Note: I am not a currency or arbitrage expert. I have studied this subject only briefly, and I think I understand how it works. I welcome comments and corrections from more knowledgeable readers.
Arbitrage, and its practitioners…arbitrageurs…have always intrigued me. Those shadowy figures lurk out there on the fringes of the international financial system, taking advantage of small differences in currency exchange rates, security prices, etc. to create profits from nothing, totally risk-free.
How does it work, and why is it legal? Even if it is legal, is it ethical? Not that the practitioners would even care. The short answer is yes, it is legal. I won’t address the ethical question. Ethics, like beauty, is often in the eye of the beholder.
There are many definitions of arbitrage, but I am interested in one particular form, known as risk-free currency arbitrage. Here’s a definition:
The simultaneous buying and selling of a currency at two different prices in two different markets, with the aim of creating profits without risk.
Here’s a hypothetical example, with greatly exaggerated price differences.
The Chinese maintain a fixed exchange rate between their currency, the Yuan, and the dollar. Let’s say the current rate is 1 Yuan = $1
The Euro has appreciated against the dollar so that 1 Euro = $1.50
But Europeans have pressured the Chinese to allow the Yuan to appreciate vs. the Euro, so that the Euro and the Yuan are now equal…1 Yuan = 1 Euro.
This would be an arbitrageur’s dream! He/she would use dollars to buy Yuan, sell the Yuan to the Europeans in exchange for Euros and then buy dollars with the Euros.
Let’s use some simple numbers to illustrate this.
1. Buy 100 Yuan for $100
2. Buy 100 Euros with the 100 Yuan
3. Buy $150 with the 100 Euros
Now, do it again, using your $150 to buy Yuan…and again…and again…and you will soon be unbelievably rich, and you have risked nothing! After 16 times, your hundred bucks is $65,684. Knowing that, you would have been foolish to start with a mere hundred bucks. Why not a thousand, or better yet, borrow a million. After those same sixteen transactions, the borrowed million would swell to over 656 million dollars! Paying back the borrowed million would be a real pleasure!
Of course, in the real world, no such huge differences in currency exchange rates or other securities exist. Arbitrageurs work on fractions of a percent, but they deal with really large amounts of money, so the profits can still be significant.
Now here comes the reason for this little exercise. The Chinese tied the Yuan to the Dollar with a fixed exchange rate of 8.28 Yuan = $1 until July of 2005. At that time, the Chinese government announced that the Yuan would be pegged to a “basket” of currencies, including the dollar. Since then, the Yuan has appreciated approximately 18% against the dollar, and is currently trading at 6.8 Yuan per dollar. Most of this appreciation occurred in the period from July 2007 to July 2008. China was buying massive amounts of US Treasury bonds at that time to finance our ballooning trade deficit with them, and any bonds purchased prior to July 2007 have depreciated about 18% since they were purchased. Obviously, China does not want the Yuan to appreciate further vs. the dollar but they are getting massive pressure from all their trading partners, who view the Yuan as undervalued, giving Chinese exporters an unfair advantage in world trade.
The Chinese are stuck between a rock and a hard place. They can’t allow the Yuan to appreciate against the dollar without eroding the value of their huge cache of US Treasury bonds, but they can’t limit the “float” of the dollar vs. the Yuan, while allowing the Yuan to appreciate vs. other currencies without creating an arbitrage chaos. Meanwhile, many trading countries are threatening to erect tariff barriers, in retaliation for what they see as manipulation of the Yuan to gain trading advantage.
All of this works to the advantage of the US. Eventually, the Chinese are going to have to let the Yuan appreciate vs. the dollar and other currencies, making Chinese exports more expensive, and US exports more competitive. Meanwhile, as the dollar falls in value, inflation will work its magic to depreciate that huge pile of treasury bonds held by the Chinese. Inflation always works to the advantage of the debtor.
I like this little quote by John Maynard Keynes:
“If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy.”
Right now, with our economy in the toilet, economists are screaming about the danger of a “deflationary spiral,” but once we weather this storm, and it may take a few years, look out! Massive inflation is coming. It’s the only way our government is going to be able to handle the massive debt they are acquiring to prevent that deflationary apocalypse. They won’t say it now, but I think inflation is the long term plan. Lots of it.
If you have investments, you had better be thinking about this. As an investment advisor that I read regularly wrote the other day:
“Which is it? Inflation or Deflation? As an investor, getting it wrong will be devastating to your portfolio!”
My guess, which is probably as good as anybody else’s, is that we may have some mild deflation in the next few years until we climb out of the current mess, but in the long run, it’s going to be inflation on a scale we have never seen before, and it won’t be limited to the dollar. Lots of other countries have debt problems at least as large as ours in proportion to their GDP. China might not, but they are going to have so many economic problems that I wouldn’t look for them to be a safe haven for your money either.
It looks like the Chinese will be as subject to their curse as the rest of us: We are all headed for some “interesting” times.
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Comments: 28
As for the bankers, arbitrage is a very small part of the international market. The Bankers are sitting pretty as Westminster and The White House let them borrow money at 0.5% interest with they then lend back to government at 3.5% or 4%.
So if people are looking for a good investment how about a wheelbarrow to take home your wages.
Currency was only eer meant to be a system of tokens for the exchange of goods. Early tokens included cowrie shells, teeth, salt and even more bizarre coinages. We have lost sight of money's true purpose and so have no idea of the real worth of things, only of how much someone is willing to pay for them.
And how do we convert things of real woth, the skill in a craftsman's hand, the wisdom of years' experience, the caring nature of a nurse and such into a system of monetary values?
The system has failed and there is no replacement in sight.
That having been embedded in our consciousness for thouands of years it is difficult to see what could replace money without itself quickly becoming money.
Preferably one that has a fixed quantity available, or one that can only grow with economic growth. The present system is crazy. The richest nation is the one that has the best printing press.
I was reading about the incarceration percentages per population. China was .16% of its population and the US was .76%. Both below 1%. When one considers polical/religious detention in China the gap is even more remarkable. I am still wondering why the big difference.
Part of the reason is the War on Drugs, which has put a lot of small time drug users in jail. That is totally stupid in my opinion. Drug use is a victimless crime. Those people should not be in jail. They should be in a drug recovery program.
Drug use is NOT a crime, any more than alcohol or tobacco use is a crime.
They are all public health issues.
If we decriminalized drug use, our prison population would be much smaller, and we would save a pile of money...some of which should be used to educate young people about the dangers of substance abuse.
I certainly agree that drug use itself is victimless, but often the way users pay for their drugs is by theft, which is not victimless. How to reconcile those facts?
There will always be crime. But I think we could get rid of a big part of the prison population.
Bt I think if we removed the drug users from the prison population the numbers would still be high. Which makes me think we are either a very violent culture or one lacking much integrity.
So where are the big protests about government paying to keep all these nonviolent people incarcerated at great public expense? No, we can't allow government to break the bank over making healthcare available to the sick, cause all our public funding has got to go to war and imprisonment.
It has been their plan and agenda since Roosevelt turned the tables on them with the New Deal, and they have been working to overturn his work ever since. Unfortunately, they have succeeded, and, much as I hate to admit it, Democrats have often been their co-conspirators.
Yes, there is a difference. If it's legal, there is no penalty at all. Decrimininization treats it like a traffic ticket. You could be fined, but it doesn't create a criminal record.
an issue I have always found a total mystery and shed some
light on it. Hope you continue to study it, because, I am sure
the topic is only baffling to people like me who are convinced
it is rocket science.
Two things, only to add: George Soros (his company) is maybe
the most famous currency trader in the world. Mr. Soros not
long ago became disillusioned with globalization, which he
said he once believed in. Second, those who adulate Ronald
Reagan credit him with taking down the Soviet Union, thereby,
ushering in a golden age of globalization.
Another thing: isn't money meant to serve a nation
by providing an exchange medium sufficient to enable
transactions; not too much around, and not too little?
Isn't that what the kings tried to do going back to
the Middle Ages?
One last thing: Charlie Munger, who is really the
less vocal half of Warren Buffet's Berkeshire Hathaway,
but very astute and reasoned, advises that we buy
very good companies. Couldn't this line of reasoning
carry over to justify the prediction that very well managed
countries are going to have safe and sound money systems?
Three that have been mentioned over and over are Canada,
Brazil, and Germany...three very different countries, and
noticeably absent from most lists is our own...that's not so
good, is it?
I have long been a skeptic about globalization. The idea of all nations allowing their domestic industries to compete head-on with the "furriners" has never seemed very realistic to me. There will always be pressure to give the local folks a bit of a leg up, so it will be a cheaters' game. Example: We give huge subsidies to huge agribusiness corporations, so they can sell their products at prices below even those of African subsistence farmers. Korea does the same for their steel producers, and I am sure there are many other examples. I think we are going to have to go back to the ancient tried-and-true method of negotiating trade agreements with each or our trading partners. Free trade doesn't work, except for the big corporations who can pay off politicians and get a sweet deal.
I don't think the American people, or the people of most other nations are well served by it. Reagan, and most Republicans, LOVE free trade, because it destroys organized labor, their great nemesis.
On the question of money, we are currently printing it like mad...hey, it's easier than borrowing it! But eventually, all that extra money is going to cause inflation, and even devalutation of the dollar. That has to affect the standard of living of every American.
Well managed countries...yeah, that makes sense, except that if the world economy goes in the toilet, they won't emerge unscathed unless they don't need to trade with the rest of us who are bankrupt. The question is...where IS the safe haven?
I haven't a clue. I'm not sure there is one.
too, Bert. In Washington, that was done by the
Board on Trades and Tariffs (I think) for a long
time. Somewhere along the line, Washington lost
its way, because pleas for (somewhat) balanced
trade have been falling on deaf ears for at least
30 years.
I hope you stay with the currency studies. Recent
publicity has the world "fleeing" from the dollar.
Again, the negative spin is in vogue. Still, a
statement like that will get your attention.
Also language seems to have a binding effect on our trade decisions.
beyond stopping foreign freighters from cherry
picking off a few runs to Alaska since they were
already here, to include a stipulation that runs
to Alaska had to be made by US manufactured,
US staffed, ships. It wound up putting a
stranglehold on commerce. Still, there is
some merit to sticking up for the American.
I mean, really, why don't we just bring in
some smart Japanese to staff our House,
Senate, Presidency, and Supreme Court.
They's do a better job and don't eat nearly
as much as what we have in there now.
Money Daily Brief: Dollar rises broadly
By Tom A. Peter | 09.21.09
Dollar rebounds: After a tough month, the dollar rose against a number of currencies, reaching a one-week high against the yen. Some analysts expect the Federal Reserve to signal that the US economy is improving after its meeting this week, preparing the way for an unwinding of some stimulus measures that had caused the dollar to fall.
Inflation fighter: India’s central bank will allow the rupee to strengthen to a seven-month high of 47.3 per US dollar by the end of this year. Economists say controlling inflation is critical in a country where 75 percent of the people survive on less than $2 a day.
URL source:
http://features.csmonitor.com/economyrebuild/2009/09/21/money-daily-brief-dollar-rises-broadly/
natural enemy of investors.
“The present era has no comparable referent in the past history of capitalism. We have a higher percentage of the intelligentsia engaged in buying and selling pieces of paper and promoting trading activity than in any past era. A lot of what I see now reminds me of Sodom and Gomorrah. You get activity feeding on itself, envy and imitation. It has happened in the past that there came bad consequences.”