Buying airline tickets is a profit opportunity in Venezuela

When something is cheaper in one market and simultaneously more expensive in another market, someone will try to profit from the price difference by buying the product in the market with the lower price and selling it in the market with the higher price. This profit opportunity is called arbitrage, which is usually discussed in the context of financial assets. In a well functioning financial system, arbitrage opportunities are rare, though not impossible. Even when such an opportunity arises, the prices will usually come back into balance in a matter of seconds as traders rush to exploit the arbitrage opportunity. Buying and selling financial assets entail transaction costs. Thus arbitrage may not pay if the price differences are small. In some unusual cases, arbitrage is the result of government policies and can be hugely profitable. In the previous post, we talk about the rampant food arbitrage in Venezuela. In this post, we discuss the arbitrage in foreign currency in Venezuela.

The arbitrage on currency (specifically US dollars) stems from the fact that there are multiple exchange rates for dollars in Venezuela. The official exchange rate is kept at 6.3 bolivars per US dollar, which is an attractive exchange rate. Everybody wants to buy US dollars at this rate, from people who plan to study abroad to businesses that import goods priced in US dollars to ordinary citizens who want to save in US dollars. But the amount of US dollars the Venezuelan government allotted at the official exchange rate is not enough to satisfy the demands. People have no choice but to get US dollars at the black market rates, which could be 60 bolivars to the US dollar (sometimes as high as 90 or 100 bolivars). So the prices of US dollars on the black market exchange could be 10 times more expensive than in the official channel.

The arbitrage opportunity is clear. You pay 6.3 bolivars for $1 according to the official exchange rate. Then sell the $1 in the black market for, say, 60 bolivars. What an investment – starting with an initial investment of 6.3 bolivars and it almost immediately ballooning to 60 bolivars! Of course, this is assuming that you can buy US dollars at the official rate.

One way to get cheap US dollars at the official rate is to possess a valid airline ticket. Any Venezuelan with a valid airline ticket can buy $3000 per year at the official exchange rate. Once the trip is over, the traveller can then sell the unused US dollars at the black market rate. This clearly presents a windfall (at least a way to make the purchasing power of bolivars goes much further) for Venezuelans who can afford to take advantage of the arbitrage opportunity. As a result, there has been a run on airline tickets for quite a long time now.

Wait, the gift from the Venezuelan government keeps on giving. By what is known as credit card scratching, travelers can make even more money. Once Venezuelans are in another country, say Ecuador or Peru, they can get $3000 on their Visa or Mastercard at the official exchange rate of 6.3 bolivars per US dollar (thus costing only 18900 bolivars). Back in Venezuela, they can sell the $3000 for 10 times the amount in bolivars. The huge disparity between the official exchange rate and black market exchange had been causing a frenzy in air travel. Everybody who has the means to do so has been trying to game the system.

This is an arbitrage on the US currency via the pretense of buying airline tickets, an illustration of the absurd conditions in the Venezuelan economy. One immediate hardship resulting from the currency (and airline ticket) arbitrage is that people with legitimate reasons for traveling abroad are having a hard time finding tickets, e.g., students who plan to study abroad and people who want to visit relatives overseas.

In a free-market financial system, the practice of arbitrage is a way to make the financial market more efficient and more well functioning. For example, any mispricing of financial assets will be eliminated by traders taking advantage of the arbitrage opportunity. For a currency that is freely exchanged in the foreign currency market (a floating rate regime), any discrepancy in exchange rates between two markets (if large enough) will also be eliminated once it is discovered by currency arbitrageurs. The arbitrage in the Venezuelan bolivar only make the mispricing and its associated problems worse.

The exchange rate regime for the Venezuelan bolivar is of course not floating (it is a fixed rate regime). But the fixed rate regime is not necessarily the problem with the Venezuelan bolivar. In 2003, the Venezuelan government tried to stem capital flight by imposing stringent exchange controls, effectively creating a two-tier currency system. The well-connected can make a fortune by doing arbitrage. The ordinary Venezuelan citizens and businesses that cannot buy dollars at the heavily subsidized official rate will have to turn to a flourishing black market, where the price of dollars is 10 times of the official rate, making life difficult for the businesses and shoppers alike.

About 70% of the products consumed by Venezuelans are imported. Importers that cannot obtain dollars at the attractive official exchange rate have no choice but to get the needed US dollars at the black market rates, which are 10 times more expensive. As a result, the imported goods are 10 times more expensive (even if the merchants are simply selling the products at cost only). Consumers are understandably outraged. The government’s response is to label the merchants price gougers and order price cuts (sometimes as much as 50%). Such actions contributed to worsening shortages of essential goods. No businesses can consistently sell their goods at substantial losses. Thus businesses go bankrupt or simply decide to not open for business. The end result of such price controls on the part of the government is that essential goods are even harder to find as before, thus worsening the shortage of foods and other essential goods.

The scarcities of basic goods stem from the government’s refusal to adopt sensible exchange rate policies. Some commentators suggest that Venezuela’s economic problems – shortage of basic goods, high inflation, and the collapse of the currency just to name a few – stem from the collapse of oil prices in the last few months in 2014. That is only a part explanation. The oil prices were still high (in the $100 plus range) earlier in the year and in the last several years. The shortage of basic goods in Venezuela was widespread during the years with high oil prices too. The collapse of the oil prices certainly do not help. The collapse of the bolivar is perhaps the most striking indication of the economic mismanagement on the part of the Venezuelan government.

The following pieces of reporting are additional fascinating and interesting reads, more indications of the serious economic troubles in Venezuela.

Counting pennies in Venezuela

Short on dollars Venezuela tries to halt black market trading

Venezuelas black market rate for US dollars just jumped by almost 40%

Of oil and coconut water

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Where have all the foods gone in Venezuela?

Up to 40% of foods that are intended to be consumed by low income Venezuelans end up being sold in the neighboring country of Columbia (see this piece from npr.org). As a result, bare or empty shelves at the supermarkets are a common sight in Venezuela.

Government policies that are set up to help the poor can sometime end up creating more problems or making the problems worse. This post highlights the food and fuel subsidy provided by the Venezuelan government.

To ensure that the poor citizens will always get the basic foods they need (and to curry favor with their constituency), Venezuelan government provides subsidized foods and fuels to its citizens. The subsidized food staples, such as milk, rice and pasta are sold at controlled prices. The end results are that foods are even more in short supply. It seems the only group of people that benefit from the policy is the organized smugglers who take advantage of the profit opportunities to buy the foods at the low subsidized prices and sell in Columbia at market prices (or near market prices).

Instead of helping the poor and the needy, the subsidy is in effect a massive transfer of funds from the Venezuelan government to the organized smugglers.

According to the piece in npr.org, up to 40 percent of subsidized goods from Venezuela are smuggled into Colombia. “The amount of staples smuggled to Colombia would be enough to load the shelves of our supermarkets,” according to a military spokesman in discussing the problem with a newspaper.

Unlike Venezuela, the food prices in the country of Columbia are not subsidized. Everybody wants to buy low and sell high. It is natural that someone would try to take advantage of this situation. This is an example of arbitrage.

Arbitrage is the exploitation of the mispricing of a financial asset in two different markets (or in two different forms). If such a mispricing exists, then you buy low from one market and sell high in the other market to reap the price difference of the asset as profit. Such profit opportunities are usually associated with financial assets. In the case of the Venezuelan economy, the government policy that is intended to help the poor is creating arbitrage opportunities in foods.

Judging from the size and scale of the smuggled foods into Columbia, the arbitrage is likely to be perpetrated by organized crime. It takes skills and organization and manpower (and probably some degree of ruthlessness) to transport and distribute 40% of a nation’s food supply across a border.

With up to 40% of the subsidized foods disappearing in Venezuela, the food shortage there becomes even more severe. According to this piece from BBC, certain staples, such as milk and toilet paper, are not always easily available in all shops. It is often necessary for shoppers in Venezuela to hunt for the items they need by going to multiple stores. When shoppers got words that certain stores have the sought after items, long lines are formed at these stores.

In the case of financial assets, arbitrage may not pay at all after you take transaction costs into account. In the case of the food arbitrage in Venezuela, there are the transportation costs and other operation costs (maybe payments to some government officials also have the effect of greasing the wheel). After taking all such operation costs into account, the smuggling apparently remains an attractive enterprise for the arbitrageurs. This fact speaks to the wide differential between the subsidized food prices and the normal market prices. With this in mind, could narrowing the price differential be one way to halt the smuggling and thus alleviate the food shortage?

With such rampant smuggling, what is the government’s response? Their plan is to fingerprint shoppers. The food shortage and smuggling problem are part of a larger economic crisis. To solve this crisis, the policymakers need to make real economic changes instead of doing a bandaid approach. See this nice summary from BBC on the Venezuelan economy. This recent panel discussion on the Venezuelan economy discusses some of the difficult steps that must be taken to halt the crisis.

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Clear signs of troubles in the Russian economy

Sometimes the signs from an economy are so clear and unambiguous that it doesn’t take an economist to know that that country is in serious trouble. At 1 AM on Tuesday December 16 (today), the central bank in Russia hiked the main interest rate to 17.5% up from 10.5%. The intention of the rate hike is to stop the downward slide of the ruble. The result: The value of the ruble dropped as much as 19 percent in the last 24 hours, the worst single-day drop for the ruble in 16 years.

The ruble has been dropping in value during all of this year. It was trading around 33 rubles to the dollar at the beginning of the year. In the last few weeks, the downward slide of the rubles has accelerated. At the begining of December, the ruble was trading at around 53-54 rubles per dollar. Just a few days before the latest rate hike announcement, the ruble was trading at 58 rubles to the dollars. According to to this piece from Washingtonpost, the ruble was trading at one point on the day of the rate hike announcement at 79 rubles to the dollar. Later on the same day, the exchange rate has been stablilized at 68 rubles to the dollar.

It seems that many people are bailing on Russia. Investors and traders are rushing to move their money out of Russian assets. Ordinarly people are hoarding US dollars as a way to hold onto their savings. What has the Russian government been doing to stem the downward slide of the ruble? For sometime now the Russian government had been using its stockpile of foreign reserves to buy rubles, in the hope of shoring up the ruble. Then there is this latest surprsied announcement of a rate hike to 17% in the hope that depositors would continue to keep their money in rubles. But neither approach seems to be working.

The biggest driver of the economic meltdown in Russia is of course the falling price of oil. The oil and gas receipts make up about half of Russia’s revenues. Weaker demand in China and India and increased supply of oil (due in part to the shale boom in the US) pushed the oil price a high of $110 per barrel earlier this year to $60 recently. Of course, the Western sanctions imposed on Russia as a result of Russian adventures in Ukraine do not help matters.

The collapse of the ruble is tied to the sharp drop in oil prices in the last several months. Just a few months ago, oil prices per barrel were in triple-digit. Now they are around $60. Oil revenues make up an outsized portion of the total export revenues that Russia take in. So the export revenues for Russia had collapsed in the space of a few months. When the value of the exports in an economy collapses, so does the currency.

Looking at it in another way. With dramatically lower oil prices and lower demand for oil, Russia is taking in fewer US dollars. As a result, there is less demand for rubles as Russian companies have fewer dollars to convert into rubles. Currency prices are ultimately driven by forces of supply and demand. Currently there is far less interest in buying rubles than just a few months ago. There is less demand for rubles due to less oil revenues in US dollars. Traders and investors try to flee from Russian assets. Ordinary Russians do not want to keep their deposits in rubles despite the enticement of the 17% interest rate. So the Russian ruble is battered on multiple fronts.

There are many problems with a crashing currency. One is that when a currency collapses, imports are more expensive, thus worsening inflation. For Russia, this is an acute problem since Russia imports a substantial portion of its foods. Another problem is that it is getting harder for Russian companies to service their US dollar debts. It now costs twice as many rubles to buy one US dollar than one year ago.

Now that the rate hike (to 17%) appears not to be working, Russia is having a new problem to cope with – an exorbitant interest rate that is going to make borrowing more costly and drive down growth. The latest dramatic rate hike looks to be an act of desperation. The fact that such a huge rate hike cannot convince people to not give up on the ruble is telling. The situation is really serious. According to this piece from Bloomberg Businessweek, “the weakening currency and surging interest rates make for a deadly combination of economic contraction and rampant inflation.”

Hiking interest rates does not seem to stem the tide of the loss in value of the ruble. Keeping interest low would mean the ruble will continue on its downward slide and inflation would continue to rise. Sustained loss in the value of the ruble may also mean that there will be more defaults of Russian corporations. This is a catch-22. It seems that there are just no good options.

It appears that the Russian government is committed to using its foreign currency reserves to stop the ruble from falling further, which is just a bandaid solution. On the other hand, those reserves could drain fast. So this is definitely not a lasting solution.

Another option may be to ease the Western sanctions. The easing or ending of the financial sanctions imposed by Western countries will restore access to the international credit market for the Russian banks and oil companies. But for this to come about, the policymakers in Russia will have to make some concessions in the Ukraine stand-off, a step that may be hard for them to make.

Some analysts predict that the Russian authority may eventually resort to capital controls, which are basically rules that are designed to keep money from leaving the country. But capital controls might not work at all. They may just cause more panic and make matter worse.

There does not appear to be good options for the Russian government. One thing is clear. Relief is nowhere in sight. Regardless of the magnitude of the interest rates, the Russian economy is expected to contract by about 0.8% according to official forecast. But the Russian central bank also indicated that the GDP may drop 4.7% if oil price stays at $60 per barrel.

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An example to illustrate the hedging of exchange rate risk

Assume that the current US-Canada exchange rate is US $0.80 per C $1 (Canadian dollar, CAD). Consider the following two examples.

1. An exporter in the United States sells high tech manufacturing equipment to a Canadian importer. The total amount of goods sold is 11 million Canadian dollars (CAD), to be received by the exporter one year from now.
2. An investor in the United States invests in one-year risk-free Canadian government bills that pay 10% annually. The US investor starts with US $8 million and exchanges the amount for C $10 million at the exchange indicated above. At the end of the year, the investor expects to receive C $11 million.

We use the two examples to illustrate the inherent risk when selling or investing abroad abroad. In terms of Canadian dollars, the prices for the manufacturing equipment may mean good profit. When the exchange rates move in the wrong way, the exporter may end up with a loss when the Canadian dollars are converted into US dollars. On the other hand, the risk-free government bills are risk-free investment for Canadian investors. But for US investors that have to convert the proceeds back into US dollars, the end result may be a loss. In this post, we use these two examples to illustrate the potential danger of exchange rate risk and discuss some of the ways to mitigate this risk.

In some sense, the two examples are one example. The exporter or investor will receive C $11 million in one year (the same cash flow made in the same currency and then converted back to the same domestic currency). Thus both examples are subject to the same dynamics inherent in the movement of exchange rates. Even though both business contracts are profitable in terms of Canadian dollars, when the exchange rates move in an adverse direction, the parties in both examples could potentially experience a loss. Thus both examples can be discussed as one example.

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The outcomes

This previous post shows how to infer from a movement of exchange rates to determine whether a domestic currency depreciates (gains in value) or depreciates (loses in value) against a foreign currency. Furthermore, when the domestic currency loses in value against a foreign currency, it is a favorable environment to export to that foreign country. Applying these ideas, we make the following observations. For both the exporter and the investor, the domestic currency = US dollars and the foreign currency = Canadian dollars.

Favorable outcome when receiving funds from abroad
• The appreciation of the foreign currency.
• The depreciation of the domestic currency.

Unfavorable outcome when receiving funds from abroad
• The appreciation of the domestic currency.
• The depreciation of the foreign currency.

When the favorable outcome happens, the exporter or the investor will make money in the domestic currency (USD). When the unfavorable outcome happens, the exporter or the investor will lose money in USD. Let’s see why.

First the favorable outcome. When you are going to receive an amount of the foreign currency and if the foreign currency gains in value (against your domestic currency), you are getting something that is more valuable than before. When the domestic currency loses value against the foreign currency, one unit of the foreign currency buys more units of the domestic currency. This means that the exporter or the investor is getting an extra return on the investment.

The unfavorable outcome. When the foreign currency loses in value against the domestic currency, you are getting something that is less valuable than before. When the domestic currency gains in value, one unit of the foreign currency will buy fewer units of the domestic currency. This has the effect of reducing the return of the investment when the foreign currency is converted into the domestic currency. If the swing in exchange rate is big enough, it will cause a loss in the domestic currency.

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Numerical examples

To reinforce the ideas discussed above, let’s look at the examples numerically. As mentioned at the beginning, the initial exchange rate is US $0.80 per C $1. Suppose that the exchange rate is US $0.9 = C $1 a year later. This means that the Canadian dollar has gained in value against the US dollar (1 Canadian dollar can now buy more US dollars). The Canadian fund to be received is now worth more in US dolalrs. The 11 million Canadian dollars are now $9.9 million US dollars. This amount is US $1.1 million over the US $8 million the investor spent in buying the Canadian bills. So this is a good outcome for the exporter or investor.

On the other hand, suppose that the exchange rate is US $0.7 = C $1 one year later. This means that the US dollar has gained in value against the Canadian dollar (1 Canadian dollar now buys less US dollars). So the Canadian fund to be received is worth less in US dolalrs. The 11 miilion Canadian dollars would only be worth US $7.7 million. This amount is US $1.1 million less than the US $8 million the investor spent in buying the Canadian bills. For the investor in Canadian government bills, this preprents a negative rate of return (investing US $8 million and receiving US $7.7 million a year later).

So fluctuation in exchange rates has real financial consequences for anyone who is involved in import/export or investing abroad. The example in this post highlights the risk when the receivables in the investment are in a foreign currency. Any exporter who received foreign funds for the goods that they sell will fear the appreciation of their domestic currency, equivalently the depreciation of the foreign currency. The same can be said for any investor who has to convert the foreign investment proceeds into their domestic currency.

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Ways to mitigate the exchange rate risk

The example illustrates that businesses that exports or imports goods and services and investors who invest internationally need to consider how to protect against adverse movements in exchange rates. Even a small variation in the exchange rate can result in a big financial loss.

One way to hedge the exchange rate risk is to use a forward contract. A foreign currency forward contract is a contract to buy or sell a specific amount of a currency at a fixed exchange rate at a specific time in the future.

If the exporter/investor worries that the Canadian dollar will depreciate in one year so that the Canadian dollars received will be worth less, they can hedge this risk by entering into a forward contract. Here’s how. At the time the export contract or investment contract is made, the exporter or investor would agree to sell 11 million Canadian dollars for US dollars at a fixed exchange rate (this is called the forward exchange rate) one year later. The counter party to the exporter/investor, usually a bank, will agree to buy 11 million Canadian dollars at the terms specified in the contract.

Suppose that the forward exchange rate is US $0.77 per Canadian dollar. When the exporter or investor receives the 11 million Canadian dollars a year later, he/she can exchange the Canadian dollars for 0.77 x 11 = 8.47 million US dollars. Entering into this forward contract has the effect of locking in a favorable exchange rate one year ahead of time.

If one year later, the exchange rate is US $0.70 per C $1 (the Canadian dollar has weakened since one Canadian dollar can buy fewer US dollars), then the exporter/investor will only get US $7.7 million if there is no forward contract. With the forward contract, the amount of US dollars the exporter/investor will receive will still be 8.47 million US dollars. This would be a happy outcome for the exporter/investor.

If the exchange swings the other way and if there is no forward contract, it would be a profitable scenario. However, the forward contract is legally binding. That means the exporter/investor will have to honor the forward exchange rate set at the beginning. For example, if one year later, the exchange rate is US $0.90 per C $1 (the Canadian dollar has strengthened since one Canadian dollar can buy more US dollars), the exporter/investor will not be able to realize the profit an has to honor the forward exchange rate of US $0.77 per C $1. The amount of US dollars received will still be $8.47 million.

There are other ways to hedge the same risk. For example, the exporter/investor can also enter into a foreign currency futures contract or buy a foreign currency option. Another possibility is to open a bank account denominated in the foreign currency that is received. In this particular example, the exporter/investor can open a bank account denominated in Canadian dollars (either in Canada or in the US). The Canadian funds can be deposited into such an account and then converted back to US dollars when the exchange rate is favorable. There are pros and cons for each option, and which method to use depends on the business needs of the exporter/investor.

We would like to point out that the basic working of futures contracts is similar to forward contracts. Both futures contract and forward contract allow people to buy or sell a specific type of asset at a given price at a specific time in the future. One important difference is that futures contracts are exchange-traded and thus are standardized contracts. On the other hand, forward contracts are private agreements between two parties and can be tailored to meet the unique or unusual requirements of the party seeking the contract. There are other differences but we will not discuss them here. Our purpose here is to give a basic illustration on how to hedge the exchange rate risk.

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What happens if the export proceeds are made in the domestic currency?

In the exporter example discussed here, suppose that the business agreement is for the exporter to receive the export proceeds in US dollars (the domestic currency of the exporter). Then the exchange rate risk is transferred from the exporter to the importer. The exporter will not worry about getting less US dollars when the exchange rate moves in the wrong way, since he/she will be paid in US dollars. The importer will have to exchange Canadian dollars into US dollars to pay for the imported goods. Then it is the importer who bears the exchange rate risk and finds ways to hedge the risk.

Previously, the payment dynamics is about receiving funds in a foreign currency. Now the importer has to make payments in a foreign currency (the US dollar in our example). The dynamics is opposite of what it is before.

Favorable outcome when making payments in a foreign currency
• The depreciation of the foreign currency.
• The appreciation of the domestic currency.

Unfavorable outcome when making payments in a foreign currency
• The depreciation of the domestic currency.
• The appreciation of the foreign currency.

In the same example discussed above, the importer will have to come up with US $8 million to pay for the imported goods. The domestic currency for the importer is the Canadian dollar and the foreign currency is the US dollar. The importer will fear that the US dollar will get stronger, in which case, he/she will have to come up with more Canadian dollars to buy the same amount of US dollars. To hedge this risk, the importer can, at the time the business deal is made, enter into a foreign currency forward contract to buy US $8 million at a fixed exchange rate one year later.

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Remarks

The hedging in the example discussed above will completely eliminate the exchange rate risk for the exporter/importer or investor. Such perfect hedging may not be possible in all circumstances. In the above example, we know the exact amount of foreign currency to be received or paid. We are also certain of the timing of the payments. We also have the certainty of the payments – the investment is in risk-free bonds for example. If the investment is not in risk-free bonds but is instead in risky Canadian equity, we would know neither the ultimate values in Canadian dollars of the Canadian equity nor how many Canadian dollars to sell forward one year later. In the exporter/importer example above, we assume that there is no credit risk – that is, payments will always be made at the appointed time. If that is not the case, the hedging tool of the forward contract will not be effective.

The risk-free interest rate of 10% in the Canadian government bills in the above example is probably not a realistic rate. Currently both US and Canada are low interest rate environments. Both countries are well functioning economies and the exchange rate movements between US and Canada are typically not volatile. So the example here is only meant to serve the purpose of illustrating the hedging of exchange rate risk. However, if a US exporter is exporting to Russia or Venezuela, then the exporter will likely to demand payments be made in US dollars.

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How to read exchange rates

The previous post discusses how the collapse of the ruble is wreaking havoc on the Russian economy. A big swings in currency exchange rates may impact a country (or a company) negatively. It is certainly the case with the Russian economy as discussed by the previous post. In this post, we examine a few more examples of exchange rates.

The exchange rate is the rate at which a domestic currency can be converted into a foreign currency. Let’s look at the example in the previous post, which is based on the following photo.

This photo was taken around December 3. On that day, if you want to buy US dollars in Moscow, you need to pay 54.3 rubles for a dollar. We would say that the exchange rate is 54.3 rubles per dollar or equivalently $0.0184 per ruble.

At the beginning of 2014, the exchange rate is around 33 rubles per dollar. So the rate of 54.3 rubles per US dollar a 11 months later represents a dramatic swing in exchange rate. Currency exchange rates go up and down all the time. In this case, one US dollar can buy 64.5% more rubles now than a year ago. This is a big price drop in rubles in a short period of time!

This big swing in exchange rates is causing a serious problem in the Russian economy. It now costs a lot more rubles to buy one US dollar (64.5% more). As a result, goods priced in US dollars are much more expensive in Russia than a year ago (assuming the US prices stay the same). For example, Russia imports about 40% of its foods. So the loss of value in rubles really hurts at the grocery store.

Let’s look at another example. Here’s a comparison of the yen-USD exchange rates.

• 105.25 yen = 1 USD (at the start of 2014)
• 121.50 yen = 1 USD (December 2014)

The US dollar is buying more Japanese yens now than almost a year ago. When a unit of money (in this case USD) can buy more of something, that something is becoming cheaper. So the Japanese yen is becoming cheaper, or has been devalued or has depreciated. We can divide 1 by the yen amount and come up with the following exchange rates.

• 1 yen = $0.0095 (at the start of 2014)
• 1 yen = $0.00823 (December 2014)

One yen is buying less US dollars than a year ago. When a unit of money (in this case Japanese yen) is buying less of something, that something is becoming more expensive. So in this case, the US dollar is becoming more expensive in relation to the yen.

The US dollar is getting stronger in this almost one-year period of time. The Japanese yen is getting weaker. But the change is exchange rates is not a dramatic as in the Russian ruble example. It costs 15.4% more yens to buy one US dollar than a year ago. This is a significant price increase, but not as dramatic and as severe as the Russian ruble example.

This example of changes in yen-USD example is beneficial to US importers of Japanese goods. Since Japanese yen is getting cheaper, the same amount of US dollars are buying more Japanese goods, or the same amount of Japanese goods will cost less US dollars to buy (assuming the prices in Japanese goods stay about the same).

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How to read exchange rates

When the value of a currency goes up, it appreciates. When the value of a currency goes down, it depreciates. In the example discussed above, the ruble loses its value against the US dollar (one USD can buy more rubles now). On the other hand, the US dollar gains in value against the Japanese yen (one Japanese yen buys fewer US dollars now). We now describe how to tell whether a currency is losing value or gaining value by looking at the exchange rates. Once the dynamics is grasped, some of the subsequent concepts will be easier to understand.

The reason we go into the trouble of spelling this relationship out is that when a currency is losing value, the exchange rate may actually be a bigger number. Recall that 33 rubles = 1 USD a year ago and 54 rubles = 1 USD now (a year later). So the exchange rate is up when the ruble is losing value. But if you convert the rate to a per ruble rate, the exchange rate is actually down. So thinking that “currency depreciation means exchange rate is down” may cause confusion, not to mention that it may be incorrect.

The key to relating the value of a currency to movement of exchange rates is simple. The idea is this. When a unit of money can buy more of the something, that something is cheaper and thus has lost value. When a unit of money buys less of something, that something is more expensive or has gained in value. The following can further illustrate.

(1a) One unit of money buys more apples Apples are cheaper

(1b) One unit of money buys fewer apples Apples are more expensive

This is the dynamics that we experience in the grocery store. If one dollar bought one pound of apples last week and the same dollar buys two pounds of apples now, we know that apples have become cheaper, or apples have declined in values. Though we don’t usually phrase it in this way with apples, we can also say that apples are losing value against the US dollar. So the above observation will help keep things straight when looking at fluctuations in exchange rates.

As discussed earlier, 33 rubles = 1 USD a year ago and 54.3 rubles = 1 USD now (a year later). So one US dollar can buys more rubles than a year ago. So rubles are cheaper or has lost in value. If we convert the exchange rates to be based on one ruble (1 ruble = $0.03 a year ago and 1 ruble = $0.0184 now), then one ruble will buy less US dollars now than a year ago. This points to the fact that US dollars have become more expensive, or have appreciated. Of course, rubles have depreciated if the US dollar has appreciated.

So there are two ways to look at a change in exchange rates, depending on how the rate is expressed. When the exchange rate of the domestic currency (the ruble in this case) is expressed as the rate of the domestic currency per unit of the referenced currency (USD in this case), a drop in value of the domestic currency means that the exchange rates has increased.

In the Japanese yen example, one USD can buy more yens now than a year ago. So the Japanese yen is becoming cheaper, or is dropping in value. Here, the drop in value in the Japanese yen corresponds with a rise in the exchange rate of yens per USD. With the exchange rates expressed as amounts of USD per yen, we can see that one yen now buys fewer US dollars than a year ago. So US dollars are becoming more expensive or has gained in value. Here, the drop in the value of the Japanese yen corresponds with a falling exchange rate of USD per yen.

To keep things straight, it is a matter of figuring out which currency is cheaper or more expensive by determining which currency can buy more of the other currency. To test out this understanding, one more example. This is the exchange rate between Yuan, one unit of the Chinese currency Renminbi and USD.

6.0508 Yuan = 1 USD (at the start of 2014)

6.1523 Yuan = 1 USD (December 2014)

Note that one US dollar can now buy a little more Yuan than a year ago. So the Renminbi is getting a litte cheaper and is dropping slightly in value against the dollar. Also note that the drop in value for Renminbi corresponds with a slightly rising exchange rate of Yuan per USD. Now convert the same rates to be USD per Yuan.

1 Yuan = $0.165 (at the start of 2014)

1 Yuan = $0.1625 (December 2014)

Note that one Yuan now buy slightly smaller amount of US dollars. This means that US dollar is becoming a little more expensive. Note that the drop in Renminbi corresponds with a slightly declining exchange rate of USD per Yuan.

To determine whether a currency depreciates or appreciates against a referenced currency, just read the exchange rates to see which currency can now buy more (or less) of the other.

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More about exchange rates

If the domestic currency is cheaper against a foreign currency, then goods that are priced in that foreign currency are more expensive. In the ruble example, imported goods priced in US dollars are more expensive in Russia. So a weaker ruble hurts imports into Russia. On the other hand, goods priced in Rubles will be cheaper in the US. So a weaker ruble helps exports of Russian goods. In general a weaker domestic currency hurts imports and helps exports.

It is interesting to examine the Yuan-USD exchange rates again.

6.8272 Yuan = 1 USD (at the start of 2010)

6.0508 Yuan = 1 USD (at the start of 2014)

6.1523 Yuan = 1 USD (December 2014)

So the larger trend in the last 5 years is that the Chinese Yuan has been rising in value against the USD. From 2010 to the start of 2014, the Yuan had become more expensive (1 USD bought less Yuan at the start of 2014 as compared to 2010). Only in the last year has the yuan been gaining slightly in value against the US dollar. The following is the screen grab of a table in the Wikipedia entry List of renminbi exchange rates.

The exchange rates for Yuan-USD were pretty stable from 1960 all the way to early 1980s. From there the exchange rates for Yuan-USD were on a rising path, which means the Chinese currency had been on a depreciating path. In the early 1980s, one USD could buy around 2.5 Yuans. For the decade 1996-2005, one USD could buy about 8 Yuans. Only in the last decade (2006-2014) had the Chinese currency been gaining in value against the US dollar. Now one USD can buy about 6 Yuans. Many observers believed that the devaluation of the Chinese currency was no accident. Some believed that the Chinese yuan was kept low to promoted exports.

Throughout the period represented in the above table, a US dollar can buy increasingly more and more Yuans. As a result Chinese products are more and more attractive to consumers in the US (from a price perspective). In the 1980s, one USD could buy about 2-5 Yuans. In the 1990s, one USD could buy about 8 Yuans. Set aside the cause of this depreciation of the Yuan, it is undeniable that the weakening of a currency promotes the exports of that country.

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Currency depreciation is good for exports

The statements (1a) and (1b) above are handy device to help keeping things straight. Using them will help decide which currency is becoming cheaper or more expensive. Another handy device is to know that the depreciation of the domestic currency against a foreign currency is good for exports to that foreign country.

Fix a currency and consider it as the base currency (or domestic currency). The base currency is compared against a foreign currency. The following conditions mean the same thing.

• The exchange rate of the number of units of the base currency per unit of a foreign currency is rising.
• The base currency is depreciating against the foreign currency.
• Goods priced in the base currency are cheaper in the foreign country.
• The exchange rate movement present a favorable environment for exports to the foreign country.

Of course, we can also have another set of statements relating currency appreciation and import by flipping the above statements.

One remark that should be made is that the exchange rate mentioned in the above 4 statements is the nominal exchange rate between the base currency and the foreign country. The nominal exchange rate is the number of units of the domestic currency that can purchase a unit of a given foreign currency. It does not take purchasing power into account. For example, when the domestic currency depreciates against a foreign currency, a unit of the foreign currency can now buy more units of the domestic currency. But if the goods priced in the domestic currency have become more expensive, the price appreciation in the domestic currency may cancel out the effect of the domestic currency depreciation. So we assume that the above 4 statements are based on nominal exchange rates.

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Dealer’s buy price and sell price

The above discussion talks about one exchange rate, which is the nominal exchange rate. When you go to foreign currency dealer, there are actually two rates. The dealer buys low and sells high (the dealer has to make a profit). In the above photo, the lower rate is 53.15 rubles per USD and the higher rate is 54.3 rubles per USD. When a tourist walks in that foreign currency store to exchange US dollars into rubles, the tourist will get 53.15 rubles for each US dollar. On the other hand, a Moscow resident who wants to exchange rubles into US dollars will have to pay 54.3 rubles to get a US dollar. The dealer buys low and sells high. The customer sells low and buys high. The spread between the two rates represents the dealer’s profit. The lower rate of 53.15 rubles per USD is called the bid price. That is the price at which a dealer is willing to buy the US dollar. The higher rate of 54.3 rubles per USD is called the ask price (or offer price). That is the price at which a dealer is willing to sell the US dollar.

The same photo also shows the exchange rates for Ruble-Euro. On that day when this photo was taken, any body who wants to sell Euro could only get 65.55 rubles for each Euro. Anyone who wants to buy Euro will have to pay 67.2 rubles for each Euro. The spread between the dealer’s buy price and sell price reflects the balance between demand and supply (or the lack of). If supply and demand are in equilibrium, the spread is likely narrow. If there is more demand for Euro than supply, the spread will be wider.

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Exercises

Consider the following exchange rates.

• KRW-USD (KRW = South Korean Won)
• 1140.50 KRW = 1 USD (at the start of 2013)
• 1150.25 KRW = 1 USD (at the start of 2014)
• 1113.96 KRW = 1 USD (December 2014)

At the start of 2013, a US importer signed a contract with a South Korean electronic maker to buy 1 billion KRW worth of smart phones. The goods were to be delivered one year later and purchase price of 1 billion KRW was also to be paid at the time of delivery. Discuss how the exchange rate movement impacted the transaction. How much more or less had the US importer had to pay in US dollars at the time of delivery as compared to one year earlier?

At the start of 2014, the same US importer signed another contract with the same South Korean electronic maker to buy 1 billion KRW worth of smart phones. The goods were to be delivered 11 months later and purchase price of 1 billion KRW was also to be paid at the time of delivery. Discuss how the exchange rate movement impacted the transaction. How much more or less had the US importer had to pay in US dollars at the time of delivery as compared to 11 months earlier?

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A foreign exchange rate board in Moscow

The Russian economy is facing severe challenges in several fronts, e.g., the economic sanctions imposed by Western countries and falling oil prices. The picture in this piece from npr.org points to another problem Russia is facing. The following is a screen grab of this photo.

The photo shows a board listing foreign currency exchange rate in Moscow on Wednesday (Dec 3). The board shows that it takes over 50 rubles to exchange for one US dollar (the dealer buy price is 53.15 rubles per dollar and the dealer sell price is 54.30 rubles per dollar). Of course, the board by itself does not tell the whole story. At the beginning of the year, the ruble was trading at 33 to the dollar and at about 35 to the dollar in the summer. The exchange rates shown in this photo represent an over 66% drop in the ruble against the US dollar. Another piece in npr.org has more headlines on the woes of Russia. This piece in Time also has good information.

About 33 rubles per dollar at the beginning of the year. Over 50 rubles per dollar almost a year later. What does this mean?

Imagine that you are a tourist in Moscow wanting to exchange dollars into rubles. At the beginning of this year, the dealer would give you 33 rubles for each US dollar. On the day this picture was taken, the dealer would give you 53.15 rubles for each US dollar. So US dollars go a lot further than before in Russia.

What is great for a tourist in Russia is not so good for the locals. Imagine you are a resident of Moscow and wishes to buy some US dollars. Perhaps you want to visit the United States or more likely you want to hold some US dollars just in case the ruble falls even further. In the beginning of this year, you could pay about 33 rubles for a dollar. On the day this picture was taken, you would need to pay 54.30 rubles for one dollar. So US dollars have become a lot more expensive. Or the ruble is getting cheaper.

The expensive dollar (or the sinking ruble) has wide ranging consequence for people in Russia. A stronger US dollar (or a weaker ruble) makes imported goods more expensive in Russia. At the beginning of the year, about 33 rubles could pay for one dollar worth of goods priced in US dollars. On the day this picture was taken (almost a year later), it would take over 50 rubles to pay for one dollar of goods priced in US dollars (over 50% more expensive). Russia imports about 40% of its foods. So the falling ruble means higher food prices. In fact, Russian citizens currently do not have a chance to buy food items imported from the West because Russian government banned most foods from the US and Europe. The ban has the effect of driving food prices even higher since it creates shortage.

A weak ruble is good for the US tourist visiting Russia. The same dynamic means that a weak ruble is good for any Russian company that exports to the US. One US dollar can buy a lot more Russian goods now than in the beginning of the year. This becomes an advantage only if the country has a thriving manufacturing base and is producing products that people in other countries want to buy. The main export of Russia is oil, which has fallen about 30% in prices in the space of a few months, with no relief in sight. So the Russian economy is in serious trouble. It is battered on multiple fronts – falling oil prices, high inflation and the collapse of the ruble. All these forces are likely to drive the Russian economy into recession next year.

What is causing the value of the ruble to fall so precipitously? A one-word explanation is confidence (the lack of it). It has been reported that the Russian public has been hoarding dollars and other major currencies. There has been a huge capital flight out of Russia, so serious that the government is imploring its citizen to bring back capital into Russia (with a promise that all will be forgiven). The value of the currency of a country is related to the long-term attractiveness of the economic opportunities available within that country. The value of a currency is driven by supply and demand. A large part of the downward pressure on oil prices stems from the slowed economy in China and India. There is much less demand for rubles to pay for the smaller amount of Russian oil that is needed by the world economy. On the other hand, some of the downward pressure on the ruble comes from its own citizens as evidenced by the hoarding of the dollars and other currencies.

The discussion of the falling value of the ruble is a great opening to talk about exchange rate and exchange rate risk. The next post has more information on exchange rates.

Here’s an update on the slide in the value of the ruble.

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