Exchange rates: We are facing the yuan era - and the euro is waning

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Exchange rates are unpredictable, is an old saying among economists.

They follow a random path, which means that at any point in time the probability of an appreciation or depreciation is the same - i.e. 50 percent.

After spending three decades in the financial markets, I hold a lot of this wisdom.

It applies to the vast majority of forecast attempts.

But there are two exceptions: very short-term and very long-term forecasts.

Short-term predictions about the movement of exchange rates are sometimes possible if one has an overview of the current situation in the market between supply and demand.

Most business is done between banks and securities firms.

Almost two thirds of this market is dominated by the top ten players.

The top three in 2019 included JP Morgan (with a 9.8 percent market share), Deutsche Bank (8.4 percent) and Citi Bank (7.9 percent).

Anyone who conducts a sufficiently large part of the business in this market can, at least in the short term, see which currencies are more or less in demand and - within the regulatory framework - benefit from them.

In this respect, the following applies: the larger the market share, the more profitable the business can be.

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In the long term, exchange rates also follow certain rules of movement that are determined by trends in the supply and demand of currencies.

So it applies that the exchange rates reflect the real price ratios over time.

The British magazine "The Economist" regularly illustrates this with the price of a Big Mac.

In January of this year, a Big Mac cost $ 5.66 in the US and £ 3.29 in the UK.

So the Big Mac exchange rate was $ 1.72 per pound.

In March, however, a pound was only $ 1.38 in the foreign exchange market, so it was cheaper than the Big Mac rate indicated.

So there are some indications that the pound will become more expensive again against the dollar in the long term.

The reason is that UK exports to the US should rise and imports from the US should fall when UK goods are cheaper.

As a result, there is demand for more pounds and fewer dollars in the market, so that the price of the pound should rise and that of the dollar fall.

Bond yields play a role

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However, the supply and demand for currencies are not only influenced by the trade in goods, but also by capital movements.

If, for example, the return on investments in the USA is higher than in Great Britain, one can expect that the British will buy dollars for pounds in order to invest their money in the USA more profitably.

Clever economists have claimed that a higher return only reflects the expectation of a falling currency and that the export of capital is therefore not worthwhile.

But practice has shown that investors do not believe in this economic cunning.

Since the yield on ten-year government bonds in the US was 0.9 percentage points above the UK in March, higher dollar demand could now be expected from this perspective.

So there seems to be a stalemate between the Big Mac and the yield differential rule.

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Finally, a third factor comes into play that affects currency demand in the long term: the status of the reserve currency.

A currency achieves this status when many payments are made with it worldwide and it is therefore valued as a cash reserve.

To do this, however, the emitting country must be economically - some also think militarily - powerful and have a large share in world trade.

The pound had this status in the 19th century and the US dollar today.

The dollar-pound exchange rate may be a good illustration of the rules of movement, but the application of the rules to the euro and Chinese yuan is more exciting.

Although the euro zone has a trade surplus, the euro appears to be overpriced against the dollar according to the Big Mac exchange rate.

Because of the low interest rates, it is of little interest to investors.

In addition, due to the poor management of the corona pandemic, the euro zone is falling behind in the global economic ranking and both its monetary and fiscal policy is politically and legally controversial.

Yuan is the furthest with digitization

China has a largely balanced foreign trade balance and - if you take the Hong Kong dollar as the Big Mac indicator for the yuan - a currency that is arguably undervalued against the dollar.

The Chinese economy was able to avoid a recession last year and is emerging stronger from the pandemic.

After the USA, China has the second largest economy in the world, while the euro zone has been relegated to third place.

The Chinese central bank renounced the glut of money staged by the western central banks.

At over three percent, ten-year Chinese government bonds therefore offer by far the highest return in the group under review.

When it comes to digitizing the currency, China is furthest ahead and, starting next year, could offer its trading partners a digital yuan as a transaction and reserve currency that is not dependent on the global payment system determined by the USA.

In the short term, trading in yuan for the Chinese and access to the Chinese financial market for foreigners is still restricted.

If the government continues on the path it has chosen, this will change in the long term.

With the rise to the reserve currency, the yuan should appreciate further.

It is still unclear whether he can steal the throne from the dollar.

But it is already becoming apparent that the euro will fall back.

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Thomas Mayer is founding director of the Flossbach von Storch Research Institute and professor at the University of Witten / Herdecke

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