New York Times
June 3, 2004
Exchange Rates the Economy

IMAGINE living in a world where you had to have yen to buy a TV, renminbi to buy toys, and dollars to buy food. Think how complicated life would be.

Surprise. That's the world we live in. Most TV's we buy are manufactured in Japan, most toys come from China, and most of our food is produced in the United States. And by and large, the workers who produce those goods want to be paid in their domestic currency.

Luckily, this complexity is hidden from consumers; those nice currency traders handle all the grungy details. When you buy an imported TV with your hard-earned dollars, those dollars are exchanged for yen somewhere along the way to pay the Japanese workers who built the TV.

How is that exchange rate determined? The basic force is good old supply and demand. If the demand for yen exceeds the supply at the current exchange rate, the cost of yen in terms of dollars will rise, and if supply exceeds demand, it will fall.

If the only reason to buy foreign currency was to use it to purchase foreign goods, international exchange would be pretty simple. Luckily for economists, the story is more complex.

People also want to acquire foreign currency to make investments. If America's interest rates are higher than Japan's, then Japanese investors will want to buy our bonds to take advantage of those higher rates. But to do so, they must first sell yen and buy dollars. This is where things get tricky.

Eventually, those Japanese investors will want to end up with yen. So they will care about not only the current interest rates on American bonds, but also the likely movement of exchange rates in the future.

What matters to them is the expected return denominated in yen, which involves both the rate of interest and the expected movement in exchange rates. This means the demand for yen will depend not only on the current exchange rate, but also on anticipations of future exchange rate movements.

The demand for currency to support international trade is pretty predictable, since the short-term trade patterns are reasonably predictable. It's the speculative demand that causes most of the short-term fluctuations, since foreign exchange traders have to make guesses about the future, and those guesses are constantly being revised.

As foreign exchange speculators change their views about the future, their demand for currency changes, resulting in exchange rate fluctuations.

On top of all this, central banks also intervene in foreign exchange markets for reasons that can be quite different from those of the other participants.

The Bank of Japan could easily decide to sell yen on the foreign exchange market. This would push down the value of yen, making Japanese goods cheaper in dollar terms.

Why would the Bank of Japan want the yen to be cheap? Well, cheap yen translate into cheap TV's and Toyotas, which means Americans keep buying those products and Japanese factories keep humming along. Japan (or any other country that depends heavily on exports) wants a cheap currency to keep its citizens employed.

In the last two years, the United States has had abnormally low interest rates. A result has been that demand for dollars has weakened, making yen more costly, thereby raising the price and reducing sales of those imported TV's.

Naturally enough, the Bank of Japan didn't want to see domestic unemployment go up, so it sold yen, keeping the currency lower than it otherwise would have been. The dollars received in exchange were used to buy Treasury bonds, with the Japanese accumulating $577 billion as of the end of January 2004. This huge currency intervention has received little attention in the popular press.

And it wasn't just Japan. The Taiwanese and the Chinese also bought United States Treasury bonds, trying to keep their currencies from appreciating against the dollar. This kept the dollar price of their exports low and kept their factories operating.

But now what happens? The Japanese economy seems at last to be recovering, and the Chinese economy is overheating. This suggests that these two financial powerhouses will cut back on their purchases of dollars, pushing the value of the dollar down relative to their own currencies.

On the other hand, American interest rates are also increasing. As the economy recovers, the Fed will push rates up, making United States bonds more attractive, which will tend to push the value of the dollar up.

Which effect will dominate? Will the dollar go up or down in the coming months?

Anyone who can answer that question with certainty would be a wealthy man. But lots of people - including wealthy men like Warren E. Buffett - are betting against the dollar.

Many experts think the foreign exchange interventions of the last two years have maintained the dollar's value at an unnaturally high level. As evidence, they point to the ballooning trade deficit and the hubbub over outsourcing and "predatory trade practices." If foreign goods and services look cheap, the dollar is probably overvalued.

Maybe it is. But by how much? And if it is overvalued, how rapidly will it fall? In the rosy scenario, the dollar has a steady decline against the renminbi and the yen; the Chinese economy has a soft landing; the Japanese recovery persists; and the American economy has a healthy recovery.

Then there's the other scenario. The dollar drops precipitously; prices of imported goods shoot up here, rekindling inflation; the Japanese economy drops back into the doldrums; and unemployed Chinese workers riot in the streets.

Needless to say, a lot hinges on which scenario materializes. Keep your eye on those exchange rates. They have a lot to do with America's recovery and the health of the world economy.

Hal R. Varian is a professor of business, economics and information management at the University of California, Berkeley.