Exchange Rates

Introduction

If a person decides to visit another country as a tourist or to export goods to or import goods from another country there will usually be a foreign currency involved in the transaction. The same applies if one is considering a mortgage or other borrowing in a foreign currency or investing in a foreign financial asset, including a foreign bank deposit. There will therefore be an exchange rate between local currency, the KM in the case of Bosnia and Herzegovina, and the foreign currency. It is necessary to understand how that exchange rate is set and how it could move in the future.

What is an exchange rate?

An exchange rate between two currencies is the rate at which one currency will be changed for the other. It is usually expressed as the amount one unit of one currency will buy of the second currency. For example, the exchange rate between the KM and the Euro can be expressed either as:

1KM = 0.511292 Euro or, 1 Euro = 1.955830 KM.

These are two different ways of expressing the same exchange rate. They mean that for each KM you trade or spend you would get Euro 52c.

The exchange rate between the US dollar and the Euro on 18 February, 2013 (the date is necessary here because the US$/Euro exchange rate moves and on a different date would be different) could be expressed either as:

US $ 1 = Euro 0.7486 or,Euro 1 = US $ 1.3358.

How are exchange rates set?

There are three main types of exchange rate systems:

A) Free - floating exchange rates;

B) Managed floating exchange rates

C) Fixed exchange rates;

A) Free - floating exchange rates: If a currency is in a free-float, its exchange rate is determined entirely by supply and demand in the foreign exchange market. It will vary frequently, even during a day. Supply and demand arise from trade and tourism and from investment transactions. But they can also be influenced by speculation if a belief develops in the market that the exchange rate is about to move or can be forced to move. Many domestic and foreign factors determine the exchange rate of currency (economic perspectives, political situation, trade balance, inflation, tax and custom duties, difference between domestic and foreign interest rates, etc.), so it is very difficult to take into account all these factors and accurately forecast future exchange rates. A country can also influence its exchange rate by varying the level of its interest rates compared with other countries. For example, in countries where the main target of monetary policy is the domestic inflation rate, if inflation is rising too strongly, they will frequently implement policies that raise domestic interest rates. This should reduce domestic demand, which in turn should reduce inflationary pressures. But it should also have the effect of making investments in financial assets denominated in the country's currency more attractive, thus increasing demand and putting upward pressure on the exchange rate. This lowers the price of imports and therefore also helps to moderate inflation.

B) Managed floating exchange rates: while the exchange rates of many countries in the world, including most major developed countries, are usually described as floating, there are few, if any, countries that don't manage the value of their currency to some degree or at some times. There are two main ways in which acountries authorities, usually the central bank, can try and manage itsexchange rate. One is by direct involvement in the foreign exchange markets as a buyer or seller of foreign exchange. A country's government and central bank will be participants in the foreign exchange markets because of their day-to-day business activities. But they may also choose to intervene in the foreign exchange market for the sole reason of trying to influence the country's exchange rate. Most countries maintain a stock of foreign exchange reserves that could be used for this purpose if necessary.

C) Fixed-exchange rates: a fixed exchange rate system is one where the country's currency is fixed, either by law or by regulation, usually to foreign currency which we call the anchor currency. At one time, the anchor for many countries was a fixed price of gold. But today, the anchor used by most countries with a fixed exchange rate is another country's currency. The main anchor currencies used for this purpose today are the US dollar and the Euro. A fixed exchange rate is not and cannot be fixed against all other currencies: one important thing to understand and remember about any fixed exchange rate system, (including the KM system in BiH) is that it is not possible to fix the value of the exchange rate against all other currencies (because most of the main currencies have free float regime among themselves). It will only be fixed against the chosen anchor currency and the currencies of any other countries that have also fixed their currency to the same anchor.

Exchange-rate regime in BiH

BiH has a fixed exchange rate system and the anchor currency for the KM is the Euro. The fixed exchange rate is set in the Law of the Central Bank of BiH. Article 32 of that Law says "the official exchange rate for the currency of Bosnia and Herzegovina shall be one Convertible Mark for 0.511292 Euro, i.e. one Euro amounts to 1.955830 Convertible Marks". The KM exchange rate against it's anchor currency has not been altered since it was first set by Law in 1997.

The Euro makes a sensible anchor currency for the exchange rate of BiH. It is the currency of 17 countries in Europe, including Austria, Germany, Italy and Slovenia, and some of the other countries in the Balkan region have also tied their exchange rate to the Euro - for example, Montenegro and Kosovo use the Euro as their domestic currency, Bulgaria has tied its currency to the Euro through a currency board arrangementas BiH has, and Croatia operates what they have described as a "psuedo currency board arrangement" and the value of the Kuna has been quite stable against the Euro for a long period. The group of countries that either uses the Euro or have fixed the exchange rate of their own currency to the Euro includes many of the major trading partners of BiH companies and the tourist destinations for BiH citizens. This gives a very important and valuable degree of stability to the KM exchange rate for many transaction BiH citizens will be involved in.

BUT, and it is a very important, not all other currencies that BiH businessmen and citizens use are fixed against the Euro and therefore also fixed against the KM. Important currencies that can and do fluctuate in value against the KM include the US dollar, the Swiss franc, the British Pound and the Serbian dinar, Turkish lira, Hungarian Forint. The following table sets out the value of the KM against these seven currencies over the last four years:

Average exchange rate of KM in selected foreign currencies during the last five years, specified as the amount of KM one would get for the currencies:

Appreciation/Depreciation

Appreciation simply means the value of a currency against another currency gets stronger. For example, in the period 2008 to 2012 the KM has appreciated strongly against the Serbian dinar (39%), Turkish lira (22%) and Hungarian forint (15%). In 2012 one would have got 39% more Serbian dinars for a given amount of KM in 2008. Imports from Serbia will be cheaper in KM, it will cost less in KMs to holiday there etc. But on the other hand, BiH exports will be more expensive and thus less competitive in Serbia and the cost of a skiing holiday in BiH for someone from Serbia will be significantly higher.

Depreciation is simply the opposite movement in the currency's exchange rate value. The value of the currency gets weaker. The KM has depreciated steadily against the Swiss franc over the last four years (for 24%) - and so have many other currencies and US dollar (12%). This means that the risks for a BiH consumer of entering financial contracts specified in these currencies has been very high in recent years. On the other side, BiH exports to Switzerland will have become cheaper in Swiss francs so BiH exporters should be more competitive in that market. But the depreciation would also have made any loans taken out in BiH in Swiss francs much more expensive to repay in KMs.

Borrowing in a foreign currency

Borrowing in a foreign currency, such as the Swiss franc, can often look attractive as the lender will usually charge a much lower interest rate on a Swiss franc loan than on a KM loan. There is a need to think very carefully about why the lender is willing to do that. The aim of the lender is to make a profit on the loan. If they are willing to charge a lower interest rate on a foreign currency loan, it is not because they feel sorry for borrowers or want to help them, it is usually because they expect currency to appreciate in value (ie get stronger) against the KM during the term of the loan so borrower will have to pay them more KMs to service the loan than the bank or other lender lent him. Always remember that it is impossible for borrower - or anyone else - to predict how far the exchange rate might move over the life of the loan. If someone tells claims they know how to predict exchange rate movements or have a model that can do so with accuracy one should be very skeptical. Anyone who could do that with accuracy should be extremely wealthy. If they are not prepared to risk their own financial wealth on the basis of their forecasts or models, one should be very wary about risking your financial wealth on the basis of their advice.

So if person borrows in a foreign currency, it cannot tell what the level of payments will be each period in KM. If persons income is in KM but it's loan payments are in Swiss francs or some other foreign currency it is taking an unquantifiable exchange rate risk. We stress again that if the potential lender or anyone else gives you an estimate of the exchange rate risk it is nothing but a guess - and could be wrong by a substantial amount - an amount large enough for borrower to be unable to service the loan and thus risk losing your house or any other collateral you have pledged to the lender.

We will take a simplified example using the data for the Swiss franc/KM exchange rate in the table above. Assume someone borrowed Swiss francs 80,000 in 2008 and had to make four equal payments of Swiss francs 20,000 in each of the next four years. In 2008, the bank would have converted their Swiss francs into KM 98,500. Their principal payments over the next four years would have been:

In this example, the borrower would have paid around KM 20,000 more than they borrowed to meet the principal payments because the Swiss franc appreciated against the KM during the life of the loan. In the real world of floating exchange rates, the movement can be in either direction and can be much greater than in the example above.

Retail foreign exchange market

In the retail market at banks and foreign exchange offices, which is where most consumers will purchase and sell foreign exchange, there will usually be two exchange rates quoted, a buying rate and a selling rate. The buying rate is the price the bank or dealer will pay you if they are buying foreign exchange from one and giving local currency in payment. The selling rate is the price the bank or dealer will charge one if it wishes to buy foreign exchange from them and to pay in KM. Most commercial banks in BiH regularly display in their branches the buying and selling exchange rates for the 10 or so foreign currencies, such as the Euro, Croatian kuna, Serbian dinar and Swiss franc, that are the most commonly traded foreign currencies in BiH. If person wishes to buy or sell a foreign currency that is not on the bank's display board it will need to ask the bank to give you a quote.

Here is an example of exchange rate list, where clients should clearly understand which exchange rate will be used for their particular transaction.

The same applies to BiH citizens who receive remittances in foreign currency from relatives abroad through banks or institutions for money transfer. The costs imposed on these foreign currency transaction come from both the exchange rate the banks and other use to convert the foreign currency to KM and by explicit fees they charge for the transaction. These costs can also be very high, especially for low-value transactions.

Hedging

One technique that can be used to offset the risk that an exchange rate may move in an unfavorable direction is to ‘'hedge" the position. In simple terms, this means that it is possible to balance the exchange rate risk from signing a foreign currency loan by entering a contract with a bank (or some other financial organization) that has the opposite exchange rate position so that the net foreign exchange position will be balanced. If a client loses money on one of the contracts, he will make it on the other.

This sounds simple. But there are some important qualifications:

Useful links

1. A Beginner's Guide to Exchange Rates and the Foreign Exchange Market. Mike Moffat. economics.about.com/CS/money/1/aa022703a.htm
2. Exchange Rate. Valentino Piana. economicswebinstitute.org/glossary/exchangerate.htm
3. Exchange-rate regime. Wikipedia en.wikipedia.org/wiki/exchange_rate_regime
4. How Exchange Rates Work. Ed Grabianowski. money.howstuffworks.com/exchange-rate1.htm