exchange rate determinants

8/13/2019 Exchange Rate Determinants

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Foreign Exchange RateDetermination and

Forecasting

Mukul Bhatia


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Foreign Exchange Rate Determination

Exchange rate determination is complex

The three major schools of thought are the

balance of payments approach, internationalparity conditions, and the asset market

approach

The exhibit provides an overview of the manydeterminants of exchange rates


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Foreign Exchange Rate Determinants

In addition to focusing on the asset market approach,

the monetary approach and the technical analysis

are also introduced

These are not competing but rather complementary

theories, so understanding all of them can enhance

our ability to capture the complexity of globalcurrency markets and exchange rates


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The Determinants of Foreign ExchangeRates

I nternational Par ity Conditions1. Relative inflation rates (RPPP)

2. Relative interest rates (international Fisher effect)

3. Forward exchange rates

4. Interest rate parity (IRP)

Balance of Payments

1. Current account balances

2. Portfolio investment

3. Foreign direct investment

4. Official monetary reserves

5. Exchange rate regimes

Asset M arket Approach

1. Relative real interest rates

2. Prospects for economic growth

3. Supply & demand for financial assets

4. Outlook for political stability

5. Speculation & market liquidity

6. Contagion & corporate governance

SpotExchange

Rate

Monetary Approach

Techni cal Analysis

Most determinants of the exchange rate, e.g., the balance of BOP, theinflation rates, the nominal and real interest rates, and the economicprospects, are also in turn affected by changes in the exchange rate

In other words, they are not only linked but mutually determined


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Foreign Exchange Rate Determination

Inaddition to gaining an understanding of

the basic theories or determining factors for

the exchange rate, it is equally important to

gain the following knowledge which could

affect the exchange rate markets:


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1. The complexities of international political economy

Foreign political risks have been much reduced in

recent years because more countries adopted

democratic form of government, so capital markets

became less segmented from each other and more

liquid

2. Societal and economic infrastructures

Infrastructure weakness were the major reasons of the

exchange rate collapses in emerging markets in the late

1990s


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Exchange Rate Determinants

3. Random political, economic, or social events For example, recent occurrences of terrorism may

increase the political risks and affect the exchange rate

market


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Exchange Rate Determination:The Theoretical Thread


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Exchange Rate Determination: The

Theoretical Thread

This section will provide a brief overview of the many

different theories to determine exchange rate and their

relative usefulness in forecasting

The theories discussed in this section include Purchasing power parity approach

Balance of payments (flows) approach

Monetary approach

Asset market approach Technical analysis


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Exchange Rate Determination: The Theoretical

Thread

The theory of Purchasing Power Paritystates that theexchange rate is determined as the relative prices of

goods

PPP is the oldest and most widely followed exchange

rate theory Paul Krugman, Nobel Prize laureate in Economics in

2008, said that Under the skin an international

economist lies a deep-seated belief in some variant

of the PPP theory of the exchange rate


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Most exchange rate determination theories have PPP

elements embedded within their frameworks However, PPP calculations and forecasts are plagued with

structural differences across countries (e.g., different tax

rules or many non-tradable production factors) and

significant challenges of data collecting in estimation


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Exchange Rate Determination: The Theoretical

Thread

The Balance of Payments (Flows) approach argues

that the equilibrium exchange rate is determined

through the demand and supply of currency flowsfrom current and financial account activities


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BoP continued The BoP method is the second most utilized

theoretical approach in exchange ratedetermination Today, this method is largely dismissed by

academics , but practitioners still rely ondifferent variations of the theory fordecision making

This framework is appealing since the BoPtransaction data is readily available andwidely reported


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Exchange Rate Determination:

The Theoretical Thread

The Monetary Approachstates that the supply and demandfor currency stocks, as well as the expected growth rates of

currency stocks, will determine the price level or the

inflation rate and thus explain changes of the exchange rateaccording to PPP


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Monetary Approach contd.

The arguments are all about currency stocks ofresidents

The inference is to link the demand or the supply of

currencies with residents behavior to adjust the stockof currencies


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Main results of the monetary approach are as follows:

Currency supply domestic currency depreciation

1. Currency supply supply of currency > demand of

currencyresidents current currency holding >

residents desired currency holdingresidents spendthe currencyprice level according to PPP,domestic currency depreciates

2. Domestic currency supply growth rate > foreign currency

supply growth ratedomestic currency depreciates vs.foreign currency

E h R D i i


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Interest rate domestic currency depreciation

1. Interest rate opportunity cost for residents tohold the currency increasesdemand of currency

residents current currency holding > residentsdesired currency holdingresidents spend thecurrencyprice level according to PPP,domestic currency depreciates

2. Increase of domestic interest rate > increase of

foreign interest ratedomestic currency depreciatesagainst foreign currency


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Real income domestic currency appreciation

1. Real income (= real GDP = outputs of productsand services )number of transactions demand of currency residents current currency

holding < residents desired currency holdingresidents decrease the spending of the currencyprice level (or because the supply of products andservices , price level and less currency is spent toachieve the same utility)according to PPP, domestic

currency appreciates


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2. Domestic real income growth rate > foreign real income

growth rate (domestic economic growth > foreign economic

growth)domestic currency appreciates against foreign

currency

E h R t D t i ti


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The monetary approach omits a number of factors:

The failure of PPP to hold in the short to medium term

The change of the interest rate and the real income

will affect the economic activities and thus affect thecurrency supply

In the above inference, however, the change of the

interest rate and the real income affect only the

currency demand


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Factors omitted by monetary approach

Currency demand appearing to be relatively unstable overtime

There are many factors other than the interest rate and

the real income to affect the money demand, e.g., the

economic boom or recession, so the money demand is

difficult to be predicted

E h R t D t i ti


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The Asset Market Approach argues that the exchange rate

should be determined by expectations about the future of

an economy, not current trade flows


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E h R t D t i ti


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More specifically, if the demand for domesticfinancial assets increases, the demand for the

domestic currency will increase, which could

results in the appreciation of the domestic

currency

Changes in monetary and fiscal policy alter

expected returns and perceived relative risks of

financial assets, which in turn alter the demandand supply of financial assets and thus exchange

rates (In the 1980s, many macroeconomic

theories focused on this topic)

Exchange Rate Determination


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Technical analysisis based on the belief that the

study of past price behaviors provides insights into

future price movements


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Technical Analysis contd.

Due to the poor forecasting performance of many

fundamental theories, the technical analysis draws more

attention and becomes popular

The primary assumption of the technical analysis is that

the movements of any market driven price (e.g., exchange

rates) must follow trends

More specifically, technical analysts, traditionally referred

to as chartists, focus on price and volume data to identifytrends that are expected to continue into the future and

next exploit trends to make profit


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The Asset Market Approachto Forecasting


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The Asset Market Approach

to Forecasting

The asset market approach assumes that the motives offoreigners to hold claims in one currency depends on anextensive set of investment considerations or drivers:

1. Relative real interest rates (an important concern for

investing in foreign bonds and money marketinstruments)

2. Prospects for economic growth (the major reason for

cross-border equity investment and foreign direct

investment)


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Asset Market Approach contd.

3. Capital market liquidity (Cross-border investors are not

only interested in investing assets to earn higher returns,

but also in being able to sell assets quickly for fair market

value)

4. A countrys economic and social infrastructure (which is

an indicator of that countrys ability to survive in

unexpected external stocks)


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to Forecasting

Asset Mkt Approach contd.

5. Political safety (which is usually reflected in political riskpremiums for a countrys securities)

6. Corporate governance practices (poor corporate

governance practices can reduce the investing will offoreign investors)


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Asset Mkt approach contd

7. Contagion(which is the spread of a crisis in one country to its

neighboring countries, and can cause an innocent country to

experience capital flight and a resulting depreciation of itscurrency)

8. Speculation(can cause a foreign exchange crisis or make an

existing crisis worse)

In summary, the asset market approach believes that the abovefactors affect the motives of investments from both domestic

and foreign investors and thus affect the exchange rate


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to Forecasting

Foreign investors are willing to hold securities and

undertake foreign direct or portofolio investment in

highly developed countries based primarily onrelative real interest ratesand the outlook for

economic growth and profitability


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to Forecasting

For 1990-2000, the US$ strengthened despite

continued worsening balances on current account

The US$ remained to be strong due to foreign

capital inflow motivated by rising stock and realestate prices, a low rate of inflation, high real

interest rates, and an irrational expectation about

future economic prospects

Actually, from 1995 to 2001, the Nasdaq indexincreased by a factor of more than 6


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Asset Market Approach contd.

After the terrorists attacked the U.S. on September 11,

2001

A negative reassessment of long-term prospects due to

the newly formed political risk in the U.S.

The drop of the stock markets and a series of failures in

corporate governance of large corporations further led

to a large withdrawal of foreign capital from the U.S.

According to both the BOP approach and the asset

market approach, the US$ depreciated since then


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Illustrative Cases in

Emerging Markets


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Disequilibrium: Exchange Rates

in Emerging Markets

The asset market approach is also applicable to

emerging markets, however, not only the relative real

interest rates and the prospects for economic growthbut also additional factors contribute to exchange

rate determination

The Asian and Argentine crises are examined as illustrative

cases in this section


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Illustrative Case:

The Asian Crisis of 1997

The roots of the Asian currency crisis extended from afundamental change in the economics of the region:the transition of many Asian nations from being netexporters to net importersdue to the following tworeasons

Rapid economic expansion Many Asian countries pegged its currency at a fixed exchange

rate with the US$, so their currencies appreciated with theUS$ being strong after 1995

The deficit of BoP generates the depreciation pressure

To support their pegged exchange rates, Asian nations requireto attract net capital inflow The most visible roots of the crisis were the excess capital

inflows into Thailand in 1996 and early 1997


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Illustrative Case:

The Asian Crisis of 1997

Thai banks continued to raise capital internationally,and extended credit to a variety of domesticinvestments and enterprises beyond what the Thai

economy could support As the investment bubble expanded, market

participants questioned the ability of the economy torepay the rising amount of debt, so the Thai baht was

attacked by international speculation


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Asian Crisis contd.

The Thai government intervened directly(using up precious currency reserves) andindirectly by raising interest rates in support of

the currency (to stop the continual outflow) On July 2, 1997, the Thai central bank allowed

the baht to float, and the Thai baht againstUS$ fell 17% in several hours and 38% in 4months


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Illustrative Case:

The Asian Crisis in 1997

The international speculators attacked a number

of neighboring Asian nations, some with and some

without characteristics similar to Thailand

It is the Asias own version of the tequila effect

Tequila effect is the term used to describe how the

Mexican peso crisis of December 1994 quickly spread to

other Latin American currency and equity markets

The spread of the financial panic is termed contagion

The Philippine peso, the Malaysian ringgit, andIndonesian rupiah all fell in the months following

the July baht devaluation


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Illustrative Case:

The Asian Crisis of 1997 The Asian economic crisis (which was much more than

just a currency collapse) had other reasons besidestraditional balance of payments difficulties: Corporate socialism

In Asia, because the influence of governments, evenin the event of failure, it was believed thatgovernments would not allow firms to fail, banks toclose, and workers to lose their jobs

This kind of policy provided the stability of the

economy, but when business liabilities exceeded thecapacities of governments to bail businesses out,the crisis happened


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Asian Crisis contd.

Overinvestment in Asian countries

Due to the low interest rate in both Japan and the U.S.,too much capital for portfolio investments flowed into

Asian countries, which supports the bubble in Asiancountries

Banking liquidity and management

The lack of transparency and monitoring mechanismsencouraged banks to underestimate the credit risk of

firms and expand the lending business too much


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Illustrative Case:

The Asian Crisis of 1997 Banks did not hedge exchange rate risk while raising

international capital, so when the domestic currency

depreciated in the financial crisis, they sufferedfurther loss

During the financial crisis, banks themselves sufferthe liquidity problem, so banks cannot provide

liquidity to firms for conducing their businesses

Political risk

Investors did not have confidence in the political

stability of southeast Asian countries. So, if there isany sign for political problems, the capital out

flowed from those countries immediately


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Asian Crisis contd.

After the crisis, the slowed economies of this

region quickly caused major reductions in

world demands for many commodities and

thus the decline of the commodity prices, e.g.,oil, metal, agricultural products, etc., which is

part of the reasons for the Russian crisis in

1998

ll


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Illustrative Case:

The Argentine Crisis of 2002

In order to eliminate the hyperinflation problem that

had underminedthe nations standard of living inthe 1980s, a currency board structure was

implemented in Argentina in the early 1990s


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Argentine Crisis contd.

In 1991, the Argentine peso had been fixed to the US

dollar at a one-to-one rate of exchange

The reason why the currency board regime can control

the inflation problem:

Limit the growth rate in the countrys currency supply to the

rate at which the country receives net inflows of U.S. dollars as a

result of trade growth and general surplus

This rigorous restriction eliminates the power of politicians to

affect the currency policy in both good and bad ways, e.g., thegovernment lost the ability to utilize the monetary policy to

stimulate the economy

Ill i C


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Illustrative Case:


Although the hyperinflation was cured by the restrictive monetarypolicy, this policy also slowed economic growth in the coming years

The real GDP shrank in 1999 (-3.5%) and 2000 (-0.4%), and theunemployment rate rose to about 15% since 1995


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In order to demonstrate the governments unwaveringcommitment to maintaining the pesos value parity withthe dollar, the Argentine government allowed banks toaccept deposits in either pesos and dollars

However, there was substantial doubt in the market thatthe Argentine government was able to maintain the fixedexchange rate

Ill t ti C


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Illustrative Case:


By 2001, after three years of recession, three

important problems with the Argentine economy

became apparent:

The Argentine peso was overvalued

The inability of the pesos value to change with the market forces

(e.g., economic growth, competitive power of firms, and so on)

led many to believe increasingly that it was overvalued

Argentine exports became some of the most expensive in all of

south America, as other countries depreciated their currenciesagainst the US$ over the decade, but not the Argentine peso

Therefore, the deficit of the current account deteriorated from

$0.65 billion (in 1991) to $8.9 billion (in 2000)

Ill t ti C


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Illustrative Case:

The Argentine Crisis of 2002 The currency board regime had eliminated monetary policy

alternatives for macroeconomic policy

The rule of the currency board regime eliminated

monetary policy as an avenue for macroeconomic

policy formulation, leaving only fiscal policies (e.g.,government spending and tax policy) for economic

stimulation

In fact, due to the continuous deficit of the BOP,

Argentina could only adopt the contraction monetary

policy from 1991 to 2000


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The Argentine government budget deficit, i.e., spending, was

out of control

As the unemployment rate grew higher, as poverty and

social unrest grew, government spending continued to

increase to solve these social and economic problems Without the proportional increase of tax receipts,

Argentine government then turned to raise

international debts to aid in the financing of its

spending (the total foreign debt had double from 1991to 2000)

Ill t ti C


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Illustrative Case:


As economic conditions continued to deteriorate,depositors, fearing that the peso would be devalued,

withdrew their peso cash balances and then

converted pesos to US$, which speeded up the

currency collapse

The government, fearing that the increasing financial

drain on banks would cause their collapse, close the

banks on December 1, 2001 to stop the flight of

capital out of Argentina


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During the political chaos in the beginning of

2002, Argentina declared the largest sovereign

debt default in history that it would not be

able to make interest payments due on $155billion in sovereign (government) debt

Ill t ti C


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Illustrative Case:


On January 6, 2002, the Argentine government

decided that the peso was devalued from Ps1.00/$ to

Ps1.40/$ as a result of enormous social pressures

resulting from deteriorating economic conditions and

substantial runs on banks

However, the economic pain continued and the

banking system remained insolvent


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The provincial governments began printing

their all money, promissory notes

Because the notes were issued by the

provincial governments, not the federalgovernment, people and business would not

accept notes form other provinces

Illustrative Case


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Illustrative Case:


The population became trapped within its own

province, because their money was not accepted in the

outside world in exchange for goods, services, travel,

or anything else

On February 3, 2002, the Argentine government

announced that the peso would be floated and the

banks would reopen


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In February and March 2002, negotiations

between the IMF and Argentina continued as

the IMF demanded increasing fiscal reform

over the growing government budget deficitsand bank mismanagement

Argentinas experience has proved that it is

not easy to adopt the currency board systemof a firmly fixed exchange rate for an economy


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Thank You

Mukul Bhatia

exchange rate determinants

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