China’s enormous capital account surplus is growing ever-wider as speculation is fueling capital inflow and convertibility restrictions simultaneously limit capital outflow. The exchange of Chinese Yuan for foreign currency is heavily regulated, and in practice, usually forbidden. In attempt to narrow the surplus, China’s Central Bank has pledge to loosen restrictions on capital outflow. Now, businesses and consumers will be able to exchange their Yuan for foreign currency, on a limited basis of course. For example, Chinese insurance companies will be allowed to invest overseas, and keep proceeds earned from such investments- in dollars.  This concession was made in response to rising foreign pressure to revalue its domestic currency. China continues to maintain such a revaluation will occur, but offers no timetable. Reuter’s reports:

Analysts say the remarks show that Beijing is reluctant to revalue, or adjust the yuan’s value, fearing that heated speculation may pose a greater danger if it rushes into change. The top policy priority is to relieve pressure on the yuan while developing a market infrastructure to help create conditions to let the yuan eventually move more freely.

Read More: China unveils new steps to resist yuan revaluation

Rumors that South Korea is planning to diversify its foreign exchange reserves are abounding. If these rumors are borne out, the dollar’s role as the world’s reserve currency could be numbered. As the USD continues to depreciate, so do the dollar-denominated reserves of many (Asian) nations. Is a massive sell-off of dollars imminent? In the short term, the answer is no, as there is no viable alternative reserve currency to the dollar. The EURO represents the only other currency that one could even argue deserves reserve status.  In reality, the short and medium-term prospects for the Euro area economy are not great, and the region’s population may actually decrease before it increases.

The EU would love nothing more than for the EURO to function as a reserve currency, for it would allow the region to borrow money at extremely low rates. However, countries currently fix their currencies to the Dollar- not the Euro. It is possible that these countries will eventually peg their domestic currencies to a basket of foreign currencies, but exchanging all or even most of their USD for Euros would be logistically impossible. In addition, the USD is and will continue to be the world’s most important currency. Many, if not most exchange rates, are quoted exclusively in dollars. US capital markets are the most liquid and dependable in the world. Global commodity prices are always denominated in dollars, and are usually paid for in dollars, even if the United States bears no involvement in the transaction. Some analysts predict the Chinese Yuan (RenMinBi) will one day become an important currency, especially if China’s economy continues to grow. The London Telegraph reports:      

…the euro will never become equal to the dollar as a reserve currency. In the very long run, the most likely candidate for that role, and even to surpass the dollar, is the renminbi.

Read More: Should the euro be the reserve currency?

The 10 members of ASEAN, and economic organization of Asian countries, signed a comprehensive swap agreement today. The purpose of the swap agreement is to guarantee members with USD that they can use to pay off their debts. Currency swaps allow nations to exchange one currency for a different currency at a fixed exchange rate, on a predetermined date in the future. In this case, the signatory ASEAN nations retain the right to exchange their domestic currencies for USD at 3 month intervals, which they can use to pay off USD denominated liabilities. The new agreement is really just an expansion of a rudimentary version, signed after the Southeast Asian Economic Crisis of 1997-98. During this period, Asian countries witnessed the rapid devaluation of their currencies, which prevented them from paying interest on outstanding debt, and led to the temporary collapse of their national economies. ABS-CBNnews.com reports:

But even in an [economic crisis] contagion, some country may have stronger a reserve position and afford to still help other countries. We’re ASEAN members [who] have committed financial resources to help each other. That is the most important idea of the swap,” said the president of the Philippine’s Central Bank.

Read More: ASEAN 5 extend $1-B currency exchange

Today, the United States upwardly revised forecasts for the growh of its economy. What was surprising was the announcement that the US current account deficit also expanded. Coincidentally, a new report claims the US current account is closely correlated to economic growth, which is quite counter-intuitive. Apparently, as the economy grows, increases in disposable income leads consumers to import more goods for personal use. In addition, high expectations for future growth leads businesses to invest more, often in the form of imported capital and machinery. The study used historical growth rates and changes in the current account balance to demonstrate the relationship. It pointed to Germany as an example, where a record trade surplus is coinciding with record unemployment and economic stagnation.  In short, reports the Financial Times:

America’s trade deficit is essentially an accounting abstraction. Our attention should focus on what really matters – economic growth, job creation, industrial output, and the free and open markets that promote real growth.

Read More: Forget Trade Deficits: Go for Growth

Malaysia’s currency, the Ringgit, is currently pegged to the dollar. Some officials feel it may be undervalued by as much as 12%; accordingly, it may soon allow the currency to float. Economists are forecasting the dollar could decline an additional 30% in the short-term, which would actually leave the Ringgit overvalued, relative to the rest of the world’s currencies. To make matters worse, it looks like the global economy will recede in 2008, which gives Malaysia only a few years to un-peg the Ringgit. Failure to do so, could exacerbate the effects of such a global recession on the Malaysian economy. At this point, Malaysia has two options. It could either un-peg the currency and allow to float completely, or instead gradually adjust the peg until the Ringgit stabilizes at its fair value. Forexmarkets.com reports:

"We still have a lot of reserves to defend the peg because it is undervalued. But this will not work well if the currency is overvalued. As such, the ringgit must be allowed to appreciate gradually," said the executive director of the Malaysian Institute of Economic Research.

Read More: Earlier de-pegging of ringgit will avoid painful adjustment in 2008

The UK Central Bank voted to keep interest rates constant at 4.75%. However, for the first time in almost a year, the vote was not unanimous. All of the voting  members are confident in the state of of the British economy, but some expect a slow-down in the second half of this year, due to declining household spending and subsequent declines in retail sales. A mixed report on British manufacturing also seemed to support a negative outlook on the economy. If the economy does lose steam, the Central Bank might move to lower interest rates, which could negatively impact the Pound Sterling. BNP Paribas reports:

In the coming months, economic growth is likely to slow. Against this backdrop, we [BNP] expect the Bank of England to adopt a more accommodative stance in the second half of the year.

Read More: United Kingdom: One hawk in the dovecote

As the USD has declined, the price of oil has risen. Why is this?  In a nutshell, this inverse relationship exists because global oil prices are denominated in dollars. Thus, as the USD declines, oil producers are paid fewer ‘units’ of foreign currency in exchange for oil. They must compensate for this decline in real revenues by raising the price of oil (in dollars). The same relationship holds in reverse, albeit for a different reason. The United States consumes a disproportionate large amount of the global oil supply. Thus, as the price of oil rises, stock market capitalization and economic growth suffer. This can also be accompanied by a decline in the USD.

Read More: Oil Prices Up, Dollar Down – Coincidence?

Investors have been flocking to the so-called Aznac (Australia and New Zealand) currencies of late, in search of high yields. Australia and New Zealand both currently offer some of the highest interest rates in the industrialized world. Moreover, analysts believe the two central banks will further tighten credit by raising interest rates in the near term. In the past, investors in search of risk-less, stable, returns simply purchased American treasury securities. However, as the USD declines, foreign investors earn negative real returns on the treasuries they hold. As a result, many are beginning to move money to other developed nations, where the risk of default is equally unlikely, but interest rates are higher. The Australian Financial Review Reports:

What looked like the long-awaited rebirth of the US dollar at the start of this year appears to have been a false signal. Investors, starved for yield elsewhere, are responding by recycling out of US dollar-denominated assets.

Read More: Investors switch to the Anzac currencies

In his semi-annual testimony before Congress, Alan Greenspan reinforced beliefs that America’s economy will grow between 3.75% and 4% this year, with inflation expected to be around 2%. While he did not explicitly acknowledge a near-term hike in interest rates, one must look no further than the futures market to realize that such hikes are probably imminent. In all likelihood, the fed will continue to coax interest rates upwards at a ‘measured’ pace, from the current 2.5% towards a ‘neutral’ target of 3% – 5%.  Greenspan also offered his opinion on George Bush’s proposed overhaul of the American social security system. Such an overhaul, he reckoned, would force the US to borrow $1-2 trillion in the short term, and add to the already significant downward pressure on the USD. Reuters Reports:

Greenspan said he would consider a $1 trillion debt increase large. Some estimate the Bush proposal could require twice that amount of new borrowing over the next decade, spurring opposition because the country already is running record budget and trade deficits.   

Read More: Greenspan: US rates low; budget discipline needed

Japan has the largest USD reserves in the world, valued at over $700 Billion. The recent appreciation of the Japanese Yen against the dollar has effectively devalued these reserves. In fact, for each Yen gained against the Dollar (i.e. a move from 105 JPY/USD to 104 JPY/USD), Japan loses over $7 Billion Dollars. As a result, Japan’s central bank may follow Russia’s example by shedding some of its USD reserves, and replacing them with Euros.  Analysts predict that Japan will ultimately hold Euros and USD in a 1:1 ratio. Japan is feeling additional pressure as a revaluation of the Chinese Yuan looms on the horizon. If its central bank doesn’t begin gradually selling off its dollar reserves now, it may find itself competing with China for buyers, which will only accelerate the decline of the dollar. Forexnews.com reports:

Japan should especially start lightening its hand from US assets before China initiates the fray when it eventually revalues its currency and sees less of a need to purchase US dollars in intervention over time

Read More: The Year of the Yen

The Reserve Bank of India (RBI) has been working overtime recently to hold down the value of the Rupee. The RBI has been buying dollars for over two weeks in order to make sure exports remain competitive. Nonetheless, the Rupee may still be overvalued by as much as 3%, reckon some analysts. This is largely due to foreign capital inflows, as foreigners have poured money into Indian equities at an astounding rate. Investors are anxiously awaiting the presentation of India’s federal budget, on Febrary 28. If the budget conforms to investor expectatations, India’s stock market should continue to hit new highs. Reuter’s reports:

India’s coalition government will present its second budget a week from Monday, in what analysts expect to be an expansionary package, focused on farms, healthcare, education and sanitation along with major tax reforms.

Read More: India Markets-Rupee near 6-wk low, shares flat pre-budget.

The Euro has appreciated over 25% against the USD in the last two years, much to the chagrin of the European Union, whose economy is stagnating.  Many believe the Euro’s recent strength and the subsequent decline in exports, is to blame. The US economy, on the other hand, is as strong as ever, on pace to grow at 4% this year. For this reason, the EU’s pleas for the US to prop up the dolar have fallen on deaf ears. Solving this problem, therefore, will require a multilateral effort. In order to stop the slide of the dollar, the EU must convince other nations to buy American Treasury Securities. However, analysts reckon that this represents only a short-term fix, as the dollar may continue to slide.  In this case, the European Union would find themselves earning a negative real return on their Treasury holdings. REFCO News reports:

Fundamentals support a further decline in the dollar and nearly every economist has notched higher their 12-month EURUSD forecasts towards 1.40. Therefore the ECB would simply be fighting an inevitable trend, making intervention a difficult decision since it would be a losing proposition.

Read More: Will the ECB save the Euro?

Congress is beginning to question free trade, which they feel benefits other nations more than the United States. These other nations are given access to a vast market in which they may sell their low-priced products. The United States, goes the argument, gains nothing as its producers cannot compete with their overseas counterparts, whose costs of production are much lower. Politicans point to the $600 Billion trade deficit as evidence that free trade is failing the US.  In fact, some have recently voiced support for curtailing free trade with other nations. Proposed legislation includes the end to presidential trade promotion authority, the establishment of high tarrifs on Chinese imports, and/or even the withdrawal from the WTO. MarketWatch reports:

[Two Senators] have introduced legislation that would impose a tariff on imports from China unless China stops pegging its currency to the dollar.  [They] feel that Congress has to respond to China’s failure to float its currency.

Read More: Free trade under fire in Congress

South Korea’s dollar reserves have hit an all-time high of $200 Billion, eclipsing the previous record of $199 Billion, set last month.  South Korea attributed the increase in reserves to interest paid by the United States on outstanding Treasury securities. However, analysts wonder if the increase in South Korea’s reserves is actually an attempt by the Korean central bank to hold down its currency. The South Korean Won appreciated 15% against the USD last year, which could potentially harm its economy by eating into exports.   Reuters reports:

Analysts say South Korea has not abandoned a long-held policy of curbing the won in a bid to keep its exports competitive, especially since exports have been the main driver of economic growth over the past two years.

Read More: S.Korea FX reserves edge above $200 bln by mid-Feb

Before you undertake currency investment, it is important you understand the forces that drive exchange rates. Many of these factors are intangible and/or psychological, and, thus, are impossible to characterize. However, those factors which are generally recognized as fundamental determinants are spelled out below. 

1. Inflation                     

A low rate of inflation, relative to other countries, implies that prices of goods in services in one country are increasing at a comparatively slow pace. These goods and services then appear cheaper in the eyes of foreigners, who increase  demand. If the law of purchasing power parity holds, the nation’s currency should appreciate to offset the relative decrease in prices.

2. Interest Rates

The correlation between a nation’s interest rate and its exchange rate is easy to grasp. We would expect savvy investors to invest their money where, for a given level of risk, the returns are highest.  Thus, when a disparity in interest rates exists between countries whose risk of default is equal, investors would likely lend to the country that was offering the higher interest rate.  In order to invest in or lend to another country, one must first obtain that nation’s currency.  This increases demand for that nation’s currency, and causes it to appreciate in value.         

3. Current-Account / Trade Balance

When a country runs a current account deficit, it typically means that the nation imports more than it exports. This tends to skew the exchange rate in favor of the country that runs a trade surplus, as foreign demand for its currency must be comparatively high. In due course, the exchange rate may adjust so as to make the first nation’s products affordable to foreigners, and bridge the gap between imports and exports.

4. Public (government) debt

The relationship between government debt obligations and its exchange rate is not as cut-and-dried. Basically, government borrowing to finance deficit spending increases inflation, which literally eats into the value of that nation’s currency. In addition, if lenders believe there is any risk of default, they may sell the debt (in the United States, this debt takes the form of treasury securities) on the open market, exerting downward pressure on the exchange rate.

5. Political and Economic Factors

Most investors are risk-averse; accordingly, they will invest their capital where there is a certain degree of predictability. They tend to avoid investing in countries that are typified by governmental instability and/or economic stagnation. In contrast, they will invest capital in stable countries that exhibit strong signs of economic growth. A nation whose government and economy are perennially stable will attract the most investment. This, in turn, creates demand for that nation’s currency and causes its currency to appreciate in value.

Read More at Investopedia.com.

Canada is a nation rich in natural resources. Accordingly, its economy has benefited from recent spikes in commodity prices, coupled with a broad increase in demand for raw materials. Unfortunately for Canada, this increase in demand has exerted upward pressure on its currency (CAD), which could  plausibly lead to a reduction in future foreign demand for its products. The result is something of a catch-22: present increases in exports may be offset by future decreases. In response, the Canadian Central Bank will forgo a planned hike in exchange rates, and instead wait until the Canadian Dollar (hopefully) depreciates relative to the USD. Mellon Financial Reports:

General USD movement…is problematic, as the economy is penalised by the stronger CAD, without benefiting from higher demand for Canadian products.

Read More in a report published by Mellon Financial.

Brazil’s once-battered economy is finally showing strong signs of economic growth. The central bank and ministry of finance intend to keep it this way, by controlling inflation and reining in government spending. The Central Bank has pursued an aggressive policy of tight money, in order to prevent the rate of inflation from returning to the double digit levels it breached as recently as 2 years ago. If the central bank follows through on plans to raise interest rates, Brazil could witness the appreciation of its currency, as investors from other countries flock to Brazil in search of higher returns. Some analysts, however, are worried that the central bank may be acting too agressively in its rate hikes. The Economist reports:

[The central bank’s] friends worry not that it is misguided, but that it may now become over-zealous… [Some analysts believe] the central bank should accept a bit more inflation this year—say 5½-6%—rather than aiming to hit the target precisely.

Read More: Brazil’s central bank: Risks, new and old

This week, Federal Reserve Chairman Alan Greenspan is schedule to testify before Congress on the state of the economy. Currency traders are already trying to forecast the impact this testimony will have on exchange rates. They will be watching Greenspan, to see if he foreshadows changes in American interest rates. Many traders are anticipating good news about the current account and trade imbalances, which they believe will accelerate the dollar’s recent rally against the Euro. Others expect the exchange rate will improve irrespective of Greenspan’s testimony, due to technical factors. FXStreet.com reports:

The euro’s steep fall against the dollar in January "suggests (that) the probability of another extended move lower by euro/dollar (i.e. 5 percent) in the coming weeks is slim, especially since there is no new information to suggest the dollar’s downtrend should be over," said analysts at ABN AMRO in a research note.

Read More: FOREX-Dollar steady against euro; market eyes Greenspan

The Central Bank of the Russian Federation has announced that it
began targeting the rouble exchange rate against a euro-dollar basket. Some are saying that this announcement may cause similar moves by the central banks of Asian countries.The Financial Express reports:

The bank said it had begun targeting a dual currency basket — made up of 90 US cents and 10 euro cents — as of February 1, and would gradually raise the weighting of euros. “Increases of the weighting of the euro in the twin currency basket, to a level appropriate for the task of exchange rate policy, will take place step-by-step as market players adapt,” it said.

Read more: Russia’s central bank gets serious

U.S. Treasury Undersecretary for International Affairs John Taylor spoke today on global trade imblances, although no information on how quickly the Yuan will be revalued was forthcoming.

Policy-makers around the world are taking steps that should cut any risk stemming from global trade imbalances, a senior U.S. Treasury official said on Friday.

"I think there’s a policy in place that is dealing with this," U.S. Treasury Undersecretary for International Affairs John Taylor told a conference sponsored by the Stanford Institute for Economic Policy Research.

…Taylor said he could not offer timetable on how quickly China, which pegs its yuan currency at about 8.28 to the dollar, might move toward a more flexible exchange rate, but that needed steps were begin taken.

Read more: Policy aiming for better global balance-US’ Taylor