Chapter 7 Foreign Exchange Rate Determination

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 7-2 Foreign Exchange Rate Determination Chapter 6 described the international parity conditions that integrate exchange rates with inflation and interest rates. This chapter extends the discussion of exchange rate determination to the other two major schools of thought on the determination of exchange rates: –The balance of payments approach –The asset market approach

Exhibit 7.1 The Determinants of Foreign Exchange Rates Parity Conditions 1. Relative inflation rates 2. Relative interest rates 3. Forward exchange rates 4. Interest rate parity Balance of Payments 1. Current account balances 2. Portfolio investment 3. Foreign direct investment 4. Exchange rate regimes 5. Official monetary reserves Asset Approach 1. Relative real interest rates 2. Prospects for economic growth 3. Supply & demand for assets 4. Outlook for political stability 5. Speculation & liquidity 6. Political risks & controls Spot Exchange Rate Is there a well-developed and liquid money and capital market in that currency? Is there a sound and secure banking system in-place to support currency trading activities?

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 7-4 Foreign Exchange Rate Determination It is important to remember that these three theories are not competing, but rather are complementary to each other. Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 7-5 Foreign Exchange Rate Determination In addition to gaining an understanding of the basic theories, it is equally important to gain a working knowledge of how the complexities of international political economy; societal and economic infrastructures; and random political, economic, or social events affect the exchange rate markets.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 7-6 The Balance of Payments (BOP) Approach The relationship between the BOP and exchange rates can be illustrated by the use of a simplified equation that summarizes BOP data: (X – M) + (CI – CO) + (FI – FO) + FXB = BOP Where X = exports of goods and services, M = imports of goods and services, CI = capital inflows, CO = capital outflows, FI = financial inflows, FO = financial outflows and FXB = official monetary reserves. Current Account Balance Capital Account Balance Financial Account Balance Reserve Balance Balance of Payments

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 7-7 The Balance of Payments (BOP) Approach Fixed Exchange Rate Countries: –Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. –To ensure a fixed exchange rate, the government must intervene in the foreign exchange market and buy or sell domestic currencies (or sell gold) to bring the BOP back to near zero. –It is very important for a government to maintain significant foreign exchange reserve balances to allow it to intervene in the foreign exchange market effectively.

7-8 Exhibit 7.3 Thailand’s Deteriorating Balance of Payments, Source: International Financial Statistics, International Monetary Fund, Washington DC, monthly.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 7-9 The Balance of Payments (BOP) Approach Floating Exchange Rate Countries: –Under a floating exchange rate system, the government of a country has no responsibility to peg its foreign exchange rate. –The fact that current and capital account balances do not sum to zero will automatically (in theory) alter the exchange rate in the direction necessary to obtain a BOP near zero.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved The Balance of Payments (BOP) Approach Managed Floats: –Countries operating with managed floats, while still relying on market conditions for day-to-day exchange rate determination, often find it necessary to take action to maintain their desired exchange rate values. –They seek to alter the market’s valuation of a specific exchange rate by influencing the motivators of market activity, rather through direct intervention in the foreign exchange markets. –The primary action taken by such governments is to change relative interest rates.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved The Asset Market Approach to Forecasting The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others): –Relative real interest rates –Prospects for economic growth –Capital market liquidity –A country’s economic and social infrastructure –Political safety –Corporate governance practices

Copyright © 2004 Pearson Addison-Wesley. All rights reserved The Asset Market Approach to Forecasting Foreign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability. The asset market approach is also applicable to emerging markets, however in these cases a number of additional variables contribute to exchange rate determination (previous slide).

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Disequilibrium: Exchange Rates in Emerging Markets Although the three different schools of thought on exchange rate determination (parity conditions, balance of payments approach, asset approach) make understanding exchange rates appear to be straightforward, that it rarely the case. The large and liquid capital and currency markets follow many of the principles outlined so far relatively well in the medium to long term. The smaller and less liquid markets, however, frequently demonstrate behaviors that seemingly contradict the theory. The problem lies not in the theory, but in the relevance of the assumptions underlying the theory.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: The Asian Crisis 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. The most visible roots of the crisis were the excess capital inflows into Thailand in 1996 and early As the investment “bubble” expanded, some market participants questioned the ability of the economy to repay the rising amount of debt and the Thai bhat came under attack.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: The Asian Crisis The Thai government intervened directly (using foreign currency reserves) and indirectly by raising interest rates in support of the currency. Soon thereafter, the Thai investment markets ground to a halt and the Thai central bank allowed the bhat to float. The bhat fell dramatically and soon other Asian currencies (Philippine peso, Malaysian ringgit and the Indonesian rupiah) came under speculative attack.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: The Asian Crisis The Asian economic crisis (which was much more than just a currency collapse) had many roots besides traditional balance of payments difficulties: –Corporate socialism –Corporate governance –Banking liquidity and management What started as a currency crisis became a region-wide recession.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: The Russian Crisis of 1998 The crisis of August 1998 was the culmination of a continuing deterioration in general economic conditions in Russia. From 1995 to 1998, Russian borrowers (both government and non-governmental) had gone to the international capital markets for large quantities of capital. Servicing this debt soon became an increasing problem, as it was dollar denominated and required dollar denominated debt service.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: The Russian Crisis of 1998 The Russian current account (while a healthy surplus of $15 - $20 billion per year) was not finding its way into internal investment and external debt service. Capital flight began to accelerate, and hard currency earnings flowed out of the country. As the Russian rouble operated under a managed float, the Central Bank had to intervene in foreign exchange markets to support the currency if it came under pressure.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: The Russian Crisis of 1998 During the month of August, 1998, the Russian government continued to drain its reserves and had increasing difficulties in raising additional capital in support of its reserves on the international markets. By mid-August, the Russian Central Bank announced it would allow the rouble to fall, postponed short-term domestic debt service and initiated a moratorium on all repayment of foreign debt owed by Russian banks and private borrowers to avert a banking collapse.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: The Argentine Crisis of 2002 In 1991 the Argentine peso had been fixed to the US dollar at a one-to-one rate of exchange. A currency board structure was implemented in an effort eliminate the source inflation that had devastated the nation’s standard of living in the past.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved 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 currency board regime had eliminated monetary policy alternatives for macroeconomic policy –The Argentine government budget deficit – and deficit spending – was out of control

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: The Argentine Crisis of 2002 In January 2002, the peso was devalued 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. Social unrest continued as the economic and political systems within the country collapsed; certain government actions set the stage for a constitutional crisis.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Forecasting in Practice Numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants. Some multinational firms have their own in- house forecasting capabilities. Predictions can be based on elaborate econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Forecasting in Practice Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements can be subdivided into three periods: –Day-to-day –Short-term (several days to several months) –Long-term

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Forecasting in Practice The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be. Whereas forecasting for the long run must depend on the economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches.

Exhibit 7.12 Differentiating Short-Term Noise from Long-Term Trends Time Foreign currency per unit of domestic currency Fundamental Equilibrium Path Technical or random events may drive the exchange rate from the long-term path