A Framework for Foreign Exchange Valuations

1. A Framework for Foreign Exchange Valuations Dr Robert S Gay Fenwick Advisers February 18, 2013

2. FX Fundamentals Over horizons that might span as long as a decade, a few fundamentals tend to dominate a currency’s value regardless of the noise embodied in short-term volatility and distortions that might persist for years. • Relative inflation rates (concept of purchasing power parity) • Current account position, which reflects a country’s competitive advantages or natural endowments, especially if a country has persistent surpluses or deficits. • Net foreign assets or liabilities as well as both their quality and quantity • Net foreign liabilities of the banking sector tend to pose systemic risks to domestic banking industry • Net foreign assets of companies and households tend to represent accumulated savings and investments that engender significant benefits in form of repatriated income flows • Both the quality and quantity of net foreign assets are a major considerations in determining a country’s ability to service foreign debt and also influence its willingness to service debt. • Income flows from foreign assets tend to prolong trends in currency values long beyond the time when superior fundamentals and/or comparative advantages rule. • As with all saving, the key to their effect on market valuations depends in large part on whether the saving was invested wisely or foolishly.

3. Net Foreign Assets as a Proxy for Creditworthiness and Long-term Currency Trends

4. Short-term ‘Noise’ For short horizons of 3-6 months, exchange rates are buffeted by a host of factors that may or may not be the source of a trend in valuation. • Significant disparities in nominal interest rates can encourage hot-money ‘carry’ trades if local debt instruments are liquid and accessible • Surprising economic data or political events that may portend changes in monetary or government policies • Technical trading that underpins a currency’s volatility • Large cross-border transactions

5. Medium-term Influences On a longer horizon of one to five years, factors affecting exchange rates tend to be rooted in domestic economic fundamentals relative to those abroad. • Relative strength of domestic demand at home and abroad • Changes in current account balances • Mix of imports and exports (demand elasticities) • Competitiveness of key industries • Prices of key commodities • Technology transfer to lower-wage countries • Safe haven status • Monetary and fiscal policy settings

6. Medium-term Influences (cont) Of particular interest are the monetary policy settings relative to those elsewhere. • Classic policy mix for appreciation: tight money/loose fiscal policy • Classic policy mix for depreciation: loose monetary conditions/tight fiscal policy • Otherwise, currencies often bear the burden of adjustment if a country’s policies and/or economic performance is somehow asynchronous with those elsewhere. • Such disparities can cause a currency to become over- or undervalued for long periods until the mispricing eventually takes a toll on the nation’s competitiveness or foreign investment. • Capital controls tend to reduce volatility associated with short-term influences but raise the chances of amplifying the effects, for better or worse, of mispriced exchange rates over medium terms.

7. FX and Leverage Propositions: During periods of increasing leverage, distortions in currency values can persist for many years without self-correcting. During periods of widespread deleveraging, distortions in currency values tend to be undermined by recession/deflation and creditor nations fill the financing void left by global banks.