Foreign Exchange Rate Determination and Forecasting

Mukul Bhatia

Foreign Exchange Rate Determination

Exchange rate determination is complex The three major schools of thought are the balance of payments approach, international parity conditions, and the asset market approach The exhibit provides an overview of the many determinants of exchange rates

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 global currency markets and exchange rates

The Determinants of Foreign Exchange Rates

International Parity Conditions
1. 2. 3. 4. Relative inflation rates (RPPP) Relative interest rates (international Fisher effect) Forward exchange rates Interest rate parity (IRP)

Technical Analysis
Spot Exchange Rate

Monetary Approach

Asset Market Approach

1. 2. 3. 4. 5. 6. Relative real interest rates Prospects for economic growth Supply & demand for financial assets Outlook for political stability Speculation & market liquidity Contagion & corporate governance

Balance of Payments
1. 2. 3. 4. 5. Current account balances Portfolio investment Foreign direct investment Official monetary reserves Exchange rate regimes

Most determinants of the exchange rate, e.g., the balance of BOP, the
inflation rates, the nominal and real interest rates, and the economic prospects, are also in turn affected by changes in the exchange rate In other words, they are not only linked but mutually determined

Foreign Exchange Rate Determination

In addition 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:

Foreign Exchange Rate Determinants

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

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

Exchange Rate Determination: The Theoretical Thread

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

Exchange Rate Determination: The Theoretical Thread

The theory of Purchasing Power Parity states that the exchange 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

Exchange Rate Determinants

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

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 flows from current and financial account activities

Foreign Exchange Rate Determinants

BoP continued The BoP method is the second most utilized theoretical approach in exchange rate determination Today, this method is largely dismissed by academics , but practitioners still rely on different variations of the theory for decision making This framework is appealing since the BoP transaction data is readily available and widely reported

Exchange Rate Determinants

Critics may argue that this theory emphasizes on flows of currency, but stocks of currency or financial assets of residents play no role in exchange rate determination The monetary approach considers the currency stocks of residents The asset market approach argues that exchange rates are altered by shifts in the supply and demand of financial assets

Exchange Rate Determination: The Theoretical Thread

The Monetary Approach states that the supply and demand for 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 rate according to PPP

Exchange Rate Determinants

Monetary Approach contd. The arguments are all about currency stocks of residents The inference is to link the demand or the supply of currencies with residents behavior to adjust the stock of currencies

Exchange Rate Determinants

Main results of the monetary approach are as follows: Currency supply domestic currency depreciation 1. Currency supply supply of currency > demand of currency residents current currency holding > residents desired currency holding residents spend the currency price level according to PPP, domestic currency depreciates 2. Domestic currency supply growth rate > foreign currency supply growth rate domestic currency depreciates vs. foreign currency

Exchange Rate Determination: The Theoretical Thread

Interest rate domestic currency depreciation 1. Interest rate opportunity cost for residents to hold the currency increases demand of currency residents current currency holding > residents desired currency holding residents spend the currency price level according to PPP, domestic currency depreciates 2. Increase of domestic interest rate > increase of foreign interest rate domestic currency depreciates against foreign currency

Exchange Rate Determinants

Real income domestic currency appreciation 1. Real income (= real GDP = outputs of products and services ) number of transactions demand of currency residents current currency holding < residents desired currency holding residents decrease the spending of the currency price level (or because the supply of products and services , price level and less currency is spent to achieve the same utility) according to PPP, domestic currency appreciates

Exchange Rate Determinants

2. Domestic real income growth rate > foreign real income growth rate (domestic economic growth > foreign economic growth) domestic currency appreciates against foreign currency

Exchange Rate Determination: The Theoretical Thread

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 the currency supply In the above inference, however, the change of the interest rate and the real income affect only the currency demand

Exchange Rate Determinants

Factors omitted by monetary approach

Currency demand appearing to be relatively unstable over time 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

Exchange Rate Determination: The Theoretical Thread

The Asset Market Approach argues that the exchange rate should be determined by expectations about the future of an economy, not current trade flows

Exchange Rate Determinants

Asset Market Approach contd. Since the prospect of an economy is reflected on the demand of financial assets in that economy, the asset market approach believes that changes of exchange rates are affected by changes of the supply and demand for a wide variety of financial assets: Shifts in the supply and demand for financial assets alter exchange rates (not the demand and supply of financial assets determine the exchange rate) The asset market approach is also called the relative price of bonds or portfolio balance approach

Exchange Rate Determination: The Theoretical Thread

More specifically, if the demand for domestic financial 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 demand and supply of financial assets and thus exchange rates (In the 1980s, many macroeconomic theories focused on this topic)

Exchange Rate Determination: The Theoretical Thread

Technical analysis is based on the belief that the study of past price behaviors provides insights into future price movements

Exchange Rate Determinants

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 identify trends that are expected to continue into the future and next exploit trends to make profit

The Asset Market Approach to Forecasting

The Asset Market Approach to Forecasting

The asset market approach assumes that the motives of foreigners to hold claims in one currency depends on an extensive set of investment considerations or drivers: 1. Relative real interest rates (an important concern for investing in foreign bonds and money market instruments) 2. Prospects for economic growth (the major reason for cross-border equity investment and foreign direct investment)

Exchange Rate Determinants

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)

The Asset Market Approach to Forecasting

Asset Mkt Approach contd.
5. Political safety (which is usually reflected in political risk premiums for a countrys securities) 6. Corporate governance practices (poor corporate governance practices can reduce the investing will of foreign investors)

Exchange Rate Determinants

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 its currency) 8. Speculation (can cause a foreign exchange crisis or make an existing crisis worse) In summary, the asset market approach believes that the above factors affect the motives of investments from both domestic and foreign investors and thus affect the exchange rate

The Asset Market Approach to Forecasting

Foreign investors are willing to hold securities and undertake foreign direct or portofolio investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability

Exchange Rate Determinants

Asset Mkt Approach contd. The experience of the U.S. illustrates why some forecasters believe that exchange rates are more heavily influenced by economic prospects than by the current account
For 1981-1985, the US$ strengthened despite growing current account deficits
Relatively high real interest rates and good long-run prospects cause heavy capital inflow into the U.S.

The Asset Market Approach 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 real estate 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 index increased by a factor of more than 6

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

Illustrative Cases in Emerging Markets

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 growth but also additional factors contribute to exchange rate determination
The Asian and Argentine crises are examined as illustrative cases in this section

 The roots of the Asian currency crisis extended from a fundamental change in the economics of the region: the transition of many Asian nations from being net exporters to net importers due to the following two reasons
Rapid economic expansion Many Asian countries pegged its currency at a fixed exchange rate with the US$, so their currencies appreciated with the US$ being strong after 1995

Illustrative Case: The Asian Crisis of 1997

The deficit of BoP generates the depreciation pressure

To support their pegged exchange rates, Asian nations require to attract net capital inflow The most visible roots of the crisis were the excess capital inflows into Thailand in 1996 and early 1997

Illustrative Case: The Asian Crisis of 1997

Thai banks continued to raise capital internationally, and extended credit to a variety of domestic investments and enterprises beyond what the Thai economy could support As the investment bubble expanded, market participants questioned the ability of the economy to repay the rising amount of debt, so the Thai baht was attacked by international speculation

Asian Crisis contd.

The Thai government intervened directly (using up precious currency reserves) and indirectly 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 against US$ fell 17% in several hours and 38% in 4 months

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, and Indonesian rupiah all fell in the months following the July baht devaluation

Illustrative Case: The Asian Crisis of 1997

The Asian economic crisis (which was much more than just a currency collapse) had other reasons besides traditional balance of payments difficulties:
Corporate socialism

In Asia, because the influence of governments, even in the event of failure, it was believed that governments would not allow firms to fail, banks to close, and workers to lose their jobs This kind of policy provided the stability of the economy, but when business liabilities exceeded the capacities of governments to bail businesses out, the crisis happened

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 Asian countries Banking liquidity and management The lack of transparency and monitoring mechanisms encouraged banks to underestimate the credit risk of firms and expand the lending business too much

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 suffered further loss During the financial crisis, banks themselves suffer the 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 is any sign for political problems, the capital out flowed from those countries immediately

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

Illustrative Case: The Argentine Crisis of 2002

In order to eliminate the hyperinflation problem that had undermined the nations standard of living in the 1980s, a currency board structure was implemented in Argentina in the early 1990s

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., the government lost the ability to utilize the monetary policy to stimulate the economy

Illustrative Case: The Argentine Crisis of 2002

Although the hyperinflation was cured by the restrictive monetary policy, this policy also slowed economic growth in the coming years The real GDP shrank in 1999 (-3.5%) and 2000 (-0.4%), and the unemployment rate rose to about 15% since 1995

Argentine Crisis contd.

In order to demonstrate the governments unwavering commitment to maintaining the pesos value parity with the dollar, the Argentine government allowed banks to accept deposits in either pesos and dollars However, there was substantial doubt in the market that the Argentine government was able to maintain the fixed exchange rate

Illustrative Case: The Argentine Crisis of 2002

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 currencies against 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)

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

Argentine Crisis contd.

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 1991 to 2000)

Illustrative Case: The Argentine Crisis of 2002

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

Argentine Crisis contd.

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 $155 billion in sovereign (government) debt

Illustrative Case: The Argentine Crisis of 2002

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

Argentine Crisis contd.

The provincial governments began printing their all money, promissory notes Because the notes were issued by the provincial governments, not the federal government, people and business would not accept notes form other provinces

Illustrative Case: The Argentine Crisis of 2002

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

Argentine Crisis contd.

In February and March 2002, negotiations between the IMF and Argentina continued as the IMF demanded increasing fiscal reform over the growing government budget deficits and bank mismanagement Argentinas experience has proved that it is not easy to adopt the currency board system of a firmly fixed exchange rate for an economy

Exchange Rate Determinants

Thank You

Mukul Bhatia