Demystifying Currency Manipulation and Speculation in Foreign Exchange Markets

Daniel Makina, University of South Africa

The public brouhaha that has erupted over the alleged currency manipulation by banks in South Africa can be likened to making a mountain out of molehill. Similarly, the jugular reaction of the Minister in the Presidency, Khumbudzo Ntshavheni, blanketly blaming the private sector for the currency manipulation, is a typical case of burning the whole forest to kill one rabbit. Nevertheless, such reactions are understandable given that the foreign exchange market could be one of the least understood markets in functioning economies. The billionaire Warren Buffet once remarked: “The foreign exchange market is the most irrational market in the world”. It is a remark that underscores the challenges we face when we try to predict currency movements.

Currency manipulation

In the literature, currency manipulation is defined as the intentional efforts taken by a government or its central bank to influence the value of its own currency in the foreign exchange market. This is achieved through various ways, typically through buying or selling currencies, adjusting interest rates, or implementing trade policies. The objective for engaging in currency manipulation is to gain a competitive advantage in international trade. In one respect, through deliberate devaluing its currency, a country can make its exports cheaper and more attractive to foreign buyers, potentially boosting its trade surplus. In another respect, a country could seek to strengthen its currency to reduce the cost of imported goods and fight inflation.

Currency manipulation can distort trade balances and lead to tensions among nations. It was one of the causes of the Great Depression of 1930s when nations engaged in competitive devaluations. In other words, it was believed to have amplified the depression. To guard against the practice, the IMF and WTO have provisions that prohibit their members from the using currency manipulation to gain trade advantages.

The alleged transgressions by South African banks cannot be termed currency manipulation because it is a government or its central bank that has the capacity to engage in currency manipulation. At best the transgressions could be described as collusion pricing of currency for either individual traders’ benefit or institutional benefit. Given that the value of the rand in the foreign exchange market is market-determined, the actions of the banks could be interpreted in one of the following two ways. First, the banks might have formed a parallel or black foreign exchange market outside the official market for some of their clients whereby they set or fixed the exchange rate. Conducting a parallel foreign exchange market is considered as market abuse in most jurisdictions. Some jurisdictions go to the extent of arresting such traders. The second possibility could be that the banks were simply conducting ad hoc over-the-counter foreign exchange trading for some special customers whereby the exchange rate was negotiated outside the official foreign exchange market. Such practice happens in almost all markets. A customer receiving a large foreign receipt can negotiate a better exchange rate with his/her bank than the rate in the official foreign exchange market. It is a common banking with significant transactions, such as mergers, acquisitions, large export deals, or capital transactions. In these cases, collaboration between banks can lead to manipulating bids and offers in the market at a specific time. 

However, even in this common case, it is crucial to differentiate between short-term transaction flows and the broader economic fundamentals and global situations that influence the exchange rate over the long term. Moreover, most central banks worldwide – including South Africa – have mechanisms in place to counter such long-term actions and keep the exchange rate. Stable.

Currency speculation

Currency speculation is buying or selling currencies with the intention of making profit from misalignments in exchange rates. Currency speculators can be individual traders or institutions. There are three main types of techniques used in currency speculation. The first type is termed locational arbitrage which is possible when a bank’s buying price (bid price) is higher than another bank’s selling price (ask price) for the same currency. The second type is called triangular arbitrage which is possible when a cross exchange rate quote differs from the rate calculated from spot rates. The third type is covered interest arbitrage whichis the process of capitalizing on the interest rate differential between two countries, while covering exchange rate risk. Covered interest arbitrageis only possible when interest rate parity does not hold. When market forces cause interest rates and exchange rates to adjust such that covered interest arbitrage is no longer feasible, there is an equilibrium state called interest rate parity. Under such an equilibrium state, the forward rate will differ from the spot rate by an amount that is sufficient to offset the interest rate differential between two currencies under consideration.

When the foreign exchange market is efficient, market forces would eliminate short-term possibilities of currency arbitrage. Hence, currency speculation is not a sustainable profitable activity. In an efficient market, the possibility of making profit from currency speculation is quickly eliminated. A notable case of currency speculation happened in the UK in 1992 spearheaded by George Soros who used his hedge fund, Quantum Fund, to borrow billions of pounds from various banks and sell them for other currencies, such as U.S. dollars, German marks, and other currencies. This action by the hedge fund created a huge demand for other currencies and a huge supply of pounds, which drove down the value of the pound in the market. The gamble George Soros took was that the pound would eventually be devalued because there was a limit to how much pain the government was prepared to inflict on its own people. Indeed, the Bank of England pound devalued the pound following a US$22 billion intervention in the foreign exchange market and the UK government withdrew sterling from the European Exchange Rate Mechanism on 16 September 1992. It was a day remembered as Black Wednesday, and George Soros became reputed for “breaking the Bank of England. It was reported that he could have made a US$1 billion profit from that speculative activity.

The impact of alleged case of South African banks

There have been allegations that the actions of the banks caused depreciation of the rand and loss of jobs. Unfortunately, such allegations are not supported by evidence. When we examine the performance of the rand during the period 2007 to 2013 when the banks are reported to have undertaken these activities, we find a different story. As illustrated in Figure 1 below, the dollar/rand exchange rate was relatively stable over this period. In fact, the rand appreciated against the dollar between 2009 and 2011 and only started to depreciate after 2013. On the other hand, the rand/dollar purchasing power parity was stable from 2000 to 2016.

Figure 1: Rand/Dollar Exchange Rate

The National Treasury has also argued that the alleged actions of banks to manipulate the dollar-rand exchange from 2007 to 2013 were not the main cause of the local currency depreciation its value over the past decade, or tepid economic growth. Rather, it attributes the currency depreciation to problems such as Eskom blackouts and the Transnet logistics challenges.

Promoting foreign exchange literacy

Ironically, people living in countries with underdeveloped and inefficient foreign exchange markets have a better understanding of workings of the exchange rate than those living in countries with well developed and efficient foreign exchange markets such as South Africa and developed economies. Most countries north of South Africa do not have flexible exchange rate regimes. As a result, they all have thriving parallel foreign exchange markets operated by informal traders. In fact, informal currency trading is a significant form of employment. I am personally reminded of an encounter when I was in the Gambia in 1993. I wanted to change currency but when I arrived at the bank, I found it closed. However, at the closed door of the bank, there was a young man with bag who told me that he can serve me with even a better rate.

The point I am trying to put through is that adversity has made people in underdeveloped markets to acquire foreign exchange literacy. They did not need to study international finance at university as I did. Perhaps the ignorance of the workings of the exchange rate we see around us is simply because we have not experienced adversity.