Financial Structure and Exchange Rate Dynamics: A Qualitative Study of Emerging Market Currency Internationalisation

1. Financial Structure and Exchange Rate Dynamics: A Qualitative Study of Emerging Market Currency Internationalisation AnninaKaltenbrunner Leeds University Business School A.Kaltenbrunner@leeds.ac.uk

2. Background and Motivation • Analyse the process of exchange rate determination in emerging markets in the context of currency internationalisation • Based on a Post Keynesian theoretical and methodological framework • Empirical results and suggest alternative ways of conducting research from a Post Keynesian Perspective

3. Outline • Overview of the main tenants of mainstream and Post Keynesian theories of exchange rate determination • Alternative analytical framework for exchange rate determination in DECs • Methodology • Empirical Results

4. Exchange Rate Determination in TheoryThe Mainstream • Exchange rate market equilibrating price - stable underlying fundamentals – across time, countries and actors • Importance of Financial market actors • Rational Expectations • Behavioural Finance • Rationality and Ergodicity maintained • Same fundamentals

5. Exchange Rate Determination in TheoryExisting Post Keynesian Exchange Rate Theory • Exchange rate not market equilibrating price • Expectations and positions in short-term financial markets (capital flows) drive exchange rates– Expectations creative not reactive • Expectations formed under fundamental uncertainty and anchored by social convention • No permanent fundamentals (rejection of long-run equilibrium value) • Fundamentals context, time and institution specific • Harvey (2009) • Flows (trade, fdi, portfolio) determine the exchange rate • Flows determined by base factors and indicators • Interest rates, unemployment, trade balance and inflation as most important base factors and indicators and thus exchange rate “fundamentals” in a Post Keynesian sense

6. Exchange Rate Determination in TheoryCritique Existing Post Keynesian Exchange Rate Theory • Subjectivist • Social conventions as a choice • Social relations – credit relations (financial structure) • General model of exchange rate determination? • Specific to (institutional) context of developed foreign exchange markets • Heterogeneous group of foreign exchange market participants • Ad-hoc specification of exchange rate “fundamentals” • Focus on expectations under uncertainty – anything to say about exchange rate determination beyond specific context? Theory-less? • No: Search for underlying mechanisms, processes and structures - Critical Realism

7. An alternative Analytical FrameworkDomestic Currency as International Money • One of the most important underlying structures in Post Keynesian theory in the presence of fundamental uncertainty: money • Domestic Currency as International Money (Currency Internationalisation) • Keynes‘ writings on forward foreign exchange market in Tract on Monetary Reform as early application of liquidity preference theory and „own rate of return“ (Kregel, 1982) • Sterling as the money of the system with durable assets comprised of foreign currencies

8. An alternative Analytical FrameworkDomestic Currency as International Money • Keynes General Theory: “...it may be added that, just as there are differing commodity-rates of interest at any time, so also exchange dealers are familiar with the fact that the rate of interest is not even the same in terms of two different moneys, e.g. sterling and dollars. For here also the difference between the “spot” and “future” contracts for a foreign money in terms of sterling are not, as a rule, the same for different foreign moneys” (p. 224).

9. An alternative Analytical FrameworkDomestic Currency as International Money • Exchange rate determined by (expectations about) currency’s net return relative to the currency/money of the system (Pound Sterling/US$) • Every durable asset has a measure of its „own rate of return“ in terms of money: (q-c)+a+l • Yield (q): returns on short-term domestic currency assets • Carrying Cost (c) : minimal • Appreciation (a): short-term speculative moment (animal spirit, psychology etc.) • Liquidity Premium (l): structural element • Money is credit money • Liquidity as the ability to meet outstanding external obligations (Minsky,1975) • Importance of credit relations and financial structure for exchange rate dynamics

10. An alternative Analytical FrameworkDomestic Currency as International Money • Hierarchic nature of international monetary system and consequent exchange rate dynamics in DECs • The money/currency as “creditor” currency: Creditor country > main funding currency • DEC currencies as “debtor” currencies • External debt > Any form of short-term external liabilities • Sustainable value and actual exchange rate driver • Ability to force a cash flow in its favour (trade balance/current account) • Ability to “make position” - “Institutional” Liquidity • Implications • Higher interest rates to compensate for lower liquidity premium • Higher sensitivity to changes in international liquidity preference (Dow, 1999) – importance of international market conditions for DECs • From Financial Instability to Financial Fragility

11. Methodology • Post Keynesian/Critical Realist open system ontology: Qualitative methods to uncover underlying structures, mechanisms and processes (Dow, Lawson) • If expectations and positions of financial market actors are main drivers of exchange rates have to understand how these are formed • 52 semi-structured interviews with currency traders in banks (commercial and investment) and funds (hedge funds and real money funds) in Brazil and London

12. ResultsFundamentals in Practice • Heterogeneous Foreign Exchange Market Participants • Very different conceptions of fundamentals depending on trading horizon, institution and market (onshore vs. offshore) • Concept of fundamentals (exchange rate driver vs. equilibrium concept) • Nature of fundamentals of emerging market currencies (around 40 different variables mentioned) • Interest rates, International Risk Aversion and Financial Structure (Debt and International Investment Position) top • No notion of long-run value and if so, little value for trading

13. ResultsExchange Rate Determinants in the Era of Currency Internationalisation Difference between Emerging Market and G10 Currency Trading

14. ResultsExpectations Formation-Onshore Respondents

15. ResultsExpectations Formation-Offshore Respondents

16. ResultsThe international financial crisis – Onshore Respondents

17. ResultsThe international financial crisis – offshore respondents

18. Conclusions • Process of Emerging Market Currency Internationalisation • Exchange Rates driven by expectations and positions • Alternative view of exchange rate determination which acknowledges that fundamentals (empirically observable exchange rate drivers) are context and time specific • Need to look for underlying real mechanisms, structures, processes, and social relations • Exchange rate as international money – importance of short-term returns, liquidity preference and financial structure to understand exchange rate movements (in DECs) • Risk of Currency Internationalisation – Financial Instability