Why Exchange Rate Fluctuations Matter – Especially Now

4 reasons why the exchange rates of industrialized countries have been relatively stable during the corona pandemic  

In severe economic crises, experience shows that in addition to considerable fluctuations in the stock and raw material markets, there have been severe fluctuations in the currency markets. The exchange rate changes in the currencies of advanced economies are still relatively moderate – compared to the financial and economic crisis 2008/09. Why?

Strong exchange rate fluctuations after the Lehman bankruptcy

During the financial and economic crisis of 2008/09, exchange rate fluctuations were considerable. For example, after the Lehman bankruptcy, the Euro’s value against the U.S. dollar dropped from $1.47 per Euro on September 25, 2008, to $1.25 per Euro on October 27, 2008, a 15 percent devaluation of the Euro in one month. By December 18, the exchange rate had risen to $1.46.

However, during the Corona Pandemic, the euro devaluation against the dollar between March 9th and 20th was only 6.5 percent. The Euro subsequently appreciated. However, it took almost six months (from March 20, 2020, to September 1, 2020) to gain around 12 percent in value.

The exchange rate development between the Euro and the Japanese yen or British pound sterling shows a similar trend: For both, exchange rate fluctuations during the Corona pandemic were much smaller than after the Lehman bankruptcy.

Why does an economic crisis cause exchange rate fluctuations?

A rapid economic slump causes a high degree of uncertainty among all economic actors. For investors who invest their capital worldwide, this uncertainty leads to them to invest their money in “safe havens“. Capital is mainly withdrawn from emerging and developing countries and invested in countries that are considered relatively low-risk. In addition to Switzerland and Japan, the USA is one of these safe-havens. These capital reallocations lead to changes in exchange rates.

Even at the start of the 2008/09 financial and economic crisis, which originated in the U.S., the American economy was considered a safe investment haven. This resulted in a high demand for U.S. dollars, which led to an appreciation of the dollar. In Japan, for example, many companies and private investors withdrew their investments abroad and brought them back into their own country. The result was a revaluation of the Japanese yen.

After the Lehman bankruptcy, the British currency suffered from a decline in the international stock markets’ value. This put their entire financial industry under pressure. Since the financial sector plays a much larger role in the British economy than in other European countries or even the U.S., this uncertainty for economic development in the United Kingdom led to a devaluation of the British pound.

In addition, the Bank of England cut interest rates sharply. In September 2008, the British key interest rate was still at five percent. By the beginning of March 2009, it had fallen to just 0.5 percent. This drop in interest rates was much greater than in the U.S. or the eurozone – not to mention Japan.

If interest rates fall sharply in one country, it is less attractive for international investors to invest their capital there. Instead, capital is withdrawn from low-interest-rate countries and invested in countries with higher interest rates. An interest-related capital withdrawal from the United Kingdom thus led to a devaluation of the British pound.

Why are the exchange rate fluctuations in the Corona pandemic relatively small?

In my opinion, there are four major reasons for the comparatively, relatively stable exchange rate development of the currencies of industrialized economies – i.e., the U.S. dollar, Euro, yen, pound sterling, and the Swiss franc ( not discussed here) – during the Corona pandemic:

1. 1. Interest rate differentials currently play hardly any role as the participating central banks’ interest rates are all close to zero.
2. 2. The economic slump predicted for 2020 was historically large for all industrialized nations in the spring and summer of 2020 and was also associated with a high degree of uncertainty. Hence, there were hardly any real economic reasons for capital withdrawal or shift of capital between these countries.
3. 3. Shortly after the outbreak of the corona pandemic in Europe and the USA, the central banks committed themselves to buying securities on stock exchanges in enormous quantities to stabilize the credit and financial markets. On March 18, 2020, the European Central Bank announced its “Pandemic Emergency Purchase Program,” which provided for securities purchases worth up to 750 billion euros. At the beginning of June 2020, the volume was expanded to 1,350 billion euros. On March 12, 2020, the U.S. Federal Reserve announced that it would buy bonds worth up to $700 billion if necessary as part of its open market policy. Many other central banks also chose these instruments, which led to a rapid recovery on the stock markets. As a result, there were not many incentives to exchange investments between industrialized countries’ stock exchanges, which would require corresponding foreign exchange purchases.
4. 4. The flight of investors to safe havens, however, was also an important motive in the Corona pandemic. A considerable amount of capital was withdrawn from developing and emerging countries.

How strong the fluctuations are for emerging markets and why this is a problem will be explained in my next post.