Forex Swings Hit Commodity Values

We have seen that over the past few weeks, a number of central banks are stepping in, with a view to smoothing foreign-exchange volatility. Prices of internationally traded commodities are notoriously volatile due to market fundamentals and exchange rate movements. Commodities today are a diverse group of international markets that operate quite separately from each other. 

The value of commodities is dependent upon the currency they are exchanged for and when that currency is weak the commodity will appear to be very expensive and sometimes mistakenly very valuable. The effects of Currency Agreements as well as the Trade Agreements on the participating economies are important. Both types of agreement have multiplied in recent years. Many countries have fundamentally changed the way their currencies relate to the currencies of other countries either by adopting a common currency (Euro for EU) or through Bilateral Currency Swap Agreements where the trade settlements are done in their own currencies rather than in US dollars and finally by way of Multilateral Clearing and Payment Agreement (CPA).

While trade agreements and currency unions are often justified on the basis of the presumed effect on trade volumes, the reverse is also true. Currency agreements which lead to trade cannot be avoided. Erstwhile USSR and India used to conduct bilateral trade using an instrument called a “Rupee Rouble Escrow Account”. Boris Yeltsin unilaterally abrogated 1978 protocol without any legal or compensatory financial recourse.

China has signed Bilateral Currency Swap Agreements with Brazil, Korea, Hong Kong, Malaysia, Belarus, Indonesia, New Zealand, Kazakhstan, Uzbekistan, Argentina, Iceland, Russia, Indonesia and Singapore amounting to more than US $ 95 Billion. All these countries are important trading partners of China. In addition to border trade, ordinary trade can also be settled in both countries' official currencies. Chinese authorities are taking measured steps to internationalize the usage of the RMB (Renminbi) through a bilateral currency agreement. China which now holds large US assets is trying to diversify assets away from the US dollar.

China as per certain estimate undervalues its currency to almost 35%. China does not allow its currency, to float freely on exchange markets. This along with other subsidies and mercantilist trade policies keeps Chinese exports cheap and thus more attractive to consuming countries. Trade between India and China amount to around US$60 billion with an annual growth rate of 40%. The two countries in 2009 signed a bilateral currency swap agreement, but it has not yet been officially launched. There are also reports that some of the entities who are importing from China, are trying to tweak the existing commercial regime so they can borrow in the RMB to pay off the suppliers.

Chinese prefers to do things step by step. All the bilateral agreement should be seen as China's transitional move to make its currency RMB fully convertible and to challenge the US dollar. Eventually, wider use of the RMB outside China could redefine the balance of power as the rest of the world begins settling its bills with China in RMB instead of the US dollar.

Given the importance of China in the world commodity market, the ramifications can be significant.

Published in The Economic Times