Currency Speculation The world financial markets are in turmoil once again, as they are every few years. This time it is Argentia, Turkey, and South Africa. The currencies of all three countries are rapidly declining in value. What is the economics behind declining currency values? The following points describe the underlying logic. 1. Everyone understands that one should always buy what one believes will appreciate in value and sell what one believes will depreciate in value. You can then sell the appreciated item for more than you paid for it, and you can buy back the depreciated item for less than you sold it for. Currency markets operate just like flea-markets, only on a grander and potentially vastly more devastating scale. 2. Currency speculators are businesses. That is, they take risks. If their beliefs are correct, they make money. If their beliefs turn out to be wrong, they lose money. George Soros is an examle of both: sometimes he made billions in the foreign currency markets, sometimes he lost billions. But on balance he made more than he lost. Therefore, he is a successful businessman. 3. Suppose that the current exchange rate for the South African "Rand" (the name of its currency) is R5 per $1 and the free market begins to push this rate toward R6/$1 (more Rand for the same dollar means that the Rand depreciates and the dollar appreciates in value). For various reasons (good and bad, but mostly bad), the South African government wishes to "defend" the Rand. The government must therefore enter the market and buy Rand by offering dollars from its dollar reserves (earned for instance through tourism receipts and exports of South African goods). More demand for Rand or, equivalently, more supply of dollars, will affect the exchange rate between the two. More demand makes an item more expensive, more supply makes it cheaper. Thus, the rate will go back from R6/$1 to R5/$1. 4. The price of this intervention in the foreign currency markets is that South Africa depletes its reserves of dollars. The more it depletes its reserves, the more a speculator knows that the currency defense becomes untenable. Untenable means that the Rand eventually will have to depreciate with catastrophic rapidity. (As has just happened in Argentina.) As a speculator I will therefore sell Rand and buy dollars, wait until the collapse occurrs, and then sell my dollars to buy back cheap Rand. I will make a hefty profit. 5. But do not blame the speculator. Speculators are not conspirators. They do not sit in smoke-filled backrooms and decide to "do a currency in." After all, there are thousands of them spread across the world, from New York to Hong Kong to Zurich and London. They are businesses observing markets and government actions, and they take risks on behalf on my 401(k) retirement plan, to put it personally. They had better do well, or else I will fire them (i.e., move my money to another manager). Indeed, they have a fiduciary obligation to managing my money well. 6. Who is to blame, if not the currency speculators? How about the government that does not see the writing on the wall and unwisely "defends" its currency until it runs out of dollar reserves to do the defending? But this answer masks a deeper question: why is there depreciating pressure on the currency in the first place? The answer to that question is that if investors in South Africa feel uncertain about the country's future economic prospects, they will begin to pull money out. But the money is in Rand! Thus, industrial assets are sold in Rand, and the Rand are then supplied to the currency markets to buy dollars. Thus, the Rand depreciates and the dollar appreciates. 7. Ok. Why, then, are investors uncertain about South Africa's economic future? Politics, again! With anywhere between 20 to 40 percent unemployment, atrocious social conditions, an unraveling political environment, and a dictatorial neighbor (Zimbabwe), there are better, safer, more secure places to put one's money. Hence, it gets pulled out of South Africa, and its currency begins to plummet in value. Dr. J. Brauer is Professor of Economics at Augusta State University's College of Business Administration. He can best be reached via his web site (http://www.aug.edu/~sbajmb).