Thursday, September 3, 2015

Exchange Rates Are Relative Prices

I used this analogy  in a conversation last week, and its too apt not to publish it.

Imagine you’re in the stock market and trying to evaluate two different stocks. Now, fundamental based analysis would look at earnings, book value, gearing, corporate strategy and so on, and come up with a target price for the stocks which reflects what the price of a stock should be.

The market of course can have very different ideas about how much a stock is worth, and that difference between the fundamental value and market value is one of the methods by which analysts would give a buy, hold or sell call.

Be that as it may, the stock price is often treated as a gauge of company value – the better a company performs, the higher its stock price and vice versa. That might make sense from an individual company perspective – cross-company comparisons are trickier.

Stock prices are determined by so many different factors that a direct comparison of the stock price of two companies really tells you nothing. Just to take one example, take two companies with the same overall “value”, but one with 100 thousand shares and the other 1 million. The company with the smaller capital base would have (theoretically) a share price 10x greater than the one with the larger capital base, despite the aggregate value of the shares being the same. One company isn’t better than the other just because it has a higher stock price.

What has all this got to do with exchange rates? You’ll get a conceptual idea of what an exchange rate is, by taking our two company example above and instead of quoting the stock prices in currency, quoting them in relation to each other. In our example above, the price of Company A stock (with 100k shares) has an exchange value of 1 to 10 of Company B stock.

Let’s add some shocks and see what insights we can get from them. Assume sales at both companies are growing at the same pace. What happens to the exchange rate? That’s right, nothing (or at least, nothing if the market is rational and pricing the shares based on fundamental value). Take the opposite tack – if sales at both companies were declining at the same pace, what happens to the exchange rate? Again, nothing.

Unlike the absolute price of either company stock, the exchange rate between the two shares conveys NO information on how well either company is doing.

Let’s take a more complicated example. Let’s say Company A is increasing sales, but Company B is not. What happens to the exchange rate? Company A’s “currency” should appreciate, say from 10 to 11. Let’s flip the situation a little bit – say Company A sales are stagnant, but Company B sales are actually dropping. Again, A’s “currency” would appreciate. Here you can gain some information – A is doing better than B – but again, the exchange rate tells you nothing about individual company performance. Either A or B could be doing better or worse, but you can’t tell from the exchange rate which of these situations is true.

Now let’s take this to the next level – assume Company A has a share buyback scheme, and this scheme aims to regulate the value of Company A shares relative to an outside denominator, for example in Company C shares. That is, A buys and sells its own shares on the market to maintain a fixed exchange value with Company C shares, irrespective of the price performance of Company C shares or the company performance of A.

Under these circumstances the exchange rate between A and B shares now contains NO information about the relative performance of either company, because in essence, Company A’s share price now reflects Company C’s performance, not its own.

This is really the situation we have today – the “performance” of a currency is not much of a barometer of economic health. All the major economies (with the exception of China) have freely floating exchange rates. The rest of the world on the other hand has a smorgasbord of exchange rate arrangements, from outright dollarisation (Zimbabwe) and currency boards (Hong Kong) or currency unions (Brunei, Europe), to fixed pegs (most of the Middle East and Africa, and to a certain extent Singapore), to managed or relatively free floating regimes like Malaysia’s, or Switzerland’s. Some countries, like Iran and Venezuela, have multiple official exchange rates for different purposes (and very naturally, an unofficial black market rate).

Given the differences in monetary policy and exchange rate regimes, exchange rates in these times convey very little useful information on the relative performance of economies.

One might have made a decent argument that such comparisons would be relevant under the old pre-WWII Gold standard, where all currencies were anchored on gold. One might have made a much more tenuous argument that the same applied to the Bretton-Woods system (1944-1973), where all currencies were anchored on the US Dollar, and the USD remained anchored on gold. Since business cycles in the US economy were completely divorced from gold bullion supply, this is a harder stand to take.

To summarise, without knowing what the specific respective exchange rate arrangements are, an appreciation of one currency against another could reflect:

  1. Both Country A and Country B are doing better, but Country A is doing better than Country B; or
  2. Both Country A and Country B are doing better, but Country B is doing better than Country A; or
  3. Both Country A and Country B are doing worse, but Country A is doing better than Country B; or
  4. Both Country A and Country B are doing worse, but Country B is doing better than Country A; or
  5. Neither Country A nor Country B are doing better or worse.

Making the argument that exchange rates reflect economic performance in a world with a multitude of exchange rate regimes is nonsense.


  1. Hi, can you elaborate more as to why the Singapore dollar is a limited fixed peg? Aren't they the same as the MYR, where it's "fixed according to a basket of currencies"?

    1. Malaysia doesn't fix it's currency to a basket of currency as Singapore does. Singapore's uses this "dirty peg" instead of interest rates as a tool of monetary policy

    2. @Jeng Jeng

      For a description of Singapore's monetary policy arrangements, read this.

  2. It is improper to generalize the relationship between exchange rate and economic performance. Exchange rate may be a reflection of economic performance in some scenarios and may not be so in other scenarios. One has to dig further and understand what is really happening in a particular situation. That is the beauty of learning economics. The analogy above is one scenario which indicates that there is no relationship between exchange rate and economic performance. But in other scenarios, exchange rates may resemble economic performance. In fact, in 1997-98 financial crisis of Malaysia, exchange rates seem to be a causal factor to economic performance. Their relationship totally changed. One has to understand what is going on at a particular time before drawing a conclusion.

    On another note, Ringgit has passed 4.2 mark against USD. That has beaten your anticipation. Do you think pegging is necessary now? It depends. It depends on what the goverment wants. If the government wants to attract investors, pegging Ringgit is not a bad idea. Investors need to project long term costs and revenues. Pegging Ringgit will remove one uncertainty, especially the fluctuation of the cost of labor. Off course, this is holding other factors constant.

    - Just a Joe

    1. @Just a Joe

      Pegging the Ringgit would be the worse thing to do while the USD is still appreciating, because it would require we expend our reserves to defend a level, and thus inviting speculative attack. Pegging would only work if the Ringgit was appreciating, in which case of course, why bother.

    2. Hi Hishamh, just curious why Malaysia pegged the currency in 1998, when our Ringgit was depreciating? Can u elaborate more on this paradox? Thank you.

    3. @anon 4.58

      When the Ringgit was pegged in Sept 3 1998, it was 20% up on the year low, which was hit on January 8. In addition, Malaysia put in capital controls and suspended international convertibility of the Ringgit. That effectively stopped the pressure on the Ringgit, up or down.

  3. Analysts worry about Msia finance. But do they take into account GST collection which has come into effect since April?

    1. @Zack

      GST revenue needs to be offset against SST revenue which has been abolished. The net increase from GST won't come nearly enough to replacing the potential shortfall from oil & gas.

  4. Since seeing the signs of recovery in the US, we have been hearing that the US rates rise is just around the corner.

    1. @KLSE Online;

      Isn't China's RMB devaluation put a stop to that?

    2. Actually there's no guarantee of a stop. Market volatility shouldn't influence the Fed in making their decision in the first place

  5. Gents, if you think Malaysia finances is in a mess, you ain't seen nothing. Just read what is happening in China at this blog

    So maybe we should be worried because China (one of Malaysia major trade partner) probably going to tank soon!

    Zuo De

    1. #Zuo De

      There's nothing like a piece or two of humble pie...

      Like reading that China ran through US$94 billion in forex reserves between July and August 2015 to defend the Yuan.

      That's about the size of Malaysia's total official forex reserves, according to Bank Negara.

      And the scary thing is that China still has about US$3.56 trillion of forex reserves left in it's kitty.

      That's an awful lot of firepower.

    2. You did not read in detail, one must keep some in reserve and it is estimated that reserve is between 1 trillion to 2.6 trillion (IMF estimate) and they only have basically 0.96 to 2.56 trillion left and at 200 billion a mothn to defend (the yuan), then they only have between 3 to 12 months left, depending whose estimate is correct. Like I said you haven't seen nothing yet. If China tank, all hell break-loose.

    3. Ooh never mind, it seem anything compared with Malaysia to you is always half-empty or maybe even quarter empty. Well have a happy week ahead.

  6. #Anon 5:13 PM

    If China wants the Yuan to be a component of the IMF's SDR basket, why would it need to defend the Yuan?

    If the Yuan wasn't being defended, why did China's forex reserves decrease by US$94 billion over the period mentioned?

    #Anon 5:20 PM

    I am sorry - I don't understand your "half-empty" or "quarter empty" references.

  7. Gent, for a bit of perspective, China GDP is about 10 trillion USD (2014) and its reserve is 3.6 trillion. Msia GDP is about 1 trillion RM and reserve is 400 billion RM. So both countries has a reserve to GDP of about 0.4. Yes while the absolute amount is huge, it is the same as Msia in % terms.

    1. Yup, but one is in a "strengthening" USD and the other is in a "depreciating" MYR.

      Who is better placed, if push comes to shove, to defend it's currency? Like if there is a "run" on the reserves?

    2. @anon 6.29

      As BNM is allowing the Ringgit to find its own level, the question of a "run" on reserves is moot.

    3. What about "capital flight"?

      What if holders of Ringgit-denominated assets switch their investments into US Dollar assets?

      Please don't tell me that it will not happen!

    4. @anon 12.59

      What are you talking about? It's been happening for over a year, not just in Malaysia but globally. As long as BNM doesn't interfere, there's no implications on international reserves.

    5. Really, Hisham?

      Are you saying that if there is a funds outflow from Malaysia (like investors selling their ringgit assets, converting the proceeds to US dollars or euros and sending the funds offshore), the reserves won't be affected?

      Are these funds materialising out of thin air?

      So, why has Malaysia's international reserves shrunk from a high of around US140 billion to about US$95 billion now? An accounting sleight-of-hand?

      And why are the rating agencies saying that a rundown of international reserves will be one of the "red flags" in deciding whether the country's credit ratings could be downgraded?

      After all, Brazil has just been downgraded to "junk status".

      I don't suppose that the rating agencies are doing this for "fun and games", do you?

    6. @anon

      Why should reserves be affected? Under a floating rate system, whether to use reserves or not is entirely up to the central bank. Otherwise, all outflows will be handled by the banking system and their correspondent banking network, as usually happens 99.99% of the time.

      Reserves in Malaysia have fallen due to central bank intervention. If they stop intervening, as they did in the last two weeks of August, reserves stop declining. Reserves actually rose in the last two weeks of August, despite the heaviest outflows seen since January.

      This isn't China, where all foreign currencies have to be sold to the central bank.

  8. I've been thru 4 recessions (depreciation). 1st I knew next to nothing. 2nd, Soros said see you at 5; 3rd, gees the whole world stood still; now, well maybe Soros will be right after all. But in the past 3 depreciation, always RM rebound and I think, this time round, it will be no different. So I did the reverse capital flight. Also adjust ones lifestyle, local tours, local food, local this and that until the good time come.

    So don't fret too much. A lot of this is outside ones control but how one capitalize it is.

    Hishamh, I know it is difficult, but what is your guess when it will reverse?

  9. Hisham,

    Since the RM4.10/USD level, I've been suggesting to some of my family and friends (who earn non-Ringgit, e.g. USD, yuan, SGD, etc) to park some money back to Malaysia as I think our currency is too cheap to ignore. Few listened to me (some bought landed property and few bought some undervalued stocks), while majority of them just laughed me off.

    I think the "confidence" factor of the Ringgit weakness can be very fluctuating (though it is now a one-way street) and very reversible in the event of some silly political news. Of course, the usd-strength factor is the one that hard to reverse, and China is definitely not helping. But I think RM3.80/USD is quite fair if all the political noise are removed.

    Do you think my view is reasonable? Or put it this way: if you are earning USD/SGD/yuan, would you start parking funds back to Malaysia?