Chapter 10Foreign Exchange Rate Determination and Forecasting

The Goals of Chapter 10Summarized the theories to determine the exchange rate, including the purchasing power parity approach, the balance of payments approach, the monetary approach, the asset market approach, and the technical analysisIntroduce the crises in emerging markets, including the Asian crisis in 1997 and the Argentine crisis in 2002Discuss the forecasting of the exchange rate in practice

010-*

Foreign Exchange Rate Determination10-*

Foreign Exchange Rate DeterminationExchange rate determination is complexThe three major schools of thought are the balance of payments approach (Ch 4), international parity conditions (Ch 7), and the asset market approachThe exhibit on the next slide provides an overview of the many determinants of exchange ratesIn addition to focusing on the asset market approach, the monetary approach and the technical analysis are also introduced in this chapterThese 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 rates10-*

Exhibit 10.1 The Determinants of Foreign Exchange RatesInternational Parity Conditions (Ch 7)1. Relative inflation rates (RPPP)2. Relative interest rates (international Fisher effect)3. Forward exchange rates4. Interest rate parity (IRP)Balance of Payments (Ch 4)1. Current account balances2. Portfolio investment3. Foreign direct investment 4. Official monetary reserves5. Exchange rate regimesAsset Market Approach (Ch 10)1. Relative real interest rates2. Prospects for economic growth3. Supply & demand for financial assets4. Outlook for political stability5. Speculation & market liquidity6. Contagion & corporate governanceSpotExchangeRate

Monetary Approach

Technical Analysis

0 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 determined10-*

Foreign Exchange Rate DeterminationIn 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 markets1. The complexities of international political economyForeign 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 liquid2. Societal and economic infrastructuresInfrastructure weakness were the major reasons of the exchange rate collapses in emerging markets in the late 1990s3. Random political, economic, or social eventsFor example, recent occurrences of terrorism may increase the political risks and affect the exchange rate market

10-*

Exchange Rate Determination: The Theoretical Thread10-*

Exchange Rate Determination: The Theoretical ThreadThis section will provide a brief overview of the many different theories to determine exchange rate and their relative usefulness in forecastingThe theories discussed in this section includePurchasing power parity approachBalance of payments (flows) approachMonetary approachAsset market approachTechnical analysis010-*

Exchange Rate Determination: The Theoretical ThreadThe theory of Purchasing Power Parity states that the exchange rate is determined as the relative prices of goodsPPP is the oldest and most widely followed exchange rate theoryPaul 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 rateMost exchange rate determination theories have PPP elements embedded within their frameworksHowever, 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 estimation010-*

Exchange Rate Determination: The Theoretical ThreadThe 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 The BOP method is the second most utilized theoretical approach in exchange rate determinationToday, this method is largely dismissed by academics , but practitioners still rely on different variations of the theory for decision makingThis framework is appealing since the BOP transaction data is readily available and widely reportedCritics 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 determinationThe monetary approach considers the currency stocks of residentsThe asset market approach argues that exchange rates are altered by shifts in the supply and demand of financial assets010-*

Exchange Rate Determination: The Theoretical ThreadThe 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 PPPThe arguments are all about currency stocks of residentsThe inference is to link the demand or the supply of currencies with residents behavior to adjust the stock of currenciesMain results of the monetary approach are as follows:Currency supply domestic currency depreciation1. 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 depreciates2. Domestic currency supply growth rate > foreign currency supply growth rate domestic currency depreciates vs. foreign currency010-*

Exchange Rate Determination: The Theoretical ThreadInterest rate domestic currency depreciation1. 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 depreciates2. Increase of domestic interest rate > increase of foreign interest rate domestic currency depreciates against foreign currencyReal income domestic currency appreciation1. 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 appreciates2. Domestic real income growth rate > foreign real income growth rate (domestic economic growth > foreign economic growth) domestic currency appreciates against foreign currency010-*

Exchange Rate Determination: The Theoretical ThreadThe monetary approach omits a number of factors:The failure of PPP to hold in the short to medium termThe change of the interest rate and the real income will affect the economic activities and thus affect the currency supplyIn the above inference, however, the change of the interest rate and the real income affect only the currency demandCurrency demand appearing to be relatively unstable over timeThere 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 predicted010-*

Exchange Rate Determination: The Theoretical ThreadThe Asset Market Approach argues that the exchange rate should be determined by expectations about the future of an economy, not current trade flowsSince 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

010-*

Exchange Rate Determination: The Theoretical ThreadMore 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 currencyChanges 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)Later I will introduce the determining factors in the asset market approach in detail010-*

Exchange Rate Determination: The Theoretical ThreadTechnical analysis is based on the belief that the study of past price behaviors provides insights into future price movementsDue to the poor forecasting performance of many fundamental theories, the technical analysis draws more attention and becomes popularThe primary assumption of the technical analysis is that the movements of any market driven price (e.g., exchange rates) must follow trendsMore 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

010-*

The Asset Market Approach to Forecasting10-*

The Asset Market Approach to ForecastingThe 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)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)010-*

The Asset Market Approach to Forecasting5. 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)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 rate010-*

The Asset Market Approach to ForecastingForeign 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 profitabilityThe experience of the U.S. illustrates why some forecasters believe that exchange rates are more heavily influenced by economic prospects than by the current accountFor 1981-1985, the US$ strengthened despite growing current account deficitsRelatively high real interest rates and good long-run prospects cause heavy capital inflow into the U.S.010-*

The Asset Market Approach to ForecastingFor 1990-2000, the US$ strengthened despite continued worsening balances on current accountThe 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 prospectsActually, from 1995 to 2001, the Nasdaq index increased by a factor of more than 6After the terrorists attacked the U.S. on September 11, 2001A 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 then010-*

Illustrative Cases in Emerging Markets10-*

Disequilibrium: Exchange Rates in Emerging MarketsThe 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 (see Slides 10-18 and 10-19)The Asian and Argentine crises are examined as illustrative cases in this section

010-*

Illustrative Case: The Asian Crisis of 1997The 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 reasonsRapidly economic expansionMany Asian countries pegged its currency at a fixed exchange rate with the US$, so their currencies appreciated with the US$ being strong after 1995The deficit of BOP generates the depreciation pressureTo support their pegged exchange rates, Asian nations require to attract net capital inflowThe most visible roots of the crisis were the excess capital inflows into Thailand in 1996 and early 1997010-*

Illustrative Case: The Asian Crisis of 1997Thai banks continued to raise capital internationally, and extended credit to a variety of domestic investments and enterprises beyond what the Thai economy could supportAs 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 CFs (factor 8)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

010-*

Illustrative Case: The Asian Crisis in 1997The international speculators attacked a number of neighboring Asian nations, some with and some without characteristics similar to Thailand (factor 7)It is the Asias own version of the tequila effectTequila effect is the term used to describe how the Mexican peso crisis of December 1994 quickly spread to other Latin American currency and equity marketsThe spread of the financial panic is termed contagionThe Philippine peso, the Malaysian ringgit, and Indonesian rupiah all fell in the months following the July baht devaluation010-*

Exhibit 10.3 Comparative Daily Exchange Rates: Relative to the US$010-*

Exhibit 10.2 The Economies and Currencies of Asia, JulyNovember 1997 Due to the not-completely-free-convertible features, the Chinese yuan was not devalued, but there was rising speculation that Chinese government would devalue it soon for competitive reasons (but it did not) The Hong Kong dollar survived, but with great expense to the central banks foreign exchange reserves Although Taiwan was with enough foreign exchange reserves, Taiwan caught the markets imbalance with a surprise competitive depreciation of 15% in Oct. 1997010-*

Illustrative Case: The Asian Crisis of 1997The Asian economic crisis (which was much more than just a currency collapse) had other reasons besides traditional balance of payments difficulties:Corporate socialismIn 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 jobsThis 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 Overinvestment in Asian countries (factor 2)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 countriesBanking liquidity and management (factors 3, 4, and 6)The lack of transparency and monitoring mechanisms encouraged banks to underestimate the credit risk of firms and expand the lending business too much

010-*

Illustrative Case: The Asian Crisis of 1997Banks did not hedge exchange rate risk while raising international capital, so when the domestic currency depreciated in the financial crisis, they suffered further lossDuring the financial crisis, banks themselves suffer the liquidity problem, so banks cannot provide liquidity to firms for conducing their businessesPolitical risk (factor 5)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 immediatelyAfter 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 1998010-*

Illustrative Case: The Argentine Crisis of 2002In 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 1990sIn 1991, the Argentine peso had been fixed to the US dollar at a one-to-one rate of exchangeThe 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 surplusThis 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 economy010-*

Illustrative Case: The Argentine Crisis of 2002Although 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 1995In 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 dollarsHowever, there was substantial doubt in the market that the Argentine government was able to maintain the fixed exchange rate

010-*

Illustrative Case: The Argentine Crisis of 2002By 2001, after three years of recession, three important problems with the Argentine economy became apparent:The Argentine peso was overvalued (factor 2)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 overvaluedArgentine 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 pesoTherefore, the deficit of the current account deteriorated from $0.65 billion (in 1991) to $8.9 billion (in 2000)010-*

Illustrative Case: The Argentine Crisis of 2002The currency board regime had eliminated monetary policy alternatives for macroeconomic policyThe 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 stimulationIn fact, due to the continuous deficit of the BOP, Argentina could only adopt the contraction monetary policy from 1991 to 2000The Argentine government budget deficit, i.e., spending, was out of controlAs the unemployment rate grew higher, as poverty and social unrest grew, government spending continued to increase to solve these social and economic problemsWithout 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)010-*

Illustrative Case: The Argentine Crisis of 2002As 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 ArgentinaDuring the political chaos in the beginning of 2002 (factor 5), 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) debt010-*

Illustrative Case: The Argentine Crisis of 2002On 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 banksHowever, the economic pain continued and the banking system remained insolvent (factor 3)The provincial governments began printing their all money, promissory notesBecause the notes were issued by the provincial governments, not the federal government, people and business would not accept notes form other provinces

010-*

Illustrative Case: The Argentine Crisis of 2002The 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 elseOn February 3, 2002, the Argentine government announced that the peso would be floated and the banks would reopenIn 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 (factor 4)Argentinas experience has proved that it is not easy to adopt the currency board system of a firmly fixed exchange rate for an economy

010-*

Forecasting in Practice10-*

Forecasting in PracticeAlthough the three different schools of thought on exchange rate determination (parity conditions, balance of payments approach, asset market approach) make understanding exchange rates to be straightforward, that is rarely the caseThe large and liquid capital and currency markets follow many of the principles outlined so far relatively well in the medium to long termThe smaller and less liquid markets, however, frequently demonstrate behaviors that seemingly contradict these theories or need to be explained by considering more factors (see the illustrative cases in the previous section)As a consequence, numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants010-*

Forecasting in PracticeSome multinational firms have their own in-house forecasting capabilitiesLong-term forecasts may be motivated by a multinational firms desire to initiate a foreign investmentShort-term forecasts are typically motivated by a desire to hedge account receivables or payable for perhaps a period of several monthsPredictions can be based on fundamental theories (usually used for long-term forecasts), various econometric models (e.g., time series techniques which infer no theory but simply try to find relation between future values and the past values), or technical analysis of charts and trends (more suitable for short-term forecasts)010-*

Forecasting in PracticeIn technical analysis, exchange rate movements, similar to equity price movements, can be divided into three components:Day-to-day movements (seemingly random)Short-term movements from several days to several months (temporarily deviations from the long-term trend)Long-term trendsForecasting for the long-run exchange rate movement can depends on the economic fundamentals of exchange rate determination, i.e., the inflation rates, interest rates, or the prospects of economiesMany researches suggest that the long-term exchange rate exhibits the characteristic of mean reversion, i.e., the exchange rates eventuallymove back towards the mean oraverage 010-*

Forecasting in PracticeIn practice, a synthesis of the exchange rate forecast is often adoptedFrom many theoretical and empirical studies, long-term exchange rates do adhere to the fundamental principles and theories outlined in the previous sections Fundamental principles do apply in the long term There exists a fundamental equilibrium path for a currencys valueIn the short term, a variety of random events called noise may cause currency values to deviate from their long-term fundamental equilibrium path

010-*

Exhibit 10.8 Differentiating Short-Term Noise from Long-Term Trends0 The long-term equilibrium path is not always apparent in the short term (although relatively well-defined in retrospect) Some studies also point out that the exchange rate itself may deviate in something of a cycle or wave about the long-term path10-*

Exhibit 10.7 Exchange Rate Forecasting in Practice010-*financial condition

JPMorgan Chases Forecasting Accuracy (US$/)010-* The above figure shows the forecast of JPMorgan Chase for the 90-day US$/ exchange rate into the future In February of 2004, it forecasted the exchange rate to move from $1.27/ to $1.32/ , but in fact the realized exchange rate after 90 days is $1.19/ , which illustrates the difficulty to forecast the movement of the exchange rate

Forecasting in PracticePredict exchange rate dynamicsAlthough various theories surrounding exchange rate determination are clear and sound, the difficulty is to understand which fundamental theories are driving markets at which time pointsOne example over exchange rate dynamics is the phenomenon known as overshootingThe U.S. Federal Reserve announces an expansionary monetary policy, and the markets react to this news through the immediate depreciation in the exchange rate from S0 to S1 (According to the asset market approach, currency supply real interest rate of US$ capital outflow from the U.S. US$ depreciates)With the passing of time, the price impact of this monetary policy starts working through the economy to increase the price level. According to PPP, the equilibrium exchange rate, i.e., the exchange rate in the long run, should depreciate to be S2

010-*

Exhibit 10.9 Exchange Rate Dynamics: Overshooting0 The difference between S1 and S2 reflects the dominance of different theoretical principles at different points in time (first is the asset market approach and second is the PPP theory) As a result, the initial higher value of S1 is often explained as an overshooting of the longer-term equilibrium value of S2Since the exchange rate is expressed as US$ price per euro, S1 > S0 (S2 > S0) represents the depreciation of the US dollars against the euros10-*