeted €175—but now illustrated with a devalued euro or a strengthened or appreciated US dollar.
The euro can then have devalued from $1.1000 to $1.0209, or more than seven percent. A mere one-quarter percent hike in US interest rates can cause the euro to devalue by seven percent, as an example.
Simple Math Examples Obscure Many Complications—But Still Reflect Basic Facts
Actually, many other considerations and motivations influence investors in bond and exchange markets. For instance, the euro could devalue even more than the seven percent illustrated above if French or European investors are content to earn less than 1.75%. After all, recall that Monsieur Pierre was content to accept a return of only 1.5% prior to December 2015. What the simple examples above do not incorporate is the fact that a devalued euro also potentially changes (for the European investor) the re-conversion of the principal invested into euros, on the maturity of the bond, and not just the interest earned on the bond. For that we would need to do more complicated math involving the time value of money.
Nevertheless, the above simple examples do illustrate how a mere one-quarter percent interest rate hike by the US Federal Reserve Bank can cause much larger swings in the bond and foreign exchange markets. How important is the dollar-euro exchange rate? In 2014, US–EU trade (imports + exports in goods and services) exceeded $800 billion. Transatlantic investments amounted to hundreds of billions more. To say that the international business relationship between the US and the EU is enormous is a gross understatement. Similarly, the US’ business with China and other countries is also directly affected by the strength or weakness of the dollar.
Small shocks or changes in US interest rates ripple outward to the rest of the world. Janet Yellen and her colleagues were right in agonizing so long and hard.
 This is an over-simplified example because it does not incorporate the principal on maturity and the time value of money. However, it serves to make the point that a tiny change in interest rate expectations can make a large difference in the value of the bond.
After 20 years, the Chinese government must be used to it—being bashed by US politicians and Congress as a “currency manipulator.” Indeed, the exchange value of the yuan (or renminbi [RMB]) is fixed each morning by its central bank, the People’s Bank of China (PBoC), with a narrow band of only + 2 percent allowed, up or down, within which market forces can have their say. In effect, it is an exchange rate set and controlled by the PBoC.
But why pick on just China?
Most countries “manipulate” their exchange rates…
According to the IMF (International Monetary Fund), well over half its member countries’ governments meddle, in a mild or total fashion, to influence or fix their exchange rates. As shown in Figure 1, “Fixed Peg” and “Currency Board” are countries with currency values fixed for a considerable period of months or years. In “Managed Float” cases, market forces are allowed to play, but with the government intervening (buying or selling) to bias the exchange rate upward or downward. “Adjustable Pegs” are situations where the government fixes the rate temporarily—for months at a time or daily, as in the case of China. It is only with a few major currencies, such as the dollar or euro, that the government allows a “Free Float” with minimal or no intervention.
Figure 1: Percentages of IMF Member Nations Intervening in Foreign Exchange Rates (Source: IMF)
What exactly is behind the accusation of “currency manipulation”?
Generally, the accusation alleges that the government is keeping its currency too weak, overly devalued, or undervalued in order to give an artificial boost to exports while keeping out imports. This has the effect of boosting jobs in that country.
Take China as an example. A Chinese exporter earning a dollar turns it into the bank and gets 6.4 RMB yuan. By comparing costs in China and elsewhere, IMF and other economists calculate a hypothetical purchasing power parity (PPP) rate of 5.7 RMB/$, which would supposedly prevail under market equilibrium and without government meddling. At 6.4, some economists argue the RMB is still undervalued. But if the theoretical rate of 5.7 RMB/$ were to happen, the Chinese exporter would get only 5.7 RMB per dollar at the bank counter. The 6.4 RMB/$ rate provides a 12 percent higher revenue to the Chinese exporter, compared with the hypothetical 5.7 RMB/$ rate that some economists say should prevail. The still-undervalued 6.4 RMB/$ rate, they allege, gives the Chinese exporter an advantage.
By the same token, imports into China cost 12 percent more at the allegedly undervalued 6.4 RMB/$ rate than at the PPP 5.7 RMB/$. This, they allege, makes imports into China 12 percent more expensive than they should be, thereby keeping some foreign products out of China and benefiting (or protecting) Chinese firms that produce substitute products that compete with imports. On both the import and export side, an undervalued exchange rate boosts or preserves jobs in China (at the expense of jobs in the rest of the world).
But the Chinese have already massively appreciated their currency since 2005…
It must be particularly galling to the Chinese to hear accusations of currency manipulation since, succumbing to pressure from Western countries, they have already massively appreciated their currency in the 10 years since 2005. In June 2005, following more than a decade of a fixed exchange rate at 8.27 RMB/$ (when it was indeed undervalued), the Chinese gradually appreciated their currency all the way to 6.2 RMB/$ by July 2015. In the minds of many Chinese economists, their currency is no longer undervalued at around 6.2 for three reasons:
1. Between June 2005 and July 2015, the RMB appreciated/strengthened by 36 percent (see Figure 2)
This means that Chinese exporters in 2015 earned as much as 33 percent less that they would have at the 2005 exchange rate. Several Chinese exporters found themselves uncompetitive with the stronger currency and had to shut down their operations in China and relocate production to Vietnam, Bangladesh, or Africa.
Figure 2: China’s RMB Exchange Rate History (Source: Oanda.com)
By the same token, imports into China costing 33 percent less in 2015 than in 2005 means that some Chinese domestic production was displaced by imports.
In both cases, the appreciation of the yuan (RMB) has meant reduction of jobs in China, although this is consistent with the peaking of the Chinese labor force (partially as a consequence of the one-child policy). Indeed, several areas in China have labor shortages.
2. The yuan (RMB) has appreciated even more against other currencies
The PBoC fixes the RMB only against the US dollar. But in the last two years, this has meant that as the dollar has risen against most other currencies (such as the euro or emerging-country currencies such as the Brazilian real), the RMB has appreciated or strengthened even more, piggybacking on the dollar (see Figure 3).
If one combines the RMB appreciation in Figure 2 (36 percent) with the dollar’s appreciation against most other currencies since 2013 (15 percent), the local currency cost of importing Chinese products may have risen by more than 50 percent since 2005 for many prospective buyers in a large swathe of nations from Europe to Brazil.
3. Chinese wages and costs have risen
On the east coast of China, where most of its manufacturing and economic activity takes place, wages have recently been rising at least 15 percent each year. Some jobs go unfilled. The one-child policy (reversed in 2015) has led to a plateauing of the labor force. Other costs, such as real estate, have also risen sharply. Chinese exporters are beginning to feel a squeeze between (i) rising costs and (ii) the falling RMB conversion value for the dollars or foreign currencies they earn.
So, why pick on China?
By massively appreciating their currency, the Chinese have succumbed to Western government pressure. While most economists aver that the yuan (RMB) is still undervalued, they agree that in 2015 it is not undervalued by much.
Indeed, if one were to search for a more egregious recent example, it would be the Japanese yen, which has been consciously devalued by the Shinzo Abe government by around a third since November 2012.
Figure 4: Yen per Dollar Exchange Rate November 2012–November 2015 (Source: Oanda.com)
One of the Abe government’s top priorities on taking office was to drive the yen downward (devalue it) from a historically high overvaluation of 80 yen/$ (at which rate few Japanese exporters could make any money) to a more devalued rate of 124 yen/$ (by 2015 when Japanese exporters could make profits). The math is simple. At 124 yen/$, each dollar earned by the Japanese exporter converted into 55 percent more yen, compared with the 80 yen/$ rate. In retrospect, it seems astonishing that so many Japanese governments prior to Abe’s allowed the yen to remain at an overvalued rate of 80–100 per dollar, which not only grossly dampened Japanese exports, but also put the economy into the doldrums for so many years. Most economists would agree that at around 115 yen/$, the yen would be appropriately valued—that 80 was too high and that perhaps the 124 yen/$ at end 2015 is a tad too low. At any rate, the Abe government’s actions have jump-started the Japanese export engine and restored a plethora of Japanese exporters to profitability.
But is this not also a case of currency manipulation by the Japanese? And, as noted above, the IMF reports that more than half of the world’s governments have a hand in influencing or adjusting their exchange rates.
So why then pick on only the Chinese, especially if, at 6.2 RMB/$ and with rising costs inside China, they are not too far from a realistic PPP rate in 2015?
This archive contains 2014 & 2015 posts discussing international business issues, focused on both economics and culture, in an unbiased manner. Managers, students, policy makers, and educated laypeople will gain insights on current issues, future trends, and historical perspectives.