Foreign Exchange Rate Determination (or chapter 5)
Agenda • How BOP explains exchange rates? • Asset market approach to exchange rates. • Forecasting in practice. • How different theories combine to explain recent currency crises?
Exchange Rate Determination • Basic approaches • Parity conditions • Flow (BOP) approach • Stock (asset market) approach • In addition, need to account for important social & economic events, such as: • Infrastructure weaknesses, • Speculation, • Cross-border FDI, • Foreign political risks.
Current Account Balance (X-M) Capital Account Balance (CI-CO) Financial Account Balance (FI-FO) Balance of Payments BOP Reserve Balance FXB + + + = X exports, M imports CI capital inflows, CO capital outflows FI financial inflows, FO financial outflows FXB official monetary reserves Flow (BOP) Approach • Forex as a medium of exchange.
BOP Approach • Fixed Exchange Rate Countries • Government bears responsibility to ensure BOP near 0. • If CA+CAP =/= 0, government must intervene • If government lacks reserves, will have to devalue. • Managed Float Countries • To “defend” currency, may raise interest rates. • => raises cost of capital for domestic firms
Stock (Asset Market) Approach • Forex as a store of value • Willingness to hold monetary claims depends on relative real interest rates & on country’s economic growth & profitability. • Asset approach “forward looking”: discounted future value • Movements in exchange rate reflect news. • Current exchange rate is set to equilibrate risk-adjusted expected return on assets denominated in different currencies.
Asset Model Approach Monetary Approach Portfolio-Balance Approach imperfect capital substitutability perfect capital substitutability Risk premium = 0 Interest rate parity Note: risk premium =/= 0 Forward rate biased predictor Monetarist Model completely flexible commodity prices Preferred Local Habitat Model Uniform Preference Model Overshooting Model sticky commodity prices
Asset Model: Monetary Approach • Spot exchange rate is relative price of two monies. • Flexible price model: Domestic good prices fully flexible • If domestic money supply increases domestic currency will depreciate. • If domestic real income Y rises/ domestic interest rate i falls, domestic currency will appreciate as money demand is increased • Stick price model: Goods prices are sticky (slow to adjust) relative to asset prices. • Asset prices have to move by more than in flexible price case, in order for markets to reach equilibrium.
Asset Model: Portfolio-Balance • Portfolio-balance model has two financial assets (money & bonds) and two countries (home & foreign). • Exchange rate establishes equilibrium in investor portfolios of domestic money & domestic and foreign bonds. • Balance between domestic and foreign bonds in a portfolio is positively related to expected excess return on domestic bonds over foreign bonds. • Investors’ asset preferences may be similar across countries (uniform preference model), or investors may prefer assets of their home country (preferred local habitat model).
Impact on home currency Model Increase in: supply of home country bonds supply of foreign country bonds domestic interest rates foreign interest rate expected rate of home currency depreciation home wealth home country current account surplus + depreciates - appreciates - appreciates + depreciates + depreciates - appreciates - appreciates all preferred local habitat The Portfolio-Balance Approach Effects of Macroeconomic Shocks on forex
Forecasting Techniques 3 general types of forecasts: • Intuitive – expectations should be sufficient efficient market approach • Monetary policy fundamental approach. • History technical approach.
Efficient Market Approach • Markets are efficient & reflect all available information. • Markets will follow random walk by changing only when unpredicted events occur (i.e. news). St = E[St+1]. • PPP can be interpreted as market’s consensus forecast of future exchange rates if markets efficient Ft,1 = E[St+1| It].
Fundamental Approach • Exceedingly technical. Widely used in banks. • Heavy econometrics – 3-step process: • Estimate structural model. • Estimate future parameter values. • Use the model to develop forecasts.
Technical Approach • “History repeats itself”. • Data mining in search of patterns. • Largely reliant on short-term & long-term moving averages and divining patterns in the graphs. • Not well-regarded in academia , but extremely popular among traders .
Example of Technical Analysis Source: http://www.investavenue.com/article.html?ID=5761
Forecasting in Practice • Short-term forecasts: hedge receivable, payable, or dividend • Long-term forecasts: capital structure, entry mode of investment • Cross-rate consistency. • E.g. HQ forecasts Yen 120/$, $1.50/Pound • Regional managers forecast Yen 150/Pound. • => Inconsistency. • Stabilizing expectations.
Forecast Period Regime Recommended Methods to Forecast… Forecast Period Regime Recommended Methods to Forecast… SHORT-RUNFixed Rate1. Assume fixed rate. 2. Capital controls, black market rates? 3. Official reserves? LONG-RUNFixed Rate 1. BOP: trade surpluses? 2. Domestic inflation? 3. Hard currency reserves? SHORT-RUNFloating Rate 1. Forward rates? 2. Inflation? 3. Government interventions & news releases? LONG-RUNFloating Rate 1. PPP & inflation. 2. Economic growth. 3. Technical analysis long-term trends; “waves”
Anatomy of a crisis -- Asia’97 • What caused it? Supply driven: net exporters became net importers. • Thai banks had access to capital & US$ debt at low rates. • 1997: Thai Baht under attack due to country’s rising debt. • Thai government intervened directly selling reserves & indirectly raising interest rates. • Massive currency losses and bank failures led to July 1997, central bank allowed Baht to float. • Contagion:Taiwan devaluation (15%), Korea (18.2%), Malaysia (28.6%), Philippines (20.6%) against the $. • Not affected: Hong Kong $ and Chinese renminbi. • Countries had similar characteristics: corporate socialism, in-transparent corporate governance, banking liquidity and management.
Asian Crisis Thailand’s Deteriorating Balance of Payments, 1991-1998Excess capital inflows, 1996 & 1997 Source: International Financial Statistics, IMF
Investors borrow 6.00% per annum Start End 1.06 $1,000,000 $ 1,060,000 Repay $ 1,160,000 Earn $ 60,000 Profit U S dollar money market Continuing Uncovered Interest Arbitrage S =B 25.00/$ S360 = B 25.00/$ Thai baht money market 1.12 B 25,000,000 B 28,000,000 Invest at 12.00% per annum Thai Interest/Exch. Rate Disequilibria 360 days
Russian Crisis • During 1995-1998, Russian borrowers (public & private) tapped international markets for capital. • Servicing debt a problem as US$ were required for payments • Russian rouble operated under managed float w/in band of RU 5.75/$ to RU 6.35/$ • Even after $4.3bn IMF facility, rouble fell under attack August 1998 • Financing options dried up, debt issuance cancelled. • Russia began printing money for domestic payments. • Russia defaulted on foreign debt, first time Eurobond default. • Postponed $43bn short-term debt & 90-day moratorium on repayment of foreign debt.
Brazilian Crisis – 1/ 1999(read on own) • Continuing CA deficits and domestic inflation puts in 1998 pressure on real • Heavy outflow of capital, stock market down. • Central bank raised short-term interest rates 36% -> 41% • April 1999, real appreciated against the dollar.
Things to remember • BOP and asset market approaches to exchange rates. • Forecasting in practice. • How different theories combine to explain recent currency crises – Asia, Russia?