EFFECTS OF RAISING US INTEREST RATES ON GLOBAL FX MARKETS

Nakon globalne finansijske krize koja je počela 2008. godine, kamatne stope su smanjene u mnogim državama, da bi se stimulisao ekonomski rast, ali i umanjio rizik neisplate postojećih dugovanja. Niske kamatne stope smanjuju motivaciju za štednju, što navodi potrošače da ulažu sredstva u imovinu, kao što su nekretnine, tako neposredno podstičući porast bogatstva. Takođe, pošto one čine valutu jeftinijom na međunarodnom tržištu, izvozna roba postaje kompetitivnija, dok se smanjuje inostrana potražnja za dugovanjima u datoj valuti. Svi ovi faktori bi trebalo da stimulišu ekonomiju, ali je njihova posledica i smanjena kompetitivnost na svetskom finansijskom tržištu, gde je dobit ostvarena na ulog prvenstveno uslovljena preovladavajućim kamatnim stopama. Niske kamatne stope takođe podstiču veće zaduživanje, koje postaje neodrživo kada dođe do njihovog porasta. Osim toga, investitori koji u velikoj meri ovise o kamatnim stopama kao izvoru prihoda će potencijalno tražiti spekulativnija i rizičnija ulaganja, što može dovesti do značajnih gubitaka. Konačno, pošto se tržišna kamatna stopa sastoji od realne stope i inflacije, njeno smanjenje menja ravnotežu u ovoj vezi, što može dovesti do inflatorne ekonomije. Sada kada su u SAD povećane domaće kamatne stope po prvi put od 2006. godine, važno je ispitati potencijalne posledice koje će to imati na svetsko tržište i ekonomiju drugih država. Ovaj rad nudi neke uvide u dinamiku FX tržišta i objašnjava zašto kamatna stopa u SAD ima svetski značaj.


Introduction
Exchange rate is a ratio between two currencies and is instrumental in the level of trade a country is able to achieve, as it affects the import and export prices, and thus the health of domestic economy.Exchange rates for longer maturities are also influenced by the interest rates and inflation in the respective countries, making them one of the most closely monitored, analyzed and governmentally manipulated economic measures (Patel, Patel, & Patel, 2014).Their importance to the world markets notwithstanding, exchange rates also have significant impact on a smaller scale, as they affect the cost of lending and borrowing in international markets, affecting the amount of funding available at the domestic level.Thus, they also play a role in the level of individual wealth and consumer spending patterns.This, in turn, is affected by the price and availability of goods and services, as well as profitability of various forms of investment.These are implicitly conditioned by the health of the domestic economy and the country's trading relationships with other nations.This cyclical and interrelated process is affected by many factors, including exchange rates (Bilson, 1978).A more valuable currency makes a country's exports more expensive in foreign markets, while making imports cheaper and vice versa.Thus, higher exchange rate typically lowers the country's trade balance.Before analyzing the main determinants of exchange rates in the sections that follow, some fundamentals in their calculation are offered.

Calculation of Exchange Rates
Foreign exchange refers to the exchange of one currency for another.It is written in the form CCY 1 /CCY 2 , referred to as "base currency" "variable currency", respectively (Kožul, 2011).Its value refers to how much of variable currency is paid/received for one unit of base currency.In domestic markets, the base currency is the domestic currency, whilst in international markets it is typically USD, even though various currencies are have been quoted against EUR since its introduction.When discussing exchange rates, it is essential to make the distinction between spot rates (for contracts executed now) and forward rates (applicable to various durations).

Spot Exchange Rates
Spot exchange rates apply to trades executed now.In financial markets, the delivery is typically two working days from the trade date to allow for necessary bank transfers and paperwork, as well as adjust for holidays in both countries.While any currency pair can be traded, most currencies are quoted either against EUR (Interbank spot market), or USD (Futures market), referred to as direct rate.
Other currency combinations have to be calculated from two rates against USD or EUR and are called cross-rates.For example to obtain CHF/CAD exchange rate, the amount of USD received on sale of CHF would be calculated first, and then the amount of CAD purchased by USD would imply the CHF/CAD rate.As cross-rates involve both sale and purchase, they are affected by the dynamics of three currencies.Given that traders make profit from buying/ bidding "low" and selling/offering "high", each exchange rate has two sides, creating bid/offer spread, the width of which is effected by supply and demand.It is typically very tight for major currencies, whilst for currencies quoted as cross rates it is wider, accounting for lower liquidity and the implied intermediate sale/purchase of base currency.

Forward Exchange Rates
Forward cross-currency contracts involve outright purchase or sale of one currency in exchange for another currency for settlement in the future.The same rules of exchange rate calculations apply, i.e., there is two-way price where sale is made using bid and purchase using offer quotation.In major currency pairs, the two cashflows are exchanged at maturity, whilst in some less liquid contracts only the difference between the agreed rate and the prevailing market exchange rate is settled.The pricing of forward contract in both cases is the same.The main motivation behind such trades is fixing the rate for a time period in the future.As forward cross-currency contract ugovora.U oba slučaja, izračunavanje vrednosti forvard ugovora je isto.Glavna motivacija iza takvih transakcija je fiksiranje stope za neki period u budućnosti.Kako na vrednost deviznog kursa u budućim periodima utiče ne samo odnos dve valute, nego i kamatne stope u datim državama, ona se izračunava kao odnos između varijabilne i osnovne valute koji bi bio ostvaren na dan isteka ugovora ako su obe bile stavljene na štednju po kamatnim stopama za isti period, tj.: gde je: FX f kursna razlika za period u budućnosti FX s spot kursna razlika r v kamatna stopa za varijabilnu valutu r b kamatna stopa za osnovnu valutu

Forward Cross-currency Swaps
As can be seen from the above, forward cross-currency transactions allow the counterparties to take a view on interest rates in the two currencies involved in the exchange, without actually participating in the interest rate market.A commonly used alternative is to actually buy/sell one currency now (at spot rate) and reverse the transaction by selling/buying back the same currency at a forward rate.This is known as forward swap.As the initial swap is transacted at spot and reversed at maturity at forward exchange rate, to avoid arbitrage, the swap must be valued as the difference between the two rates, i.e.: where: FS is the forward swap price FX f is the forward exchange rate FX s is the spot exchange rate r v is the interest rate applicable to variable currency r b is the interest rate applicable to base currency The forward swap enables traders to exploit interest rate differential between the two currencies.If they expect the gap to narrow (either the base currency interest rate rises or the variable currency interest rate falls), they will speculate by buying the base currency now and selling it forward.The net effect of this transaction is borrowing in base currency and depositing in variable currency.
From the equation above, it follows that if the variable currency interest rates are higher than those offered for base currency, the forward exchange rate will be higher than the spot, and vice versa.The logic behind this pricing is that, if we exchange higher-interest variable currency into lower-interest base currency at spot and place the amount on deposit, we would earn lower interest.However, if we buy the base currency forward, we are left with the original variable currency that can be invested and higher interest rate until settlement.To make investors indifferent as to which path they would take, the forward rates have to be higher to compensate for low interest rate.In this case, the base currency is said to be "at premium".If the variable currency interest rates are lower than base currency rates, the opposite is true; i.e., the base currency is "at discount" and the forward rate is lower than the spot (Kožul, 2011).
The discussions above clearly demonstrate the importance of interest rates in the FX market.As USD plays the key role in the large proportion of trades executed internationally, it directly affects the dynamics of their pricing.In sum, while numerous factors determine exchange rates, all are related to the trading relationship between participating countries (Branson 1983).Some of these are discussed below.

Differentials in Inflation
Generally, a consistently lower inflation rate would have a positive effect on the currency value, as its purchasing power increases relative to other currencies.As low inflation ensures that the value of investment does not depreciate over time, it typically results in lower interest rates.Lower inflation also signals health of economy, making the country attractive to foreign investors, thus increasing demand and the exchange rate further.

Differentials in Interest Rates
As previously noted, interest rates, inflation and exchange rates are highly correlated (Kožul, 2012a).Hence, by manipulating interest Kožul N. Effects of raising US interest rates on global FX markets je takođe signal zdravlja ekonomije države, pa je čini atraktivnom za strane investitore, što povećava zahtev za valutom pa tako i kursnu razliku.

Trgovinski uslovi
Kada država ima dobru reputaciju na međunarodnom nivou i kvalitet njene robe i usluga može da opravda visoke izvozne cene, njihova vrednost u odnosu na uvoz raste, dovodeći do pozitivnog trgovinskog bilansa i povoljnih trgovinskih uslova.Veći obim izvoza stvara veću potražnju za valutom te države, pa joj i vrednost raste.To direktno utiče na porast kursne razlike.rates, central banks exert influence over both inflation and exchange rates, affecting the relative currency value in the international markets.When domestic interest rates are high, they prompt saving and investment, offering lenders higher return relative to other countries.Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.On the other hand, they tend to reduce spending, as interest earned on savings and deposits is relatively high.In addition, the effect of higher interest rates is mitigated by high inflation, as it depreciates the real value of long-term contracts.

Trade Balance
Trade balance is the balance of imports and exports between a country and its trading partners, and pertains to all transactions related to goods, services, interest and dividends.When a country imports more than it exports, a deficit in the current account occurs, as the country is spending more on foreign trade than it is earning.This typically necessitates borrowing capital from foreign sources to make up the deficit.Consequently, the country has surplus of its own currency, while requiring more foreign currency than it receives through sales of exports.The excess demand for foreign currency lowers the country's exchange rate, resulting in declining cost of domestic goods and services.The balance is re-established when the prices of domestic products become sufficiently low to once again become competitive in foreign markets and accessible to domestic consumers (Eichenbaum, & Evans, 1993).

Public Debt
Public debt is a common source of government financing, whereby the obtained funds are utilized for large-scale public sector projects and other governmental expenditure, such as infrastructure development, education, healthcare, security, etc.While such initiatives stimulate the domestic economy, as they create jobs and improve quality of life, foreign investors are rarely attracted to nations with large public deficits, as debt encourages inflation.Thus, not only large debt increases the likelihood of default, but high inflation will also depreciate the future value of domestic currency, making it unattractive for investors.
Prior to the financial crisis of 2008, governments of Western countries could easily issue bonds to finance their spending.While government debt was deemed safe and yielded lower interest than more risky assets, they were sufficiently attractive to the investors.Consequently, if there was a shortfall at the maturity of a government bond, this could be covered by issuing a new one.
Following the crisis, this mode of financing became increasingly difficult, as many large corporations and investment institutions filed for bankruptcy and many countries were also at risk of default.This called for different measures, with some governments resorting to printing money, depreciating the value of their currency.Moreover, if a government is not able to service its deficit through domestic means, it must increase the supply of securities in the international markets, which lowers their prices.Such financing is expensive for governments and may worsen their debt exposure, increasing risk of default.This also adversely affects the country's credit rating determined by Moody's or Standard & Poor's (Kožul, 2012b), as another highly important determinant of its exchange rate.

Terms of Trade
When the country has high standing in the global community and the quality of its goods and services can command greater export prices, their value relative to those of imports improves, creating positive payment balance and favourable terms of trade.Greater export volume results in increased demand for the country's currency, whereby its value appreciates.This has a direct and positive effect on the exchange rate.

Political Stability and Economic Performance
While risky assets typically generate higher returns, to compensate investors for accepting such risk, most are drawn to politically and economically stable countries.As such countries attract foreign investors, they withdraw their capital from other countries perceived as riskier,

The Role of US Interest Rates in Global Economy
Given that USD is the currency in which most international contracts are settled and exchange rates quoted, it implicitly plays a role in all dynamics discussed above.While introduction of Euro offered the potential for having another major world currency, this expectation has never materialized and the crisis that has affected many EU countries has had an opposite effect.This is evident in the growing value of USD relative to EUR, which has risen by over 19% in the last year.Increased interest rates also signal that the US economy is improving, motivating foreign investors to place their capital there.While the cost of US exports will inevitably increase, this effect is mitigated for most corporations that operate at the level and draw significant proportion of their profits from international sources.In addition, large manufacturers tend to have their production facilities in countries where labour and resources are cheap, and increasing value of dollar will make them even more affordable.Thus, overall, for the US, the recent increase in interest rates seems to be positive.However, the dynamics of domestic and global economy are so complex, that no such simple conclusion can ever be drawn and time will tell how this recent rate increase will play out.
Globally, the picture is also mixed, as those largely depending on the interest on their USDdenominated investments will see increase in their returns, while countries with large debt will struggle to pay it off.In addition, as USD becomes more attractive to foreign investors, they will withdraw their capital from elsewhere, making it more challenging for these countries to raise their funds.This will particularly affect emerging economies that hold most of USD-denominated debt, but will also affect all exchange rates.
For those looking to invest, dollar may once again seem as a safe haven.Still, many market analysts feel that gold and silver, as well as some other precious metals, are relatively underpriced and will continue to hold high value in the long-term, given that their supply is limited, while all currencies are affected by the dynamics discussed above.

Conclusion
The exchange rate of any currency, and thus USD, is a sign of its relative value and thus attractiveness of investments in that country.While historically most pricing models assumed that interest rates will remain positive, recent changes in the global economy have challenged this view.Moreover, with falling oil prices and significant volatility in the world financial markets, it is difficult to offer any definitive predictions regarding the effects that raising US interest rates will have overall.Those with strong USD-denominated investment portfolios will see growing return on their capital, while exporters will need to compensate for the greater value of their goods and services by increasing productivity or outsourcing to countries where resources can be obtained more cheaply.Emerging market economies are posited to be affected most adversely, as they hold the largest proportion of their debt in USD, which will become increasingly difficult to finance.Finally, EUR that was following its adoption posited to be a strong candidate for an alternative major world currency has lost its value relative to the USD, suggesting that the latter will likely remain safe haven for most international investors, along with traditionally held commodities, such as precious metals.
Bankarstvo, 2016, vol.45, br. 1 value is affected not only by the fluctuations in the exchange rate between the two currencies, but also by the domestic interest rates, it is calculated as the ratio of variable and base currencies that would be available on the future date if they were both placed on deposit at their respective interest rates, i.e.: FX f is the forward exchange rate FX s is the spot exchange rate r v is the interest rate applicable to variable currency r b is the interest rate applicable to base currency Bankarstvo, 2016, vol.45, br. 1