February 12, 2017    6 minute read

Political Risk, Currencies, and Central Banks

Managing Volatility    February 12, 2017    6 minute read

Political Risk, Currencies, and Central Banks

2016 has been the year of political risk. One of the main lessons politicians and economists have (or should have) been reminded of is that globalisation produces winners and losers.

Now its losers have raised their voice and, as a result, populism and national egoism have gained ground. Furthermore, other political events have shaken up the geopolitical scenario.

Political risk has a significant impact on currency markets. Besides interest rates differentials, which have a prominent role in determining capital flows across countries, investors also want to invest in currencies perceived as safe.

Political Risk’s Effect on Investors

When political risk arises in a country there will be capital outflows, as investors start fearing that turmoil could result in a significant devaluation of the local currency due to an economic slowdown, the government being forced to devalue it, or both.

Some investors, instead of just cutting their exposure to assets denominated in that currency, will rather hedge through derivatives, typically traded over-the-counter with market makers. The latter will, in turn, hedge the increased (long) exposure on their books to the currency by selling it, thus generating further downward pressure on that currency.

All else being equal, a sudden devaluation of the currency feeds through the real economy in two ways: first, it increases aggregate demand by making exports more competitive; second, it results in price pressure by making import more expensive in local currency terms.

The size of these impacts will vary from economy to economy. Economies based on exports can benefit significantly in the short run from a currency devaluation (as in Japan’s case). The effect on foreign demand also depends on how elastic demand is with respect to prices in export sectors. The impact on inflation, on the other hand, for instance, depends on the market power of importing firms, which may or may not be able to pass cost pressure on to consumers.

The Role of Central Banks

Sometimes central banks step in to defend their country’s currency, but this is not always feasible or effective. Most central banks’ statutory objectives only mention price stability, without targeting a specific exchange rate level, but, because a consistent devaluation of the currency is very likely to feed through inflation, when the pressure is significant they are often forced to intervene.

This is done either directly on the market, by buying local currency using foreign currency reserves, or by raising policy rates to attract capital.

As mentioned above, 2016 has been full of examples of political tensions that have reflected in currency markets. There are several examples of this, where it is worth examining how the central banks in question reacted and the hurdles they had to face:

The UK

The dynamic of the pound has obviously been mostly influenced by Brexit. After the shocking result of the referendum, the pound dropped by around 12%. Other events with major influences on the currency included Prime Minister Theresa May setting a deadline in March for triggering Article 50, the October flash crash, the ruling of the Supreme Court, and May’s speech on the future of UK outside of EU and others.
Without going too deep into the pound’s incidents, it suffices to say that since Brexit it has experienced a severe devaluation. The effect on inflation has started to show itself in recent data, with recent Markit PMI (Purchasing Managers’ Index) showing manufacturers facing their highest cost pressures in 25 years (although manufacturing only accounts for 11% of UK output). The situation is causing a headache to the BoE.
Most economists expected (and still expect) a severe slowdown to take place in the UK if it were to leave the EU. Hiking rates to defend the pound would pose great risks in an already fragile situation. On the other hand, it is arguable that the solid economic performance so far is mostly due to strong consumer sentiment. Rising inflation would mostly hit consumption via lower real income, damaging the only sector that is sustaining the economy at the moment. For now, the BoE is in wait-and-see mode, waiting for further clarifications from data. It has stated that a rate hike is as likely as a cut.

Mexico

The peso has been under stress since the US presidential campaign weakened it following Trump’s rhetoric (and his executive order on the wall). It’s been one of the worst-performing emerging market currencies in 2016, weakening by around 17% against the dollar. The falling peso is a great concern to Banxico, which is already trying to control inflation which is currently above its 3% target (the latest reading came in at around 4%).

The central bank has hiked rates five times in 2016. In a moment of particular distress, after Trump started criticising automakers for producing cars in Mexico and then exporting them to the US, it even bought pesos on the market for two days in a row. Neither move was very effective, though, as neither ultimately kept the peso from falling.

Turkey

Turkey is probably the most problematic example. After the failed coup, President Erdogan tried to tighten its grip on power by getting rid of his opponents, as well as trying to change the constitution to centralise power even more. This has exacerbated an already present security problem in the country (in 2016, there were close to 20 terror attacks in Turkey). In this situation, besides the falling lira, the economy has slipped into recession.

Turkey’s economy relies significantly on tourism, which took a hit because of security concerns. The central bank increased interest rates once, without much effect. What’s more, Erdogan is putting pressure on the Bank of Turkey to cut rates in order to boost the struggling economy, which would further weaken the lira and increase inflation. The independence of the central bank is under serious threat.

The stress of the central bank is, in a way, reflected in its last policy decision, where it held the official policy rate (the repo rate, in Turkey’s case) while hiking the less important overnight lending rate. The move has had mixed reactions from analysts. Some say the system of a corridor of interest rates, in which two rather than one are manipulated, is more flexible; some say less transparent.

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