As it stands today, currency speculation is an important driver of the international economy. It facilitates investment and trade, but can also discourage progressive policies and leave the global economy more prone to risk. But how does it work? In this FX101 post we delve into the what, how, pros and cons of currency speculation.
What is Currency Speculation?
Currency speculation is the act of purchasing and holding foreign currency in the hopes of selling that currency at an appreciated, or higher, rate in future. This is in contrast to those who buy currencies to finance a foreign investment or to pay for an import.
Slightly in contrast to currency speculation, is currency trading. Both, to some extent or another, facilitate international transactions. There is nothing preventing a trader from acting as a speculator or a speculator from acting as a trader. A trader will purchase foreign currency from importers/exporters and charge a transaction fee for doing so, but there is nothing stopping them from holding on to that currency, in the hopes of selling it at an appreciated value in future (and thereby engaging in speculation).
How Does It Work?
Take, for example, a maple syrup producer in Quebec looking to export their product to Europe. Let’s say the European importer is paying the bill in euros. The Canadian exporter would then have to exchange those euros to Canadian dollars, in order to pay their suppliers and workers. But the exporter needs someone to buy those euros. This is where the currency trader or speculator comes in. For a transaction fee, the trader will purchase the euros from the exporter in the currency that they need (in this case, Canadian dollars).
Were they to speculate on that transaction in future, they would wait for a time in which the euro was unusually high compared to the Canadian dollar, or the dollar unusually low when held up against the euro. They might also look at how other currencies are standing up against the euro, and decide to make an investment there. If the market for speculation is not looking so good for the euro, they could simply trade it to another importer looking for euros, and make their money off of the transaction fees. While the potential for making money off of speculation is far greater than the amount they might make off of charging fees doing trading, there is also a much higher degree of risk involved.
Primary & Secondary Markets
An FDI, or Foreign Direct Investment, is another example of a situation in which currency traders, or speculators, are required to facilitate transactions. In this scenario, a company looking to purchase or establish a production facility in another country would need to exchange their domestic currency for the currency of the country they are expanding operations to. FDIs, as well as imports/exports and all other transactions directly related to trade and investment and the exchange of real goods and services, make up what is known as the “primary exchange market”.
The vast majority of currency transactions, however, take place on the secondary market. It is in this market that currency speculation occurs. Former United States Secretary of the Treasury, Robert Rubin, once stated that “the proper operations of secondary markets ensure liquidity in the primary markets.” (source). Put simply, currency speculation is a necessary activity enabling imports, exports and investment. Certainly, many financiers would agree with him. The more speculation and exchange that goes on in the secondary market, the easier it is for investors and traders to purchase and sell foreign currency, as with more speculators there is more currency being used in transactions and less being held in reserves.
A Risky Business: The Ramifications Involved
While currency speculation is an important factor in the smooth operations of international trade and investment, it has also been known to contribute to the disruption of that same trade, leading to the stagnation of economic development and creation of economic crises. The most challenging aspect of speculation is doing just that: speculating. Deciding upon when the right time to buy and sell is. To be successful at it often requires a keen knowledge of economics and finance, as well as an awareness of current political and economic events. But even with such qualifications, what currency speculation boils down to is playing a “guessing game”, and as such there is a great degree of risk involved.
To minimize that risk, speculators adopt strategies they hope will lead to greater accuracy in their guesses. Following the actions of other, most often larger, speculators, is one such strategy. Using forward exchange markets is another; as well, the gathering of information on what makes a healthy economy (unemployment, inflation, and productivity growth, etc.). Unfortunately, this information often comes from biased sources. For example, policies enacted by local governments that reduce the short-term profitability of financial and industrial businesses will be taken as signs to sell a currency, while policies expanding or opening profit opportunities are read as reasons to buy a currency. The end result of all of these strategies is that they can at times embrace self-fulfilling prophecies that condemn nations to financial upheaval and sometimes ruin.
Heavy trading in a specific currency can create artificial demand, leading to an increase in the price of goods beyond inflation-adjusted levels. This phenomenon has the potential to make everyday necessities unaffordable for many people – especially if it takes place in a country where a large segment of the population survive on lower incomes. What can be even more dangerous, however, is when this artificial demand is made transparent and speculators begin to sell their stock of that currency. It is in this scenario where financial ruin can occur, where the collapse of the currency drives many people into poverty overnight.
Solutions to the Problem
While currency speculation is seldom the sole cause of these financial catastrophes, it has has shown itself quite capable of turning relatively minor economic hiccoughs into far greater problems. Examples of this can be found with the financial crises in Mexico in 1994, Southeast Asia in 1997 and Argentina between 1998 and 2002. Fortunately, since that time, steps have been taken to limit the market volatility caused by currency speculation and reign in the amount of foreign currency trading taking place. The consolidation of much of Europe into the eurozone, with a single currency (the euro), is one such example. Reducing the amount of currency speculation by reducing the number of currencies in circulation.
Another, is the Tobin Tax, or Financial Transaction Tax. The concept remains controversial, as it basically entails taxing every foreign exchange transaction. Implementation of such a tax has so far been limited; taking place predominantly on a nation-by-nation basis. Indeed, the European Union is the most significant example of an politico-economic entity pursuing such a policy. The EU FTT has yet to be enacted, but if it proves successful, it could pave the way for similar taxes elsewhere.
Currency speculation is in many ways a necessary evil. International trade and finance would not function half so smoothly if there weren’t traders and speculators to facilitate the easy exchange of currencies. But that same trade and finance can just as well be disrupted, sometimes seriously, by reckless unregulated speculation. Leading to the destruction of livelihoods and the ruin of nations, as has been witnessed in the past. Hopefully the future will bring with it the possibility for currency speculation without the same substantial dangers and risks.
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