Impossible Trinity and Emerging Markets
We often mention the
Impossible trinity to evaluate how monetary policy effects on FX market. The
Impossible trinity (also known as the Trilemma) states that it is impossible to
have (1) A fixed foreign exchange rate, (2) Free capital movement, and (3) An
independent monetary policy at the same time (Figure 1).
For example, a central
bank loses monetary policy independency if one (1) fixes foreign exchange rate
and (2) allows free capital movement. The central bank needs to follow other
standard interest rate to reduce arbitrage opportunities and extreme capital
outflow. Therefore, the central bank loses its intended monetary policy.
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| Figure 1: Components of the Impossible Trinity. Source: New York Times |
China has been trying to
overcome the Impossible trinity with the largest foreign exchange reserves. But
I’d like to talk about emerging markets before addressing China. This week,
there were two main events from the ECB President Mario Draghi and the BOJ
Governor Haruhiko Kuroda. Both President Draghi and Governor Kuroda emphasized
additional monetary easing.
The title of President
Draghi’s speech on Feb. 4th was ‘How central bank meet the challenge
of low inflation.’ During the speech, he highlighted several issues.
- “…low inflation is increasingly being caused by structural factors in the global economy that cannot be addressed through domestic monetary stimulus.”
- ‘There is no reason why they should lead to a permanently lower inflation rate.’
- ‘If we do not “surrender” to low inflation – and we certainly do not – …’
What he meant by ‘we do
not surrender’ is the ECB will expand monetary policy longer than the
traditional ‘medium-term.’ So, what does he mean by the new ‘medium-term’ in
this case? President Draghi suggests that the central bank needs to boost
inflation before expected inflation falls below actual inflation. Expected and
actual inflation have an inverse relationship that lower expected inflation
will eat up positive effects of monetary easing (Figure 2).
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| Figure 2: Fisher Effect explains relationship between expected and actual inflation |
As inflation expectations
fall, it pushes up real interest rates, producing an unwarranted monetary
tightening. And the unexpected low inflation raises real debt burdens, which
has a negative effect on aggregate demand due to the different propensities to
consume and invest of borrowers and lenders. Output and inflation, then move
again in the same direction – but this time downwards.
Same thing happened last
December, when Federal Reserve Bank increased federal interest rate for the
first time in a decade. Expected inflation had been declining and stagnated at
2.6% level. With that reason, President Draghi will easy ECB’s monetary policy
for ‘medium-term.’ After his speech, however, euro (EUR) strengthened about
2.38% (Figure 3).
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| Figure 3: USD/EUR and USD/JPY graph from Feb. 1st to 5th. Source: Yahoo Finance |
BOJ Governor Kuroda spoke
in a similar tone: “there is no limit on monetary easing.’ With the President
Draghi’s speech, Japanese Yen (JPY) strengthened 2.24%
According to the
Economist in 2014, corporate cash holdings in Japan was about 44% of its GDP.
It is larger than 11% of United States and 19% of Germany. It implies that the
BOJ did not decrease its interest to negative area to boost investment. Even
further, the BOJ would not conduct additional monetary easing in that
perspective.
We can find the answer
from the ‘Carry Trade.’
EUR and JPY Carry Trade
Currency Carry Trade is a
strategy in which an investor sells a certain currency with a relatively
low interest rate and uses the funds to purchase a different currency
yielding a higher interest rate. It often carries large amount of debt.
There are two big
downsides of carry trade: (1) Large amount of debt, and (2) Foreign exchange
risk. In order to make profits from the carry trade, a trader needs to predict
future spot exchange rate. It means that high volatility in FX market will be a
burden for the carry trader.
Currency market in
emerging nations weakened overall, but its volatility has been increased. In a
high volatility environment, carry trade should reduce its size since it is
exposed to high risk. Therefore, much of easy money in carry trade flow back to
debt holders to payback principles. But illiquidity of JPY and EUR arises when
those money flow back.
To solve the illiquidity
issue, the ECB and BOJ announced another quantitative easing. By providing
additional EUR and JPY, in theory, carry traders will have enough supply
without appreciating domestic currency. Once the capitals from carry trade
comes back to home country, they will look for safe asset such as 10-year Bund,
10-year Japanese bond and gold. This is the reason behind sudden spike in safe
assets price.
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| Figure 4: Gold and silver futures price from Feb. 1st to 5th. Source: Yahoo Finance |
Who will Gain and Lose?
On the first week of
February, we can see an interesting spike or downfall in various financial
markets on Wednesday 3 pm (EST). Emerging nations’ currencies (EMCs) such as
rupiah and ringgit strengthened against USD while JPY and EUR continued its
appreciation. Those EMCs continued to strengthen on Thursday and Friday; USD
kept weakening.
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| Figure 5: USD index graph from Feb. 1st to 5th. Source: CNBC |
On the other hand, EMCs
did not have a noticeable spike on Wednesday. It showed a high volatility while
overall exchange rates were steady. It means that capitals from carry trade can
flow back ‘safely.’
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| Figure 6: JPY/MYR graph from Feb. 1st to 5th. Source: Yahoo Finance |
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| Figure 7: EUR/MYR graph from Feb. 1st to 5th. Source: Yahoo Finance |
The problem is emerging
markets. While carry traders faded away, EMCs supposed to be weakened. Yet it
appreciated against USD while stayed at the ‘steady’ level against EUR and JPY.
It may imply central bank intervention to restraint capital outflow. Of course,
we can confirm this fact later this month – when new foreign exchange reserve
data comes out. We have to take a deep look of the proportion of foreign
exchange reserves as well as the total amount of the reserve.
Conclusion
We have seen that much
liquidity flew from European and Japanese quantitative easing to emerging
markets in a form of carry trade. With recent increased volatility in financial
markets, investors reduce their positions on the market and seek for safer assets.
Central banks – BOJ and ECB – provide liquidity. Federal Reserve Bank have
indirect benefits by weakening USD. It would help to boost oil price and
potentially U.S. CPI and GDP in a long term.
However, we have to keep
in mind that this scenario will work under several conditions:
- EUR/EMCs and JPY/EMCs should be stay steady to reduce carry trading positions
- Central banks of emerging nations should have sufficient foreign exchange reserves
We have to closely
monitor trading volume of EUR and JPY, and central banks’ movement for next few
weeks to see further movement of FX markets.
