Global Trade And The Currency Market (forex) - The Big Picture Matters
Before going into the interbank world and then examine the dealing processes, let's have a second look at some key
underlying economic principles of the modern history of global trade and capital flows, partly covered in the previous chapter, and see why these developments still matter today.
As you learned in chapter Forex 1, representatives from 44 different nations who converged at the Bretton Woods conference in 1944 were determined to cobble together a system that would prevent additional depressions and to ensure a fair and orderly market for cross-border trading conditions. Most countries agreed that international economic instability was one of the principal causes of WWII, and that a new system was needed to facilitate the reconstruction process.
At that time the US was not prepared to pay with their surplus the debt of the countries ruined by war. And these, in turn, did not want to depend forever on the US economy. As a result, an agreement was reached halfway: the conference produced a new exchange rate system which was partly a gold exchange system and also a reserve currency system, with the US Dollar as a de facto global reserve currency.
While in the early 70s many economists supported the idea that the gold-US Dollar peg was not the best regime for a growing international economy, a completely free floating exchange rate system was neither seen as favorable as it could end up in competing devaluations, the destruction of cross-border trade and ultimately lead to a global depression. The Smithsonian Agreement was an attempt to reestablish a fixed rate system but without the backing of gold.
The value of the Dollar could fluctuate in a range of 2.25%, unlike the previous range of 1% during the Bretton Woods. However, this agreement also failed in the end. Under heavy speculative attacks, the price of gold shot to 215 US Dollars per ounce, the US trade deficit continued to rise and the Dollar, therefore, could be devalued more than the 2.25% limit band set in the agreement. Because of this, the currency markets were forced to close in February 1972.
Currency markets reopened in March 1973, when the Smithsonian agreement was already history. The value of the US Dollar would be determined by market forces, and not be confined to a trading band or be tied to any other asset. This allowed the Dollar and other currencies to adjust themselves to the global economic reality and paved the way for an inflationary period never seen before in modern times.
The political understanding that underpinned Bretton Woods is of importance here, as the United States made itself the core of the new system, agreeing to become the trading partner of first and last resort. This has obviously tremendous implications on monetary matters. Although this has apparently no direct implications on your daily trading, it is a key aspect to understand the market flows and many of the monetary decisions taken by nations through their monetary authorities.
While nothing that has been discussed in the previous chapter is wrong, it is only part of the story. For you as a trader and investor, there is a political dimension of the current system that matters, as it can condition your career at some point. If you learn to identify the underlying forces that move the capital flows, you will be able to develop trading strategies that fit the big picture.
Without an explicit mechanism like a gold exchange, the similarities between the original Bretton Woods system and its more recent counterpart are interesting and instructive. Not only the system still relies on the willingness of the participants to actively support it, but also today's system is characterized by the economic and political relationship the US has with rapidly emerging economies.
For a time, the original Bretton Woods system seemed to favor all nations involved. Considering the desperation and destitution of European countries and Japan, ruined by the war, they were willing to accept nearly whatever was on offer in the hope of their rebuilding process. They were totally dependent upon US willingness to remain engaged. On the other side, in view of the unprecedented and unparalleled US economic strength, economic aid packets were the obvious way to go.
These emerging countries rebuilt their economies on the backs of their growing export markets. The United States would allow Europe nearly tariff-free access to its markets. The sale of European goods in the US would then help Europe develop economically and, in exchange, the United States would receive deference on political and military matters: remember, NATO was born.
In the US growing affluence increased the demand for an ever-growing array of products from overseas markets. Predictably US imports grew and so did the US trade deficit. A trade deficit increases when the value of imports exceeds that of exports, the opposite of a trade surplus. In textbook economic theory, market forces of supply and demand act as a natural correction for trade deficits and surpluses. One would expect the value of a currency to appreciate as demand for goods denominated in that currency increases.
What happened however with the Bretton Woods arrangements was that the exchange rate system mandated the foreign central banks to intervene in order to keep their currencies from exceeding the Bretton Woods target levels.
They did this through foreign exchange market purchases of Dollars and sales of other currencies like British Sterlings, German Marks and Japanese Yen.
This procedure resulted in lower export prices from these countries than what market forces would predict, making them still more attractive for US consumers, thus perpetuating a mutual dependency on the system. source Fxstreet.com next
Before going into the interbank world and then examine the dealing processes, let's have a second look at some key
underlying economic principles of the modern history of global trade and capital flows, partly covered in the previous chapter, and see why these developments still matter today.As you learned in chapter Forex 1, representatives from 44 different nations who converged at the Bretton Woods conference in 1944 were determined to cobble together a system that would prevent additional depressions and to ensure a fair and orderly market for cross-border trading conditions. Most countries agreed that international economic instability was one of the principal causes of WWII, and that a new system was needed to facilitate the reconstruction process.
At that time the US was not prepared to pay with their surplus the debt of the countries ruined by war. And these, in turn, did not want to depend forever on the US economy. As a result, an agreement was reached halfway: the conference produced a new exchange rate system which was partly a gold exchange system and also a reserve currency system, with the US Dollar as a de facto global reserve currency.
While in the early 70s many economists supported the idea that the gold-US Dollar peg was not the best regime for a growing international economy, a completely free floating exchange rate system was neither seen as favorable as it could end up in competing devaluations, the destruction of cross-border trade and ultimately lead to a global depression. The Smithsonian Agreement was an attempt to reestablish a fixed rate system but without the backing of gold.
The value of the Dollar could fluctuate in a range of 2.25%, unlike the previous range of 1% during the Bretton Woods. However, this agreement also failed in the end. Under heavy speculative attacks, the price of gold shot to 215 US Dollars per ounce, the US trade deficit continued to rise and the Dollar, therefore, could be devalued more than the 2.25% limit band set in the agreement. Because of this, the currency markets were forced to close in February 1972.
Currency markets reopened in March 1973, when the Smithsonian agreement was already history. The value of the US Dollar would be determined by market forces, and not be confined to a trading band or be tied to any other asset. This allowed the Dollar and other currencies to adjust themselves to the global economic reality and paved the way for an inflationary period never seen before in modern times.
The political understanding that underpinned Bretton Woods is of importance here, as the United States made itself the core of the new system, agreeing to become the trading partner of first and last resort. This has obviously tremendous implications on monetary matters. Although this has apparently no direct implications on your daily trading, it is a key aspect to understand the market flows and many of the monetary decisions taken by nations through their monetary authorities.
While nothing that has been discussed in the previous chapter is wrong, it is only part of the story. For you as a trader and investor, there is a political dimension of the current system that matters, as it can condition your career at some point. If you learn to identify the underlying forces that move the capital flows, you will be able to develop trading strategies that fit the big picture.
Without an explicit mechanism like a gold exchange, the similarities between the original Bretton Woods system and its more recent counterpart are interesting and instructive. Not only the system still relies on the willingness of the participants to actively support it, but also today's system is characterized by the economic and political relationship the US has with rapidly emerging economies.
For a time, the original Bretton Woods system seemed to favor all nations involved. Considering the desperation and destitution of European countries and Japan, ruined by the war, they were willing to accept nearly whatever was on offer in the hope of their rebuilding process. They were totally dependent upon US willingness to remain engaged. On the other side, in view of the unprecedented and unparalleled US economic strength, economic aid packets were the obvious way to go.
These emerging countries rebuilt their economies on the backs of their growing export markets. The United States would allow Europe nearly tariff-free access to its markets. The sale of European goods in the US would then help Europe develop economically and, in exchange, the United States would receive deference on political and military matters: remember, NATO was born.
In the US growing affluence increased the demand for an ever-growing array of products from overseas markets. Predictably US imports grew and so did the US trade deficit. A trade deficit increases when the value of imports exceeds that of exports, the opposite of a trade surplus. In textbook economic theory, market forces of supply and demand act as a natural correction for trade deficits and surpluses. One would expect the value of a currency to appreciate as demand for goods denominated in that currency increases.
What happened however with the Bretton Woods arrangements was that the exchange rate system mandated the foreign central banks to intervene in order to keep their currencies from exceeding the Bretton Woods target levels.
They did this through foreign exchange market purchases of Dollars and sales of other currencies like British Sterlings, German Marks and Japanese Yen.
This procedure resulted in lower export prices from these countries than what market forces would predict, making them still more attractive for US consumers, thus perpetuating a mutual dependency on the system. source Fxstreet.com next