New York

May 1, 2000

J.P. Morgan Securities Inc.

Emerging Markets Research
Drausio Giacomelli (1-212) 648-1960

Market brief

Introducing J.P. Morgans Emerging

Markets Real Exchange Rate Model
This piece briefly introduces our approach to
estimating equilibrium exchange rates and
presents a snapshot of the results obtained for
Latin America. More detailed information can be
found in the country pieces and methodology paper
The results reveal no serious currency
misalignment in the region at this time
We found that the Mexican peso is not overvalued,
the the Brazilian real is equilibrium, and the the
Argentine peso is due mainly to low export prices
13% strong relative to its long-run equilibrium

used to measure this strength is named error-correction

and it measures the size of the exchange rate
misalignement from the long-run trend. The time it takes
for 50% of such misalignments to be undone is called halflife and is reported in the results. In Exhibit 1 we present a
snapshot of the results we obtained for several Latin
American countries. More information can be found in the
individual pieces.
Exhibit 1

No serious misalignment in sight

Positive (negative) numbers mean strong (weak) currency;

misalignement is measured relative to the long-run estimate

Although not high, the highest risk lies in

Venezuela, as oil prices recede in 2H00

As is often the case, simple questions require quite

elaborated answers. The goal of this piece is to present a
quick and intuitive overview of what is discussed in more
depth in our methodology and individual currency pieces.
Therefore, we devote most of this text to introduce our
approach and estimation techniques. After all, statistics is
powerful only if applied properly and used with care.

Misalignment relative to Models avg 2000 J.P. Morgans

fcst
year-end fcst
model estimates
(%)
(per US$)
(per US$)
Argentina

13

1.0

Brazil

-3

1.8

1.9

Mexico

9.7

9.9

Chile

-4

495

505

Colombia

2020

1930

Peru

3.5

3.7

Venezuela

735

750

1.0

Except for Argentina, misalignments lie within the precision band of our estimates.

Why take pains of a developing a equilibrium

exchange rate model, deriving its econometric
implementation, and building a complete data set
(including burdensome productivity computations) to
determine the equilibrium exchange rates? Simply
because we dont see any way around it. The
alternatives are, to a large extent, incomplete and
arbitrary.

Exchange rates, as is typical of asset prices, are much

more volatile than their fundamentals. The estimates
presented here are, therefore, best used as medium to
long-term references of the equilibrium. Technicals,
expectations, as well as political and economic news
(which can be provided by our country and FX analysts)
dominate the very short run and have to be superimposed
to the fundamentally driven equilibrium we present in this
piece when forecasting spot rates.

How to use our results

We estimate the long-run equilibrium trend and
fluctuations (dynamics) around it. The long-run
estimates assume balanced fiscal and monetary policies
and form the trend around which the exchange rate
fluctuates. The determinants of the long-run trend are
productivity, terms of trade, and openness to trade. The
short-term dynamics captures changes in monetary and
fiscal policies, as well as changes in country risk. From
the dynamics estimated it is possible to measure the
strength of reversal to the log-run trend. The variable

The Alternative approaches

The PPP (Purchasing Power Parity) asserts that the
real exchange rate is constant. In its weak form, it
establishes that the equilibrium exchange rate at time t+1 is
given by the exchange rate at some equilibrium time t
corrected by the inflation at home and abroad during the
interval t, t+1. Two questions emerge. First, when was it
in equilibrium? After all, if one can determine that the
exchange rate is in equilibrium at time t (s)he should be
able to determine how far way from equilibrium it is at
time t+1, regardless of PPP calculations themselves.

New York
May 1, 2000

J.P. Morgan Securities Inc.

Emerging Markets Research
Drausio Giacomelli (1-212) 648-1960

Second, why assume that real exchange rates are

constant? In the past 10 years Emerging Markets have
undergone considerable terms of trade shocks and a
major trade liberalization that significantly changed
relative prices, FDI flows, and the pace of technical
progress in tradable and non-tradable sectors. Does it
make sense to assume that the real exchange rate
remained constant throughout this period? Of course not,
as history has shown. (See glossary and reference in the
grey boxes).
The random-walk approach sees the exchange rate as
purely an asset price. It assumes that all relevant
information for forecasting at time t+1 is incorporated in
the exchange rate at time t. Therefore, the best predictor
for the exchange level at time t+1 is its current level. It is
actually difficult to beat the random walk approach in the
very high frequency estimation which is not our goal.
At lower frequencies, however, fundamentals-based
models tend to clearly outperform the random walk
approach. In addition, what makes the exchange rate
behave as an asset price is the incorporation of
information and our model is a guide to which
information to incorporate and how.
The current account approach to exchange rate
determination relies on external balance, i.e on the
sustainability of the current account. Although a
departure from the PPP in the right direction, this
approach completely fails to impose equilibrium in
domestic markets. This is a serious fault, given that the
equilibrium exchange rate of small economy is the relative
price of tradable and non-tradable (domestic) goods.
Our approach
Theory We develop a domestic and external equilibrium
theoretical framework that incorporates the main
economic shocks to which emerging markets are subject,
namely terms of trade swings, productivity changes,
trade liberalization, as well as monetary and fiscal policy
interventions. The PPP and the current account
approaches are special cases of our framework.
Regarding the econometrics, we had to use involved
techniques to obtain unbiased and efficient estimates. It
turns out that ordinary regression analysis often times
yields spurious results when dealing with the exchange
rate and its fundamentals. Spurious regressions are very
misleading, since they tend to show high explanatory
power, but are useless for forecasting their in-sample
findings simply do not carry over to the future. This
model has shown better forecasting power than the usual
PPP and random-walk approaches.

Introducing J.P. Morgans Emerging

Markets Real Exchange Rate Model
page 2

More on JP Morgans equilibrium exchange rate model

Methogology An intuitive overview followed by an in depth

discussion of the theory and econometrics behind the results
presented here can be found in Introducing JP Morgans
Emerging Markets Real Exchange Rate Model: Theory and
Econometrics, April of 2000. A powerpoint presentation is
also available in our Emerging Markets homepage.
Data Data sources comprise J.P. Morgans data bank, the
World Bank, IMF statistics, central banks, OECD, and local
research institutes.
Glossary
Econometrics Statistics applied to economics.
Effective productivity The productivity of a country relative
to its trade partners. It uses the same trade weights utilized
to compute the real effective exchange rate.
Equilibrium exchange rate The level that balances: 1)The
NPV of a countrys net foreign assets and 2)domest supply
and demand without generating either inflation or deflation
Non-tradable goods Goods that are not subject to foreign
price competition through trade (e.g. hair cuts)
Productivity The share of output that is not attributed to
factors of production (labor and capital). It results from the
better combination of those inputs.
Real exchange rate (RER) The nominal rate corrected by
inflation. If a currency is quoted relative to the US$, the real
exchange rate uses both home and US deflators.
Real effective exchange rate (REER) It is an extention of the
RER, where the currency is quoted against a basket of trade
partners (weighted by trade volume shares) deflated by
home and basket inflation. Higher REER means appreciation.
R-squared A measure of the fitting power of a regression.
Stability tests Test how stable throughout the sample the
coefficients estimated are.
Terms of trade The exported-imported goods prices ratio.
Tradable goods Goods that are subject to price arbitrage
through trade. Note that: 1)The boundary between tradables
and non-tradables cannot be sharply defined; 2)A good
does not have to be traded to be tradable. Consequently, an
country that is open to trade does not have to show a high
share of exports plus imports in GDP. It suffices that a large
share of its economy is subject to foreign pricing.
Unbiased estimates Their probability distribution is centered
on the true value of the variable estimated

New York
May 1, 2000

J.P. Morgan Securities Inc.

Introducing J.P. Morgans Emerging
Emerging Markets Research
Markets Real Exchange Rate Model
Drausio Giacomelli (1-212) 648-1960 page 3

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