Exchange Rates and Debt Bondage

The increasingly sordid LIBOR scandal has pulled back the curtain shielding the international financial system, revealing decaying regulatory bodies and rampant corruption. People around the world are indignant that a key financial benchmark could be distorted with such ease and that this tampering could go unnoticed for so long. This should be a wakeup call around the globe to take stock of other financial tools that are also vulnerable to manipulation and under-regulated.

Argentina's Peso devaluation in 2001 reflected another case of investor speculation. Photo by Alex Proimos / Flickr.

Argentina’s Peso devaluation in 2001 reflected another case of investor speculation. Photo by Alex Proimos / Flickr.

The means by which exchange rates are determined is one such example. Often, exchange rates changes are discussed as if they are part of a quasi-mystical realm that is completely disconnected from the real world. But currencies don’t rise and fall in accordance with some divine will. They’re set by investors and speculators in financial capitals around the world. Basic international monetary economic text books explain that the exchange rate between two countries is determined by the interest rates in each country and the expected future exchange rate between the countries. The formula is: E= Expected future exchange rate [(1+interest rate of the foreign country)/(1+interest rate of the home country)].

The term “expected future exchange rate” is nothing more than a way of making what investors in London, New York, and Tokyo think might happen seem legitimate. When developing countries announce any major policy shifts, new expenditures, or forecasts for their export-driven crops, investors around the globe take note. They change their expectations about the future exchange rate, which in turn shapes the current exchange rate.

The recent debacle demonstrates that financial actors neither impartial nor ethical. The LIBOR scandal should raise concerns about the validity of any financial indicator or benchmark that hinges on the whims of financiers.

The volatility of exchange rates wouldn’t be nearly as damning were developing nations able to borrow in their own currency. Investors and financial institutions that loan money to developing countries prefer to be repaid in stable currencies such as U.S. dollars, yen, or euros. Investors contend that the currencies of developing nations are risky because of the likelihood that they will depreciate.

This laughably ignores the role that the investors themselves play in that depreciation. Though countries have the option of pegging their currency to another country’s to maintain a consistent exchange rate, such as Argentina did in the 1990s, international investors can speculate against the peg and break it. This can contribute to a currency’s sharp devaluation, such as the one Argentina suffered in 2001.

Many poor countries owing dollar-denominated debts that must be serviced with revenue raised in part in their own depreciating currencies are thus forced to make payments on increasingly expensive, and often untenable, loans.

This constant threat of devaluation, in addition to mounting debt, has shackled developing countries for decades. Impoverished, debt-ridden countries have modeled their policies in accordance with the whims of financial institutions to no avail. The events surrounding the LIBOR debacle shouldn’t be considered an anomaly within the financial world. It’s simply a new, and rather reliable, red flag signaling the urgent need to repair our corrupt and broken financial system.

Bankers, investors, and financiers wield too much leverage over key financial indicators and benchmarks and regulatory systems are too anemic. The LIBOR scandal isn’t an anomaly in an otherwise efficient system. It’s a natural outgrowth of an untethered and corrupt sector. Deep reforms that protect against the financial industry’s abuses are long overdue.

Hilary Matfess is an Institute for Policy Studies intern and a Johns Hopkins University student.