How would the rupee develop in 2019

Exchange rates as a corona barometer: how currency fluctuations reflect the crisis

May 6, 2020 - The corona pandemic has led to a serious crisis in the global economy since the beginning of the year, which - like every crisis - is also evident in the currency markets. The price of the national currencies traded there reflects the strength of the respective national economy. The big changes in exchange rates since January show how the economies of the world are being hit very differently by the crisis. Basically, a crisis leads to a flight to “safe havens”, that is, to the currencies of the most stable national economies: First and foremost is still the US dollar, which has appreciated by around five percent in the last three months. The currencies of industrialized countries are losing some of their value, whereas the currencies of typical emerging countries have fallen by an average of ten percent in a few weeks. Some currencies, such as the Brazilian real, crashed by as much as 25 percent, which is further destabilizing the economy. Some emerging markets have been able to slow this fall through foreign exchange market intervention.

Economic crises go hand in hand with a reassessment of the opportunities and risks of financial investments. Due to the economic downturn, the opportunities generally decrease and the risks increase. This leads to corresponding adjustments in the prices of assets, and exchange rates can in this sense be understood as the prices of currencies. The bigger the crisis, the bigger the rate and price changes. So it is basically not surprising that many exchange rates have changed significantly in the current Corona crisis.

A characteristic of every crisis is the escape to a “safe haven” that offers protection from the storms in the financial markets. International investors try to preserve their capital, which is why they sell particularly risky assets and invest their capital in low-risk investments. This reinforces the price adjustment that is already taking place. The safe haven must, if possible, offer the value retention of the capital as well as liquidity, so that the capital can be invested there, but also withdrawn again if necessary.

As in any crisis, the US dollar will appreciate in 2020

These safe haven characteristics apply to the US dollar as it does to few other assets. Investors around the world have the highest confidence in the dollar and trade it to an extent that far surpasses all other currencies. Almost two thirds of international trade is settled in dollars. Cross-border holdings of corporate bonds are 70 percent held in dollars. Over 40 percent of foreign exchange trading takes place in dollars, and central banks hold an average of 60 percent of their foreign exchange reserves in the US currency.infoMatteo Maggiori, Brent Neiman, and Jesse Schreger (2019): The Rise of the Dollar and Fall of the Euro as International Currencies. AEA Papers and Proceedings, 109, 521-526.

As of January 22, 2020, the day since Johns Hopkins University began recording the spread of the novel coronavirus, at that time, there were only known cases outside of China in Thailand, South Korea, and Taiwan. Cases that had already occurred in the US were only later associated with the virus. Over the period of three months, the registered corona cases rose from around 500 to over 2.8 million., The US dollar has appreciated by around five percent (Figure 1.) The same figure also shows the number of corona cases recorded worldwide Cases shown with dashed lines. The correlation between the appreciation of the dollar and the number of recorded corona cases is quite high with a coefficient of 0.6, which suggests an effect of the confirmed cases on the exchange rates.

Illustration 1: The dollar as a safe haven
Standardized Bloomberg US Dollar Spot Index, January 22, 2020 = 100, and number of corona cases worldwide (logarithmic scale)

 

Note: The index tracks the performance of the US dollar against ten other major currencies. The end-of-day dates are used. Sources: JHU CSSE, Bloomberg
© DIW Berlin

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Note: The index tracks the performance of the US dollar against ten other major currencies. The end-of-day dates are used. Sources: JHU CSSE, Bloomberg
© DIW Berlin

The development of the US dollar can be divided into four phases: When the first number of cases became known and increased at the end of January, the dollar appreciated by around two percent by the end of February. The first death outside of China was recorded in the Philippines on February 2nd and the first in Europe on February 14th in France. The US imposed an entry ban from China on January 31. At this time, the USA is still a safe haven.

In the second phase, which begins in the last week of February, the dollar depreciates and on March 9th it is back at the level of January 22nd. Investors fear that after Europe, the virus could now also hit the United States. In the last week of February, the American stock markets fell by almost ten percent. By March 11th, the S&P 500 Index, which comprises the 500 largest companies in the USA, will lose around 25 percent of its value.

However, in the third phase from March 9th, the US currency rises rapidly. US President Donald Trump imposed an entry ban from Europe and declared a national emergency on March 13. On March 15, the US Federal Reserve (Fed) reacted for the second time since the beginning of March, lowered the key interest rate to 0.25 percent and resumed its bond purchase program worth a total of 700 billion US dollars. The USA decided on a fiscal package of enormous proportions. The state plans to spend an additional 2,000 billion US dollars, which corresponds to around ten percent of the forecast US gross domestic product. Within two weeks, the dollar appreciated by eight percent. Investors are fleeing other currencies into the dollar. The Fed is trying to allow other central banks to borrow dollars and is extending its currency swap agreements with the Canadian, UK, Japanese, European and Swiss national banks. On March 19, additional currency exchange agreements will be made with Australia, Brazil, Denmark, South Korea, Mexico, Norway, New Zealand, Singapore and Sweden. This allows these central banks to provide US dollars to their domestic banks and maintain the dollar's liquidity. After the national currency has been exchanged for dollars at current market prices, the currencies will be exchanged back at the same exchange rate within a period of up to three months. On March 23, the US Federal Reserve announced that it would continue to buy bonds indefinitely to further calm the markets.

In the fourth phase, after all measures to strengthen the US dollar have become known, its value drops rapidly within three days from its high on March 23, and has since fluctuated at the four to six percent higher level since then End of January. The devaluation of the dollar goes hand in hand with the status of the USA as the country with the highest number of registered cases of illness. The epicenter of the corona crisis now seems to have jumped from Europe to the USA.

The currencies of the industrialized countries are falling little and inconsistently

The currencies of other industrialized countries (or currency areas such as the euro) perform very differently. The four most important currencies of the industrialized nations - the euro, the Japanese yen, the Swiss franc and the British pound - will develop quite parallel to the end of February and will generally depreciate slightly against the dollar (Figure 2). After that, the yen, Swiss franc and euro gained strongly in value, while the pound lagged somewhat. The yen and the franc appreciate particularly strongly and have increased by more than five percent compared to the beginning of January. Overall, they remain almost unchanged against the US dollar, making them safe assets as well. If you look at the effective euro exchange rate, measured against the currencies of the most important trading partners, this is the same at the end of April as at the beginning of the year, despite the slight depreciation of the euro against the dollar.

Japan seems to have had the virus relatively well under control so far, with just under ten confirmed cases per 100,000 population and fewer than 350 deaths (as of April 24). In Europe, the corona pandemic had broken out much more severely by then. The euro will lose 3.5 percent by the end of April, while the pound will fall twice as much by almost seven percent. The fact that the British currency is depreciating against the currencies of other industrialized nations may also be related to the poorer health measures and capacities: The number of intensive care beds in the United Kingdom (6.6 per 100,000 inhabitants in 2012info) The number of intensive care beds in the United Kingdom is now around 8.7 per 100,000 inhabitants. For a European comparison, however, there are only figures for 2012. Cf. Leo Ewbank, James Thompson and Helen McKenna (2017): NHS hospital bed numbers: past, present, future (updated March 2020 by Siva Anandaciva). King's Fund. (Available online). At a European average of 11.5) infoA. Rhodes et al. (2012): The variability of critical care bed numbers in Europe. Intensive Care Med, 38, 1647-1653. is relatively small and the lockdown was implemented relatively late (a week later than, for example, Spain and France). In addition, the kingdom carries out fewer tests per capita (9,500 per million inhabitants) than countries like the USA (15,000), Spain (29,000), Italy (27,000) or Germany (25,000). Infohttps: //www.worldometers.info/ coronavirus /, as of April 24, 2020

Figure 2: Global devaluation against US dollar info The recorded currencies are (in each case the exchange rate against the US dollar): JPN - Japanese yen, CHF - Swiss franc, EUR - Euro, GBR - British pound, CHN - Chinese yuan, IND - Indian Rupee, RUS - Russian ruble, BRA - Brazilian real. The gray gradients describe the currencies of the following countries, descending by value on April 27, against the dollar: Taiwan, Philippines, Peru, Romania, Singapore, South Korea, Malaysia, Thailand, Argentina, Poland, Indonesia, Hungary, Czech Republic, Chile, Turkey, Colombia , Mexico and South Africa.
Change in percent, 01/01/2020 = 100

 

Note: The values ​​of the 26 exchange rates [6] are spot prices, in each case end-of-day rates. The exchange rates are quoted in US dollars per currency unit. Source: Bloomberg
© DIW Berlin

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Note: The values ​​of the 26 exchange rates [6] are spot prices, in each case end-of-day rates. The exchange rates are quoted in US dollars per currency unit. Source: Bloomberg
© DIW Berlin

Exchange rates in emerging markets are falling sharply

Worst of all, however, the virus hits emerging countries and, of course, poor developing countries, whose health systems are less developed and which generally have less room for maneuver in terms of fiscal policy. Investors flee these currencies during the crisis as they foresee difficult economic times due to lockdowns, less trade and less tourism. Added to this is the collapse in the price of oil, which is taking important revenues from oil exporting nations.

Since the exchange rates of developing country currencies are often not formed in markets, this study focuses on the currencies of the BRIC countries (Brazil, Russia, India and China) compared to the industrialized countries and other emerging countries mentioned above (Figure 3). Since the end of January, international investors have been losing confidence in the emerging markets and withdrawing almost 100 billion US dollars net capital from the beginning of the year to the beginning of April. The extent of the capital outflow is significantly greater than in the financial crisis of 2008, when almost 25 billion US dollars net in portfolio investments were withdrawn from emerging markets over a similar period of time.infoInstitute of International Finance (2020): Capital Flows Report Sudden Stop in Emerging Markets, 9 . April. In the meantime, China has developed far more economically than the other countries. This is also noticeable in the current crisis: While the Chinese renminbi has depreciated only just under two percent against the US dollar, the depreciation for Brazil is more than 25 percent. The Indian rupee and the Russian ruble depreciate by just under seven percent and just under 17 percent, respectively.

The differences between the BRIC countries are partly explained by the falling oil price. As a result, Brazil and Russia lose additional income that they could use for fiscal packages to cushion the economic effects of the crisis - if they wanted to. There are also differences in dealing with the corona virus. China seems to be relatively successful here. After the virus broke out in China, strict measures were able to contain it quite effectively, so that new infections stagnated from the end of February. In contrast, the Brazilian President Bolsonaro is an avowed opponent of strict isolation and so one might ascribe to Brazil a frivolous handling of the pandemic. For example, on April 16, the Brazilian president sacked the health minister who was encouraging citizens to take distance measures, while Bolsonaro supported public protests against restrictive measures.

Figure 3: Currency development in the BRIC countries
Depreciation against the US dollar, 1/1/2020 = 100

Note: The values ​​of the exchange rates are spot rates at the end of each day. The exchange rates are quoted in US dollars per currency unit. Source: Bloomberg
© DIW Berlin

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Note: The values ​​of the exchange rates are spot rates at the end of each day. The exchange rates are quoted in US dollars per currency unit. Source: Bloomberg
© DIW Berlin

These two countries are examples of their regions. Overall, the Asian currencies seem to be getting through the crisis relatively well, which fits the well-known success stories of Corona containment in South Korea and Singapore. In addition to the Chinese renminbi, the new Taiwan dollar and the Philippine peso maintain their value in relation to the dollar. Thailand, South Korea and Malaysia have been facing devaluations of up to seven percent since the beginning of the year. South American currencies, on the other hand, are losing more value. In addition to Brazil, Mexico and Colombia are particularly hard hit.

Basically, all emerging countries are badly hit by the crisis and its consequences. The rapid capital withdrawal has increased financing costs for emerging markets and their companies. In addition, foreign demand is collapsing due to the virus. A weaker currency would, under normal circumstances, lead a country to export more when its goods have become cheaper on world markets. However, global demand is currently so low that devaluations are not very helpful as a stimulus.

Stabilize falling currencies through foreign exchange market intervention

One way to effectively slow down the devaluation of one's own currency is to intervene in the foreign exchange market. e.g. Marcel Fratzscher et al. (2019): When Is Foreign Exchange Intervention Effective? Evidence from 33 Countries. American Economic Journal: Macroeconomics, 11, 132-156. Countries that hold large amounts of foreign currency reserves can use it to stabilize their currencies if demand for their currency collapses during the crisis. For example, if the demand for Indonesian rupiah falls in times of crisis because investors want to sell Indonesian bonds and exchange rupiah for dollars, the central bank can buy up this oversupply of rupiah, thereby reducing its foreign currency reserves. As a result, the value of the currency falls less sharply than if no intervention had been made. Such a connection was already observed in the global financial and economic crisis of 2008/09. And now it seems to apply again.infoKathryn M.E. Dominguez, Yuko Hashimoto and Takatoshi Ito (2012): International Reserves and the Global Financial Crisis. Journal of International Economics, 88, 388-406.

Data on intervention volumes are only published sporadically at the time of the intervention. For example, the Indonesian central bank announced on April 4 that its holdings of international assets had fallen by around $ 9 billion in March and that it had used a large part of it to stabilize its own currency, the rupiah. In the same press release, she described the rupiah as being severely undervalued at the moment. By the beginning of April, the Indonesian exchange rate rose by five percent against the dollar. Many emerging market central banks have intervened and sold foreign exchange reserves since the beginning of the year. These countries include Brazil, India, Colombia, Mexico, Peru, Russia and probably Malaysia and Singapore as well.

Since a large part of the foreign exchange reserves from around the world are held in dollars at the US Federal Reserve and are shown separately in the statistics, changes in these stocks can indicate how much intervention has been made. These holdings of short-term marketable US Treasuries, which are published every two weeks, fell by around $ 150 billion from late February to late April. This makes up five percent of the total external inventory (Figure 4). However, country-level details are mostly unclear, and how much currencies would have depreciated without intervention is difficult to gauge.

Figure 4: States use their foreign exchange reserves Fed trust holdings of marketable US Treasuries in billions of dollars

Note: The figure on the right shows an excerpt from the figure on the left over the period since January 2020. The Fed announces the status of its holdings of US government bonds that can be marketed on behalf of other central banks every second Wednesday. Source: Federal Reserve Bank of St. Louis
© DIW Berlin

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Note: The figure on the right shows an excerpt from the figure on the left over the period since January 2020. The Fed announces the status of its holdings of US government bonds that can be marketed on behalf of other central banks every second Wednesday. Source: Federal Reserve Bank of St. Louis
© DIW Berlin

Conclusion: Foreign exchange market intervention can mitigate currency crashes in emerging markets

If you look at exchange rates in terms of their ability to depict the risks of the economic development of an economy, they also seem to be a kind of barometer for the effects of the corona crisis. If a currency appreciates in view of the uncertain global situation, it is considered a safe haven. The strong appreciation of the dollar shows that the US currency is still regarded as a low-risk investment goal in the current crisis, despite the high number of infections. In addition to the Japanese yen and the Swiss franc, the euro and the Chinese renminbi have also shown themselves to be relatively stable during this crisis, while currencies from emerging countries, which for various reasons may be more severely affected by the pandemic, depreciate very sharply. These devaluations can exacerbate the crisis, so countermeasures are indicated. Foreign exchange market interventions can be a helpful instrument against the currency crash and are also used in this crisis to stabilize not only the currency but also these economies.

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Abstract

The corona pandemic has led to a serious crisis in the global economy since the beginning of the year, which - like every crisis - is also evident in the currency markets. The price of the national currencies traded there reflects the strength of the respective national economy. The big changes in exchange rates since January show how the economies of the world are being hit very differently by the crisis. Basically, a crisis leads to a flight to “safe havens”, that is, to the currencies of the most stable national economies: First and foremost is still the US dollar, which has appreciated by around five percent in the last three months. The currencies of industrialized countries are losing some of their value, whereas the currencies of typical emerging countries have fallen by an average of ten percent in a few weeks. Some currencies, such as the Brazilian real, crashed by as much as 25 percent, which is further destabilizing the economy. Some emerging markets have been able to slow this fall through foreign exchange market intervention.

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