Tuesday, November 25, 2008

Year on year fx movements: $ and £

I was puzzling over the present divergence between a weakening sterling and strengthening dollar vis a vis the Kenya Shilling. Basic economic theory suggest that exchange rates between two countries reflect movements in two accounts. Current and capital account. The current account reflects the balance of payments i.e export and imports while the capital account reflects flow of capital. If you imagine that Kenya only imports but doesn't export anything to the US we'd then have a demand for dollars vs kenya shillings and vice versa where capital inflows were only coming into Kenya. Capital flows are assumed to only be driven by changes in interest rates.

Stepping back from boring theory, the big practical drivers today in these exchange rates are tourism, remittances and trade (exports and imports) in that order. In fact for tourism and remittances, US and UK rank 1 and 2 respectively in terms of the fx earned or sent into Kenya. A basic look at the financial news today will tell you that both nations are suffering equally from similar issues. Similarly trade patterns with the two won't have changed so fundamentally in a period of 5 months. So what is driving this divergence?

If the other factors are moving tghe same way, this leaves one player I haven't mentioned. The key driver is in my opinion, the fx market-makers and dealers who trade (sorry speculate on) on fx movements.

Further reading on similarly puzzling fx rate movements between Canada and US.

6 comments:

Ssembonge said...

I believe the divergence is due the flight to 'quality'. The U.S dollar is still the currency of choice in the world markets.

The graph confirms that this is the right time to invest dollars overseas.

I hope the dollar holds for a few more weeks.

MainaT said...

I figured as much, only I didn't think currency traders had such an overwhelming impact on the fx rates in Kenya.

Will the dollar strength hold? Only because of its symbolism.

coldtusker said...

US$ can't hold coz the $1.5 trillion (to be) injected will create a surplus of US$...

I do not know which currencies will manage to stay 'strong'.

I expect some hedge funds, central banks & (stronger) banks will start selling US$ & buy other currencies straining the value of the US$.

coldtusker said...

KES is affected since its all about cross-rates. Arbitrage is alive all over...

Kenyan banks will exchange US$ for GBP the moment the values 'diverge'...

Kenya can expect more US$ vs GBP since its exports (e.g. tea & coffee) is priced in US$.

MainaT said...

CT-previously, the values of the two were vary well correlated i.e. moved in the same direction as per the chart.
I guess the pt I was trying and you've made is that the key driver of our exchange rates seems to be arbitrage where I previously used to work on the basis that one could forecast rates just based on the time of the yr (tourism and diaspora funds tend to follow a pattern)

Ssembonge said...

This article has an interesting take on the British Pound; Is Bankrupt Britain Trending Towards Hyper-Inflation?