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The Deutsche Bank Guide To Exchange-Rate Determination
The Deutsche Bank Guide To Exchange-Rate Determination
Deutsche Bank@
Global Markets Research
May 2002
A Survey of
Exchange-Rate
Forecasting Models and
Strategies
Bandwagon Effect/
Trend-Following Behavior Purchasing Power Parity
Savings/Investment
Risk Appetite
Balance Trends
Real Current
Account Capital
Interest-Rate
Differentials Trends Flows
David Folkerts-Landau
Relative
Fiscal
Managing Director, Head of Monetary
Policy Policy
Economic Portfolio-Balance
Considerations
Growth
Global Markets Research
Table of Contents
Introduction .................................................................................................... 4
May 5, 2002
Sources:
Introduction
Getting the exchange rate right is a critical objective of all The adjacent schematic diagram provides a convenient il-
international investors. Unfortunately, getting the exchange lustration of the layout of this guidebook and highlights
rate right on a reasonably consistent basis is far from easy. the myriad of channels through which fundamental and
As anyone involved in the business of currency forecast- technical forces jointly affect exchange rates. Some of those
ing can attest, it can be a humbling experience. channels will tend to exert a more profound impact on ex-
change rates in the short run, while others will tend have a
Currency forecasts can go awry for a variety of reasons. more profound impact in the medium or long run. We ex-
For instance, if one's expectation of the direction in which plore each of those channels in the chapters that follow.
fundamental-based forces are heading is flawed, so will
be one's forecast of a currency's future path. Even if one's In the chapter entitled "Exchange Rate Determination in
interpretation of the underlying fundamental forces were the Short Run," we investigate the potential risks and re-
correct, currency forecasts might still go awry if short-term wards of using a variety of short-run forecasting tools in
technical forces carried exchange rates far from their fun- formulating short-term FX strategies. These include mov-
damental equilibrium path. ing-average trend-following trading rules, sentiment and
positioning surveys, FX dealer customer-flow data, infor-
Scores of empirical studies have found that fundamental- mation embedded in currency option prices, and risk ap-
based models tend to perform poorly in terms of explain- petite indices.
ing exchange-rate trends, particularly over short-term peri-
ods. However, fundamental-based models tend to work We find that moving-average trading rules would have gen-
better over medium and especially longer-run horizons. erated significant risk-adjusted excess returns over rela-
Unfortunately, most fund managers, whose performances tively long periods for most major currency pairs, although
are evaluated over relatively short time spans these days, losing trades tend to occur far more frequently than win-
are often not willing to risk significant sums of capital on ning trades, in many cases by a factor of 3 to 1. The high
the basis of longer-term, fundamental-based projections. frequency of losing trades suggests that moving-average
That is why many market participants have recently turned trading rules can be risky over short periods and that an
their attention away from longer-run fundamental-based investor would need considerable risk capital on hand to
forecasting approaches in favor of shorter-term forecast- absorb such losses to stay in the game until exchange rates
ing tools such as technical-based trend-following trading eventually become more highly trended.
rules. In addition, there has recently been significant inter-
est in flow, sentiment, and positioning indicators to deter- The evidence on flow, sentiment, and positioning surveys
mine the exposure of market participants to the individual suggests that these indicators should be viewed more as
currencies. Such indicators are often used as contrarian contemporaneous rather than as leading indicators of ex-
indicators to determine whether a currency is significantly change-rate movements. We argue that such indicators can
overbought or oversold, and thus ripe for a correction. be useful as confirmation indicators in conjunction with
traditional trend-following trading rules in formulating short-
Given the wide variety of forecasting approaches, we term FX strategies.
thought it would be useful to put together a guidebook
that summarized each of those approaches in an easy-to- In the chapter entitled "Exchange Rate Determination in
read format. Our intention was to create a user-friendly the Long Run," we explore the fundamental forces that
format where the written text was purposely kept to a give rise to long-term cycles in exchange rates. The chap-
minimum and where the charts and tablesabout 400 in ter begins by noting that deviations from estimated PPP
allwould tell the story. values have tended to be large and persistent, suggesting
that fundamental forces other than relative national infla-
This guidebook recognizes that the tools required for short- tion rates have played a key role in driving the long-term
term investors differ significantly from those needed for path that exchange rates have taken. We investigate a va-
medium and long-term currency managers. Hence, the riety of fundamental variables that have had some suc-
guidebook devotes separate chapters to the determina- cess in explaining the long-term path that currencies have
tion of exchange rates over short, medium, and long-term taken, including relative productivity growth, persistent
horizons. trends in a country's terms of trade, long-term trends in
net foreign asset and liability positions, and long-term
trends in national savings and investment.
Exchange-Rate Determination
in the Short, Medium, and Long Run
Bandwagon Effect/
Purchasing Power Parity
Trend-Following Behavior
Real Current
Account Capital
Interest-Rate
Differentials Trends Flows
Relative
Monetary Fiscal Portfolio-Balance
Economic
Policy Policy Considerations
Growth
In the chapter entitled "Exchange Rate Determination in The overall conclusion one draws from a variety of empiri-
the Medium Run," we investigate a wide range of cyclical cal studies is that the success of early-warning systems in
forces that have caused currencies either to rise or fall on terms of generating correct out-of-sample projections is
a medium-term basis relative to their long-run equilibrium mixed. While most early-warning models can point to a
path. In many cases, these medium-term deviations from significant number of correctly predicted crises, those
the long-run equilibrium path have been quite sizeable and same models also have a tendency to generate a sizable
persistent. We find that medium-term trends are influenced number of false alarms and missed crises.
by a variety of macroeconomic indicators such as the trend
in real interest-rate differentials, current and capital-account Perhaps all that one can say after reviewing all the differ-
balances, relative monetary and fiscal policies, relative eco- ent approaches to exchange-rate determination is that no
nomic growth, and portfolio-balance considerations. single approach has a monopoly on being right all of the
time. Some strategy systems such as moving-average trad-
Finally, in the chapter entitled "Anticipating Currency Cri- ing rules and forward-rate bias strategies appear to have a
ses in Emerging Markets," we set out to identify those long-run track record of success, but one needs to be mind-
economic and financial variables that have had success in ful that there were a number of periods in the past when
correctly predicting whether an emerging-market currency significant losses were incurred from following these strat-
might be vulnerable to a speculative attack, and whether it egies. Likewise, some key fundamental variables may have
is possible to construct an early-warning system that can closely tracked the trend in exchange rates in the past, but
successfully pinpoint when a speculative attack might oc- there is no guarantee that they will continue to do so in
cur. Empirical research finds that crises-prone currencies the future. If divergent trends begin to set in, fund manag-
typically display a number of classic symptoms that warn ers must decide whether to disregard the trend in those
of an impending attack. Those symptoms include exces- key fundamental variables or not.
sive real appreciation of the emerging-market currency,
weak domestic economic growth, rising unemployment, Although many fund managers might prefer to follow a
an adverse terms of trade shock, deteriorating current-ac- rigid rule or trading system for formulating FX strategies,
count balances, excessive domestic credit expansion, bank- one should not sell short a judgment-based approach to
ing-system difficulties, unsustainably large government currency investment management. In the end, successful
budget deficits, overly expansionary monetary policies, a FX management is based as much on "art" as it is on "sci-
high ratio of M2 money supply to reserves, foreign-ex- ence."
change reserve losses, falling asset prices, and/or a huge
build-up in short-term liabilities by either the private or public
sector.
Exchange-Rate Determination
in the Short Run
A Stylized Model of Exchange-Rate Overshooting
at the End of a Long-Term Uptrend
Currencys
Value
Economic Fundamentals
Time
Market Sentiment
(Consensus Inc. Index of Bullish Opinion)
Speculative Positioning
(Net IMM Contracts)
Order Flow
(DB Customer Order Flow Database)
q L qL q qU qU
Real Exchange Rate
Source: Adapted from DeGrauwe (1996)
How FX Dealers View the Determination of Exchange Rates in the Short Run
When FX dealers were asked recently what role funda-
FX Dealers Perception of the Role of Fundamentals
mental factors played in the determination of exchange
in Explaining Exchange-Rate Movements
rates, 97% of the respondents felt that fundamentals
played no role on an intra-day basis. However, over me- FX Dealer Survey QuestionDo You Believe Exchange-Rate
dium and longer-term horizons, FX dealers felt that funda- Movements Reflect Changes in Fundamental Value on an:
mental forces did play an important role, with 57.4% of
the respondents believing that exchange rates reflect fun- Intraday Medium-Run Long-Run
Basis Basis Basis
damental value on a medium-term (within six months)
(up to 6 months) (beyond 6 months)
basis, and 87% believing exchange rates reflect fundamen-
tal value on a long-term (over six months) basis. Yes 3% 57.8% 87%
No 97% 42.2% 12%
When asked to rank the most important determinants of No Opinion 0% 0.0% 1%
exchange rates on an intra-day basis, FX dealers indicated Source: Yin-Wong Cheung, Menzie D. Chinn, and Ian W. Marsh,
that bandwagon effects, speculative forces, and over-re- How Do UK-Based Foreign Exchange Dealers Think Their Market Operates?,
NBER Working Paper 7524, February 2000.
action to news were the principal driving forces in the very
short run. On a medium-term basis, economic fundamen-
tals and technical trading increase in importance from the
dealer community's perspective, but FX dealers also con- FX Dealers Perception of the Most Important Factor
tinued to assign importance to speculative forces as a key That Explains Exchange-Rate Movements
determinant of medium-term trends in exchange rates. For
longer horizons, FX dealers believed that economic funda- FX Dealer Survey QuestionSelect the Single Most Important
mentals were the dominant factor driving exchange rates. Factor that Determines Exchange Rate Movements on an:
However, a not insignificant number (11.3%) believed that
Intraday Medium-Run Long-Run
technical trading was important even in the long run.
Basis Basis Basis
(up to 6 months) (beyond 6 months)
The FX dealer survey also asked dealers whether they
thought that exchange rates were more predictable on an Bandwagon Effects 29.3% 9.5% 1.0%
intra-day basis or on a medium-term (up to six months) or Over-reaction to News 32.8% 0.7% 0.0%
long-term (beyond six months) basis. FX dealers were Speculative Forces 25.3% 30.7% 3.1%
Economic Fundamentals 0.6% 31.4% 82.5%
asked to assign a rating of 1 if there was no predictability, Technical Trading 10.3% 26.3% 11.3%
a rating of 5 if there was a high predictability and a rating Other 1.7% 1.5% 2.1%
of 2, 3, or 4 if there was low, medium, or better than aver-
age predictability, respectively. Since FX dealers tend to Source: Yin-Wong Cheung, Menzie D. Chinn, and Ian W. Marsh,
How Do UK-Based Foreign Exchange Dealers Think Their Market Operates?,
trade on an intra-day basis, one might have thought that NBER Working Paper 7524, February 2000.
they would assign a high rating to exchange-rate predict-
ability on an intra-day basis. This was not the case. Indeed,
62% of the dealer respondents gave ratings of 1 or 2, to
the predictability of exchange rates in the short run, while FX Dealers Perception of the Predictability of
only 11% gave ratings of 4 or 5. Exchange-Rate Movements
For medium and longer time horizons, the confidence in FX Dealer Survey QuestionOn a Scale of 1 to 5, Indicate If You
exchange-rate predictability increases, with 30.4% of deal- Believe the Market Trend Is Predictable on an:
ers assigning a ranking of 4 or 5 on a medium-term basis
Intraday Medium-Run Long-Run
and 35.1% assigning a ranking of 4 or 5 on a longer-term
Basis Basis Basis
basis. The question that we need to ask ourselves is: if FX (up to 6 months) (beyond 6 months)
dealers are more confident in predicting exchange rates
on a medium/long-term basis rather than on an intra-day 1 (Least Predictable) 21.6% 5.9% 17.2%
basis, why then do traders concentrate their energies on 2 40.3% 20.7% 16.4%
very short-run trading? The answer might be that traders 3 26.9% 43.0% 30.6%
4 9.0% 18.5% 20.9%
are in a better position to evaluate and manage FX risk on 5 (Most Predictable) 2.2% 11.9% 14.2%
a short-term basis, which overrides their greater confidence
in medium/long-term exchange-rate predictability. Source: Yin-Wong Cheung, Menzie D. Chinn, and Ian W. Marsh,
How Do UK-Based Foreign Exchange Dealers Think Their Market Operates?,
NBER Working Paper 7524, February 2000.
Technical Analysis:
The Advantage of Trading
With and Not Against the Trend
Market Price
Exchange Rate
Trendline
Fundamental Analysis:
May prematurely recommend Todays
selling a currency that has Spot
overshot its long-run Rate
equilibrium level.
Long-Run Equilibrium
Exchange Rate
Technical Analysis:
Even though a currency overshoots its
long-run equilibrium level, a technician
will recommend maintaining long positions
as long as the trend in the exchange
rate is up.
Time
Source: Rosenberg (1996)
Trough2 Peak3
Trough2
Peak1
Trough 3
Trough1 Market Price
Trendline
Trendline
Head Right Shoulder
Market Price Neckline
Left Shoulder
Market Price
lating the recent past trend of exchange rates into the fu- T
ture, buy or sell signals will be issued only after a currency Time
has already started rising or falling. Although this means
that trend-following trading rules will not capture the very
top and bottom of market moves, they may nevertheless
be profitable if the ensuing exchange-rate movements per- Moving-Average Crossover Strategy
sist long enough and carry far enough to generate signifi- DM/US$
cant excess returns.
S LRMA
B
SRMA
Time
x%
Market-Swing
Requirement
P1
B1
B S1
x%
T T1
Time Time1
DEM Mov. Avg. Days 1/32 1/33 1/31 1/28 1/30 1/29 1/34 1/20 1/35 1/19
Total Return (%) 5.01 4.89 4.38 4.20 3.96 3.88 3.98 3.58 3.43 3.13
Std. Dev. (%) 11.06 11.06 11.06 11.06 11.06 11.06 11.06 11.06 11.06 11.06
Sharpe Ratio 0.45 0.44 0.40 0.38 0.36 0.35 0.36 0.32 0.31 0.28
JPY Mov. Avg. Days 8/59 8/60 7/61 8/61 7/60 9/60 9/62 9/61 8/62 8/63
Total Return (%) 9.19 9.16 8.83 8.86 8.76 8.79 8.63 8.63 8.53 8.49
Std. Dev. (%) 11.75 11.75 11.75 11.75 11.75 11.75 11.75 11.75 11.75 11.75
Sharpe Ratio 0.78 0.78 0.75 0.75 0.75 0.75 0.73 0.73 0.73 0.72
GBP Mov. Avg. Days 1/19 1/18 1/20 1/21 1/22 1/16 1/24 1/15 1/17 1/23
Total Return (%) 5.80 5.45 5.36 5.32 5.28 5.20 4.91 4.82 4.80 4.49
Std. Dev. (%) 9.46 9.47 9.46 9.46 9.46 9.47 9.45 9.47 9.47 9.45
Sharpe Ratio 0.61 0.58 0.57 0.56 0.56 0.55 0.52 0.51 0.51 0.48
CHF Mov. Avg. Days 1/57 1/59 1/58 1/56 1/60 1/55 1/69 1/54 1/61 1/65
Total Return (%) 8.63 8.44 8.40 8.40 7.87 7.79 7.50 7.24 7.21 6.84
Std. Dev. (%) 11.65 11.64 11.66 11.65 11.63 11.66 11.63 11.66 11.63 11.64
Sharpe Ratio 0.74 0.72 0.72 0.72 0.68 0.67 0.65 0.62 0.62 0.59
CAD Mov. Avg. Days 14/199 14/200 14/197 13/197 14/198 13/198 15/195 15/193 15/194 14/196
Total Return (%) 1.88 1.88 1.86 1.83 1.82 1.81 1.75 1.66 1.64 1.59
Std. Dev. (%) 4.81 4.81 4.81 4.81 4.81 4.81 4.81 4.81 4.81 4.81
Sharpe Ratio 0.39 0.39 0.39 0.38 0.38 0.38 0.36 0.34 0.34 0.33
AUD Mov. Avg. Days 13/39 13/38 13/40 1/16 13/42 13/41 14/43 13/37 13/43 13/45
Total Return (%) 3.53 3.44 3.41 2.99 2.73 2.54 2.45 2.44 2.37 2.34
Std. Dev. (%) 10.30 10.31 10.28 10.29 10.28 10.28 10.28 10.31 10.28 10.28
Sharpe Ratio 0.34 0.33 0.33 0.29 0.27 0.25 0.24 0.24 0.23 0.23
NZD Mov. Avg. Days 10/17 11/15 10/18 10/15 11/17 14/196 10/16 11/20 11/16 11/14
Total Return (%) 5.20 4.99 5.10 4.76 4.67 4.28 4.28 4.41 3.85 3.38
Std. Dev. (%) 10.79 10.80 10.78 10.80 10.79 10.14 10.80 10.78 10.80 10.81
Sharpe Ratio 0.48 0.46 0.47 0.44 0.43 0.42 0.40 0.41 0.36 0.31
Note: A Sharpe Ratio measures the amount of return on an investment (less the return of a risk-free asset) per unit of risk, which is proxied by its standard deviation.
Datastream is the source of the underlying exchange-rate data.
Given the Sharpe ratios shown in the table on the preced- one-year rolling basis. As the charts below show, there
ing page, one might wonder why more investors do not were periods when risk-adjusted return performances were
rely on trend-following trading rules more regularly. One high and other periods when risk-adjusted return perfor-
reason is that investors might have a fairly high Sharpe mances were downright poor. This was clearly the case
ratio threshold for committing capital to any particular trad- for several key exchange rates in 2001, with one-year roll-
ing strategy. For instance, many investors might not em- ing Sharpe ratios falling into negative territory for the Deut-
brace a trading strategy rule unless it generated a Sharpe schemark, British pound, and Swiss franc.
ratio of at least 0.50. And in some cases, an even higher
Sharpe ratio might be required for an investor to add sig- Except for the yen and the dollar-bloc currencies, total re-
nificant risk capital to a particular trading rule. If that were turn performances were not that impressive in 2001. In
the case, only the yen and Swiss franc would qualify as most cases, currencies were largely range-bound versus
currencies worthy of trading from a technical perspective. the U.S. dollar in 2001 and therefore generated a consider-
able number of false signals that yielded small but fre-
While the estimated Sharpe ratios may have been high on quent losses. On the other hand, the yens downtrend
average for the 1986-2002 period, one should note that particularly in late 2001was clearly evident and exploit-
the Sharpe ratios were highly volatile when viewed on a able by following a moving-average crossover trading rule.
2
2
1
1
0
0
-1
-1
-2
-3 -2
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
2
2
1
1
0
0
-1
-1
-2
-3 -2
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Average Annual Return 5.0% 9.2% 5.8% 1.9% 3.5% 5.2% 8.6%
Standard Deviation of Returns 11.1% 11.8% 9.5% 4.8% 10.3% 10.8% 11.7%
Sharpe Ratio 0.45 0.78 0.61 0.40 0.34 0.48 0.74
Average Profit on Winning Trades 2.97% 5.92% 2.27% 3.69% 2.03% 2.11% 4.63%
Average Profit on Losing Trades -0.77% -1.72% -0.62% -1.03% -0.63% -0.84% -0.84%
Ratio of Profits/Losses 3.86 3.44 3.66 3.58 3.22 2.51 5.51
Note: A Sharpe Ratio measures the amount of return on an investment (less the return of a risk-free asset) per unit of risk,
which is proxied by its standard deviation.
Datastream is the source of the underlying exchange-rate data.
40
150
30
100
20
Source: Datastream
50 Source: Datastream
10
0 0
.9 2.0 1.1 0.2 0.7 1.6 2.5 3.4 4.3 5.2 6.1 7.0 7.9 8.8 9.7 0.6 1.5 2.4 3.1 -5.4 -2.1 1.3 4.6 8.0 11.4 14.7 18.1 21.4 24.5
-2 - - - 1 1 1 1
Return(%)
Return(%)
250 25
200 20
150 15
100 10
Source: Datastream Source: Datastream
50 5
0
.1 2.8 1.4 0.1 1.2 2.5 3.8 5.2 6.5 7.8 9.1 0.4 1.8 3.1 4.4 5.7 7.0 8.3 9.7 1.0 2.3 3.6
0
-4 - - - -2.46 0.81 4.07 7.34 10.6 13.6
1 1 1 1 1 1 1 1 2 2 2
Return(%)
Return(%)
120
100 60
80
40
60
Source: Datastream Source: Datastream
40
20
20
0 0
-5.
73 4.13 2.52 0.91 0.69
- - - 2.3 3.9 5.51 7.12 8.72 0.33 1.93 3.54 5.15 16.2 -2.4 -1.7 -1.0 -0.4 0.3 1.0 1.7 2.3 3.0 3.7 4.4 5.1 5.7 6.4 6.8
1 1 1 1
Return(%)
Return(%)
Profit and Losses on Individual DEM Trades Profit and Losses on Individual JPY Trades
(Generated by Moving-Average Crossover Strategy) (Generated by Moving-Average Crossover Strategy)
(Most Recent 140 Trades) (1986-2002)
Returns(%) Returns(%)
10 30
8 25
20
6
15
4
10
2
5
0
0
-2 -5
Datastream is the source of the Datastream is the source of the
underlying exchange-rate data. underlying exchange-rate data.
-4 -10
12-27-95 04-21-97 03-27-98 01-14-99 11-08-2000 10-02-2001 01-01-87 12-27-89 02-02-94 01-23-98 03-07-2002
Trade Dates Trade Dates
Profit and Losses on Individual GBP Trades Profit and Losses on Individual CAD Trades
(Generated by Moving-Average Crossover Strategy) (Generaged by Moving-Average Crossover Strategy)
(Most Recent 140 Trades) (1986-2002)
Returns(%) Returns(%)
6 20
5
15
4
3 10
2
1 5
0
0
-1 Datastream is the source of the
Datastream is the source of the
underlying exchange-rate data. underlying exchange-rate data.
-2 -5
06-12-97 06-01-98 01-27-99 01-03-2000 01-12-2001 09-24-2001 11-03-86 06-23-89 11-02-90 09-16-94 04-25-96 01-14-97 08-06-99
Trade Dates Trade Dates
Et Et Et
Market Sentiment and the U.S. Dollar Market Sentiment and the U.S. Dollar
(Consensus Inc. Index of Bullish Opinion) (Consensus Inc. Index of Bullish Opinion)
(1998-1999) (April 2000-November 2001)
Analysts Bullish on the US$(4-Week Avg.)(%)____ US$ Index---- Analysts Bullish on the US$(4-Week Avg.)(%)____ US$ Index----
90 102 90 108
80 100 80 106
104
70 98 70
102
60 96 60
100
50 94 50
98
Based on Consenus Inc. Index of Bullish Market Opinion
40 92 40 By permission of Consensus, Inc., (1) (816) 373-3700,
Sources: Datastream; Consensus, National Futures and Financial Weekly, 96
Based on Consenus Inc. Index of Bullish Market Opinion www.consensus-inc.com
30 90 30 94
Jan-98 Apr-98 Jul-98 Oct-98 Jan-99 Apr-99 Jul-99 Oct-99 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01
Speculative Positioning and the U.S. Dollar Assessing the Statistical Significance of
(IMM Derived Net Non-Commercial FX Positions)
(April 2000-November 2001) Sentiment/Positioning/Flow Variables as
Sum of Net Contracts vs. USD(000s)____ US$ Index----
100 108
Explanatory Variables of Exchange-Rate Movements
(January 15, 1999-November 2, 2001 Weekly Data)
106
50 Lagged
104 Contemporaneous One Period
Lagged
Contemporaneous One Period (+)
Euro Risk Reversals & US$/Euro Exchange Rate Yen Risk Reversals & Yen/US$ Exchange Rate
Euro Calls(+)/Puts(-) Trading at Premium vs. USD Yen Calls(+)/Puts(-) Trading at Premium vs. USD
Calls(+)/Puts(-) Trading at Premium____ US$/Euro---- Calls(+)/Puts(-) Trading at Premium____ Yen/US$(reverse scale)----
1.5 0.98 3.0 (100)
0.96 (105)
1.0 2.0
0.94 (110)
0.90 (120)
0.0 0.88 0.0 (125)
0.86 (130)
-0.5 -1.0
0.84 (135)
Source: Datastream; DB Source: Datastream; DB
-1.0 0.82 -2.0 (140)
Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02
One could envisage a marketplace where there exists both Given the potential impact that order flow can have on
private and publicly available information. Publicly available exchange rates in the short run, a large FX dealer's order
information consists largely of macroeconomic-related book can provide valuable information to both traders and
data, which is available to all market participants at the investors who wish to keep abreast of underlying private
same time. However, there may be microeconomic-related investor shifts in portfolio behavior, whether those shifts
information that is important for exchange rates, but is not are of a macro or micro-economic nature.
Publicly
Available
Information
Change
Portfolio Order in
Shifts Flow Exchange Rate
Information
Not Publicly
Available
Fundamental Analysis--46.2%
Fundamental Analysis--36.3%
Technical Analysis--40.2%
Flow Analysis--16.8%
Flow Analysis--23.5%
Technical Analysis--37.0%
Source: Gehrig and Menkhoff (2002) Source: Gehrig and Menkhoff (2002)
Fundamental Analysis--32.4%
Intraday--25.4%
A Few Days--37.3%
Technical Analysis--41.4%
Flow Analysis--26.2%
A Few Weeks--21.9%
Source: Gehrig and Menkhoff (2002) Source: Gehrig and Menkhoff (2002)
107
5
106
0 105
104
-5
103
Source: DB, Datastream
-10 102
Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01
30
20
10
-10
Source: Russell Mellon
Source: Russell Mellon, Datastream
-20
1996 1997 1998 1999 2000 2001 2002
10
-10
-20
-5
-10
-15
12
10
2
Source: Based on the Russell Mellon Survey
0
1996 1997 1998 1999 2000 2001 2002
1400
10
1200
1000
0
800
600 -10
400
Source: Bloomberg, Datastream
200 -20
1994 1995 1996 1997 1998 1999 2000 2001 2002
15
5
10
0
5
-5
0
-10
-5
-15 -10
1998 1999 2000 2001 2002
Long-Run
Equilibrium
Path
Time
The evidence on PPP suggests that there are often signifi- 45 degrees
cant and persistent departures from PPP in the short and
1.0 2.0 Exchange Rate
medium run. One key reason is that arbitrage in tradable
(DM/US$)
goods might be limited by transaction costs, tariffs, and Source: Rosenberg (1996)
entry and exit barriers. If such barriers to arbitrage were
significant, a large "zone of inaction" might exist whereby
firms would be unwilling to arbitrage traded-goods prices,
and thus significant departures from PPP would exist over
a certain range of exchange-rate movements. Real ex-
change rates would fluctuate randomly inside this zone of
inaction, but if the real exchange rate moved outside of
the transaction bands, arbitrage would finally become prof-
itable enough to bring the real exchange rate back inside
the zone of inaction.
Real
Exchange Rate
(q)
q
q
Time
The Response of Real Exchange Rates The Response of Real Exchange Rates
to Changes in Relative Prices to Changes in Nominal Exchange Rates
When Nominal Exchange Rates are Fixed When Relative Prices Levels are Stable
e$
e$
(pE /pUS)
(pE/pUS)
Time Time
Real Real
Exchange Rate Exchange Rate
(q$) (q$)
q$ q$
q$ q$
Time Time
PPP
% Overvalued
(+)
(0)
Time
(-)
% Undervalued
Weighted-Average Trend
in Fundamentals
Economic Fundamentals
Time
Substantial Negative--18.1%
Source: Federal Reserve
Bank of Philadelphia
Substanial Positive--0.0%
No Effect--43.6%
We are writing to tell you that at current levels the exchange value of the dollar is having a strong
negative impact on manufacturing exports, production, and employment. A growing number of American
factory workers are now being laid off principally because the dollar is pricing our products out of
markets both at home and abroad. Small firms are being affected as well as large ones. As you
balance your responsibilities for international monetary stability and domestic economic growth, we
ask that you take into account the growing burden an overvalued dollar is imposing on U.S. manufacturing.
Since early 1997 the dollar has appreciated by 27 percent. Industries such as aircraft, automobiles and
parts, paper and forest products, machine tools, medical equipment, steel, and other capital goods
as well as consumer goods producers are being affected very significantly. No amount of cost
cutting can offset a nearly 30 percent dollar markup.
The total effect on the U.S. economy is staggering. These output losses are particularly serious at this
time, as they coincide with a general economic slowdown. The economic fundamentals have changed
dramatically in the last six months. Production and profitability are down, and manufacturing employment
has fallen by more than a half million jobs since mid-2000. Yet, in the face of slowing economic growth,
declining interest rates, and rising manufacturing unemployment, the dollar has remained high.
In our view, a clarification of Treasury policy is in order, to be certain that it is not seen as endorsing an
ever stronger dollar irrespective of the economic fundamentals. We urge the Treasury to make it clear
that the value of the dollar should be consistent with economic reality and market conditions. This
policy should be buttressed by a commitment to further reductions in interest rates and to cooperating
in exchange markets as appropriate. Moreover, it is vital that the Treasury not condone currency
manipulation by trading partners seeking to make their exports more competitive.
Mr. Secretary, 18 million workers and their families depend directly on the continued strength and
competitiveness of American manufacturing. Many more Americans rely on stockholdings in our
companies for their retirement income. We would like to meet with you to describe more fully the
effects the value of the dollar is having on us. We hope you will be able to accommodate our request.
Respectfully,
CPI-Based Purchasing Power Parity (PPP) Estimates PPI-Based Purchasing Power Parity (PPP) Estimates
March 15, 2002 PPP % Over/ March 15, 2002 PPP % Over/
Currency (vs. US$) Spot Rate Estimate Under-Valued Currency (vs. US$) Spot Rate Estimate Under-Valued
Swedish Krona 10.32 7.02 -47.0 Swedish Krona 10.32 7.73 -33.4
Canadian Dollar 1.59 1.24 -27.7 Euro 0.88 1.14 -22.7
Australian Dollar 0.53 0.72 -27.5 Australian Dollar 0.53 0.67 -22.1
N.Z. Dollar 0.44 0.60 -27.2 Swiss Franc 1.66 1.38 -20.0
Euro 0.88 1.18 -25.4 Deutsche Mark 2.21 1.85 -19.8
Norwegian Krone 8.78 7.11 -23.5 N.Z. Dollar 0.44 0.52 -15.9
Deutsche Mark 2.21 1.80 -22.9 Norwegian Krone 8.78 7.75 -13.3
Danish Krone 8.41 7.07 -18.9 Danish Krone 8.41 7.46 -12.8
Swiss Franc 1.66 1.45 -14.5 Canadian Dollar 1.59 1.43 -11.2
Japanese Yen 129.06 117.32 -10.0 Japanese Yen 129.06 117.36 -10.0
British Pound 1.43 1.55 -8.0 British Pound 1.43 1.46 -2.6
US$ Index 117.18 96.32 21.7 US$ Index 117.18 104.22 12.4
40
20
-20
-40
Source: www.economist.com
-60
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The Yen and Relative Export Prices The Yen and Relative Consumer Prices
Yen/US$____ Japan/U.S. Export Prices---- Yen/US$____ Japan/U.S. Consumer Prices----
350 1.20 350 1.20
The Yen and Relative Unit Labor Costs The Yen and Relative Producer Prices
Yen/US$____ Japan/U.S. ULCs---- Yen/US$____ Japan/U.S. Wholesale Prices----
350 1.50 350 1.80
1.30
250 250 1.40
1.20
200 200 1.20
1.10
150 150 1.00
1.00
% Change in % Change in
Relative Inflation Relative Inflation
50 50
40 40
30 30
20 20
10 10
0 0
-10 -10
-20 -20
-30 -30
-40 -40
-50 -50
-50 -40 -30 -20 -10 0 10 20 30 40 50 -50 -40 -30 -20 -10 0 10 20 30 40 50
% Change in Exchange Rate % Change in Exchange Rate
% Change in % Change in
Relative Inflation Relative Inflation
50 50
40 40
30 30
20 20
10 10
0 0
-10 -10
-20 -20
-30 -30
-40 -40
-50 -50
-50 -40 -30 -20 -10 0 10 20 30 40 50 -50 -40 -30 -20 -10 0 10 20 30 40 50
% Change in Exchange Rate % Change in Exchange Rate
Adapted from Peter Isard, Hamid Faruqee, G. Russell Kincaid, and Marin Fetherston,
Methodology for Current Account and Exchange Rate Assessments,
IMF Occasional Paper 209, 2001.
If a currency's real long-run equilibrium value is determined When structural changes on those three fronts occur, how-
by the interaction of savings, investment, and external- ever, the real long-run equilibrium exchange rate will ei-
balance considerations, its value would be constant over ther rise or fall in response to those changes. A structural
time only if there were no structural changes on the sav- rise in investment, a sustained move toward fiscal stimu-
ings, investment, or external-balance fronts over the rel- lus, or a persistent decline in private savings should give
evant time period. (This is illustrated in the top diagram.) rise to a trend increase in the real long-run equilibrium ex-
change rate over time, as shown in the bottom diagram.
The opposite would give rise to a trend decline in the real
long-run equilibrium exchange rate.
Equilibrium Real
Exchange Rate (q)
$
q1
Investment-Spending
Schedule Stable Over Time
S-I1
CAB1
Equilibrium Real
Exchange Rate (q)
'
q4
(
q3
S-I4
q2 %
$
Structural
S-I3 q1
Shifts in
Investment
Spending
S-I2
CAB1
S-I1
CAB2
yen's real long-run equilibrium value. Japan's fiscal stance
Structural
was tightening, investment spending was declining, and, Improvement
in Current
at the same time, Japan's current-account surplus was Account
CAB1
undergoing a structural deterioration as competition from
Asia intensified. As illustrated in the bottom diagram, those
forces combined to cause the yens equilibrium value to (-) (0) (+) Savings minus Investment,
Current-Account Balance
decline from q1 to q2.
S-I1
Structural
Decrease in
q1
$ Investment or
Govt Spending
Chinn and Alquist (2000) M1, GDP, Short-Term Interest Rates, CPI, 1.19-1.28
Ratio of Nontraded/Traded Goods Prices
Lorenzen and Thygessen (2000) Net Foreign Assets, R&D Spending, 1.17-1.24
Demographics,
Ratio of Nontraded/Traded Goods Prices
Clostermann and Schnatz (2000) Real Long-Term Yield Spread, Oil Price, 1.13
Government Spending,
Ratio of Nontraded/Traded Goods Prices
Many economists cite the rise in U.S. productivity growth Productivity Growth Rates
relative to productivity growth overseas beginning in the (Percentage Changes in Multifactor Productivity)
second half of the 1990s as one of the key variables that
drove the dollar sharply higher versus most major curren- 1990-95 1996-99
cies. Clearly, the gains in productivity were a uniquely U.S. (%) (%)
phenomenon. A recent Federal Reserve Board Study found U.S. 0.79 1.47
that multifactor productivity growth in the U.S. surged in Canada 0.26 0.27
France 0.89 1.12
the second half of the 1990s, while it decelerated in Japan
Germany 1.02 1.07
and was broadly unchanged in Euroland. Italy 1.32 -0.14
Japan 1.31 0.85
Fed Chairman Alan Greenspan has been a strong advo- U.K. 1.21 0.95
cate of the thesis that the dollars seven-year uptrend was Australia 1.15 2.11
productivity-related. According to Mr. Greenspan, "The evi- Denmark 2.37 0.31
Norway 2.48 1.13
dent strengthened demand for the dollar, relative to the Switzerland -0.57 0.84
euro, has reflected a market expectation that productivity
Source: Gust, C. and Marquez, J., Productivity Developments Abroad,
growth in the United States is likely to be greater than in Federal Reserve Bulletin, October 2000.
continental Europe in the years ahead."
The importance of relative productivity growth as a key U.S. and Euroland Productivity
(Derived from OECD Calculations of
determinant of the dollar's value versus the euro can be Unit Labor Costs and Compensation Growth Rates)
gleaned from the accompanying charts. U.S. and Euroland (Index) U.S.____ Euroland----
3000
labor productivity growth did not differ by much in the 1980s
and early 1990s. But beginning in 1995, U.S. productivity 2500
growth surged relative to the trend in Euroland. Indeed,
the trend in long-term Euroland/U.S. relative productivity 2000
growth appears to explain a large portion of the 1995-2000
slide in the euro's value versus the U.S. dollar. 1500
1000
500
Source: OECD Economic Outlook
0
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
1.1
1.30
1.0
1.20
0.9
1.10
0.8
1.00
0.7
Source: OECD Economic Outlook
0.6 0.90
87 88 89 90 91 92 93 94 95 96 97 98 99 00
1.0
0.4 0.4 0.4
0.4 0.8
0.3 0.3
0.6 0.5 0.5
0.4
0.2 0.4 0.3
0.2 0.2
0.2
0.0 0.0
U.S. U.K. Japan Germany France Italy Canada U.S. U.K. Japan Germany France Italy Canada
U.S. Productivity Gains and the DollarIs the Dollar Now Fairly or Over-Valued?
A new study by McKinsey & Company, Inc. ("U.S. Produc- ity. Interestingly, the study finds that of the 59 sectors of
tivity Growth: 1995-2000") sheds additional light on the the U.S. economy that were investigated, only six sectors,
sources of the U.S. productivity surge. The McKinsey study representing 28% of the economy, contributed to the 1995-
contends that U.S. productivity increased in the 1995-2000 2000 productivity gains. The six sectors that made sub-
period for both cyclical and structural reasons. The study stantial contributions to U.S. productivity growth were: 1)
finds that U.S. labor-productivity growth rose from an aver- wholesale trade, 2) retail trade, 3) security and commod-
age 1.4% per annum over the 1987-95 period to an aver- ity brokers, 4) electronic equipment/semiconductor firms,
age 2.5% per annum over the 1995-2000 period, with only 5) industrial equipment/computer firms, and 6) telecom
about one-half of the incremental gains projected to be services. The other 53 sectors, representing 72% of the
long-lasting. economy, made either small positive or negative contribu-
tions that effectively washed each other out for a net-zero
The McKinsey study projects that U.S. labor productivity contribution to the U.S. economy's total productivity gains.
growth will ease a bit toward an average 2.0% per annum
pace over the next five years as the influence of shorter- Of concern to both the U.S. economy and the dollar is the
run cyclical factors washes out. While this would repre- fact that 72% of the overall U.S. economy did not partici-
sent a slowdown from the 1995-2000 pace, it would nev- pate in the productivity gains registered in the past five
ertheless exceed the pace of productivity growth in 1987- years. The dollar rose strongly because the gains regis-
95. tered by the other 28% were so powerful that they were
able to boost the overall U.S. economy's productivity
A 0.5% per annum increase in labor-productivity growth growth far above the pace of productivity growth in
might not seem like a lot, but if such a gain were sus- Euroland and elsewhere. For those sectors that enjoyed
tained over a 10-year period, it could contribute up to $1.2 strong productivity gains, the dollar's rise has not dented
trillion in additional surpluses on the U.S. Federal govern- their overall competitiveness, as the positive effects of a
ment budget balance. It could also cut the cost of a 50- relative rise in productivity have effectively offset the nega-
year fix to Social Security in half. tive effects of a rising dollar. But the other 72% that did
not participate in the productivity surge have been left to
The McKinsey study finds that the gain in U.S. labor pro- compete in world markets with an overvalued exchange
ductivity over the 1995-2000 period was more than just an rate without an offsetting gain in productivity. That is why
IT story. The study contends that regulatory changes, strong a large number of U.S. firms have begun to complain that
competition, better management, and favorable cyclical the dollar's strength is negatively affecting their long-run
factors all played a positive role in boosting U.S. productiv- competitiveness.
40
20
Source: Datastream
-20
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
1987-95 1995-99
Productivity Productivity
Growth Growth
3.2
3
1.2
1.0
1
0.4 0.4
0
1970-80 1980-90 1990-99
1 -1.6
-2
0.2 -2.3
0 -3
1970-80 1980-90 1990-99 1970-80 1980-90 1990-99
-1.0
2 1.8
-2
1.2
1 0.9
-4
-4.9
0 -6
1970-80 1980-90 1990-99 1970-80 1980-90 1990-99
Changes in a country's terms of trade can, at times, exert In the case of the euro, the price of oil has been found to
a strong influence on the direction that exchange rates be an important explanatory variable, with higher oil prices
take. For instance, in commodity-oriented industrial econo- contributing to a weaker euro, and vice versa. A recent
mies such as Australia, New Zealand, and Canada, where Bank of Canada study found that a similar relationship held
commodity exports make up a large part of GDP (relative between energy prices and the C$, with higher energy
to the rather small shares in the G3 economies), one finds prices bearish for the C$ and lower energy prices bullish
a strong positive relationship between the trend in relevant for the C$.
commodity-price indices and the trend in the A$, NZ$, and
C$, respectively. A recent study by the central bank of Norway (Norges Bank)
finds that there is a non-linear relationship between oil
prices and the Norwegian krone. A change in oil prices
Commodity Exports as a Percentage of GDP tends to have a larger impact on the krone's value when
(for Selected Industrial Countries)
(%) the price of oil is below $14 a barrel or above $20 a barrel.
25 When oil prices fluctuate inside the $14-$20 range, the
impact of oil price changes on the krone's value is found
20 19.4 to be insignificant.
15
12.1 12.0
Source: OECD
10
5.2
5 3.7
1.8
0.5
0
N.Z. Canada Australia UK Germany U.S. Japan
The Australian Dollar and Commodity Prices The Canadian Dollar and Commodity Prices
Reserve Bank of Australia Commodity Price Index Bank of Canada Commodity (excl. Energy) Index
US$/A$____ RBA Commodity Price Index(US$-Terms)---- C$/US$(reverse scale)____ BoC Non-Energy Commod. Price Index----
1.00 120 (1.30) 140
The Euro and the Price of Oil The Norwegian Krone and the Price of Oil
(since April 1997) (since January 1999)
US$/Euro(reverse scale)____ Brent Oil(US$/bbl.)---- Nkr/DM(reverse scale)____ Brent Oil(US$/bbl.)----
(0.80) 40 (3.80) 40
35 35
(0.90) (4.00)
30 30
(1.00) (4.20)
25 25
20 20
(1.10) (4.40)
15 15
(1.20) (4.60)
10 10
Source: Datastream Source: Datastream
(1.30) 5 (4.80) 5
1997 1998 1999 2000 2001 2002 1999 2000 2001 2002
Several researchers have noted that there exists a posi- A second reason for the positive relationship between the
tive long-run relationship between a country's net interna- trend in net international investment positions and the trend
tional investment position as a percentage of GDP and its in real exchange rates is the effect of the transfer of wealth
real effective exchange rate. There are several reasons why implied by external-account imbalances. The cumulative
this relationship tends to hold. trend in current-account imbalances gives rise to shifts in
the residence of wealth from deficit to surplus countries,
First, exchange rates typically do not adjust to equilibrate and such wealth transfers give rise to portfolio adjustments
the current-account balance in each and every period. The that put upward pressure on surplus-country currencies
reason for this is that a deficit country may be able to at- and downward pressure on deficit-country currencies over
tract sufficient capital inflows to finance its deficit for a time.
considerable time. Indeed, if those inflows are consider-
able, the deficit country's currency might, in fact, rise even Given that most investors prefer to keep the bulk of their
as the current-account deficit widenswitness the U.S. wealth in domestic and not foreign-currency assetsthe
in 1981-85 and again in 1995-2002. so-called home-country biasinvestors in surplus coun-
tries will find themselves accumulating more foreign-cur-
If a country's current-account deficit rises persistently over rency assets than they desire relative to their domestic
time, however, there is likely to come a point when it can holdings. Over time, surplus country investors will attempt
no longer be easily financed. When that point is reached, a to rebalance their portfolios in favor of domestic-currency
currency's real value could then come under considerable assets. As they do, the surplus country's currency will tend
downward pressure. Hence, although the exchange rate to rise relative to the deficit country's currency. The Japa-
and the current-account imbalance may not appear to be nese yen and the Deutschemarkto a lesser degree
positively related on a monthly or quarterly basis, cumula- underwent long-term appreciations from the 1980s until
tive trends in current-account imbalances and exchange the mid-1990s as their cumulative current-account sur-
rates tend to be more closely aligned. pluses rose.
The Japanese Yen and the U.S./Japan The Deutschemark and the U.S./German
Cumulative Current-Account/GDP Differential Cumulative Current-Account/GDP Differential
/US$____ Cum. Curr.-Acct. as % of GDP Diff.---- (%) DM/US$____ Cum. Curr.-Acct. as % of GDP Diff.---- (%)
300 20 3.50 0
10
250 3.00 (10)
0
200 (10) 2.50 (20)
A final reason why the trends in net international invest- Although the U.S. has seen its net international investment
ment positions and real exchange rates are positively re- position deteriorate sharply in the past decade, the dollar
lated is that heavily indebted nations need to service their has nevertheless remained extraordinarily resilient. One
net external debts, and that can only be done if the debtor explanation is that, although U.S. external liabilities exceed
country runs a trade surplus to generate the income to U.S. external assets by a wide margin, the U.S. has tended
service those debts. In order for the debtor country to run to earn a higher return on its external assets than it has
a trade surplus consistently over time, the real exchange paid out on its external liabilities. The result has been that
rate of a debtor country would need to decline. Similarly, a net investment income flows, until recently, posted a mod-
country with a large cumulative current-account surplus est surplus. While U.S. net investment income flows have
would need to see its currency's real value rise over time recently swung into a modest deficit position, the deficit
to insure that the surplus and the associated net foreign does not appear to be sizeable enough at this stage to
asset position did not continue rising to unsustainably high seriously damage the dollar's long-run prospects.
levels.
30
0
20
-500
10
0
-1000
-10
-1500
-20
Source: Datastream Source: Datastream
-2000 -30
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
The dollar has exhibited a tendency to both rise and fall Third, at the end of each major cycle, there has been a
over long-term cycles, with each of the dollar cycles since tendency for the dollar to overshoot its long-run equilib-
the floating of exchange rates in 1973 sharing a number of rium level, often in a climactic fashion.
common features.
Finally, when the dollar has overshot its fair value at the
First, the magnitude of the dollar's exchange-rate move- end of a long cycle, the deviation in the dollar's value from
ments in each cycle has generally been large, often far its estimated PPP value has often given rise to serious
exceeding the forecasts of portfolio managers, market pun- imbalances on either the internal or external-balance fronts
dits and forward-exchange rates. in the U.S., Europe, or Japan. When those imbalances
reached a critical level, it often set market forces in motion
Second, the period of each dollar cycle has tended to be to bring the overshoot to an end, and to plant the seeds
long, often surpassing by a wide margin the typical length for a 180-degree shift in the dollar's long-term trend.
of U.S. and foreign business cycles. That would suggest
that cyclical factors alone cannot account for the tendency
of the dollar to move in large and protracted swings.
Source: Datastream
CAB1
S-I1
& &
q3 q3
Upward Revision in
% the Currencys Real %
q2 q2
Long-Run Equilibrium
$ Value over Time $
q1 q1
CAB3
Persistent
CAB2 Structural
Increases in
Current-Account
CAB1 Balance
Long-Term Cycles in Exchange Rates: The Dollar and Euro in the 1990s
Most long-term exchange-rate cycles are not driven by a In the case of the euro, its long-term decline since the
single shock to the internal or external-balance schedules, early 1990s also reflected a multitude of problems includ-
but rather by a series of separate, yet related shocks that ing: (1) pervasive structural rigidities in European labor and
reinforce one another in driving an exchange rate higher or product markets, (2) an adverse fiscal/monetary policy mix
lower over time. For instance, the dollar's long-term uptrend in Euroland, (3) higher oil prices, (4) an adverse structural
between April 1995 and November 2000 reflected a com- shift in Euroland capital flows, and (5) excessive pessimism
bination of favorable factors including: (1) "New Economy" regarding the potential problems associated with the launch
forces that helped propel U.S. investment spending and of the new euro notes and coins in early 2002.
productivity growth higher, (2) a structural shift in capital
flows from emerging markets and Euroland to the U.S., (3)
higher oil prices, and (4) relatively tight U.S. monetary and
credit conditions up until 2001.
US$ Real
Exchange Rate
F
q4
Tighter Fed Policy
q3 E
Higher Oil Prices
D
q2
Structural Shift in Portfolio Flows
C
q1
U.S. Investment Boom
B
PPP=q0
Correction Time
of Initial
Undervaluation
A
110
1.40
100
1.20
90
1.00
80
Source: Datastream Source: Datastream
70 0.80
1995 1996 1997 1998 1999 2000 2001 2002 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Real Gross Non-Residential Fixed Capital U.S. Nonresidential Fixed Investment and
Formation in the U.S., Euroland, and Japan Equipment & Software Investment
(1992-2000) (Year-over-Year Percentage Changes)
(Cumulative % Change) U.S.____ Europe---- Japan.... (%) Fixed Investment____ Equipment & Software----
140 20
120
15
100
10
80
60 5
40 0
20
-5
0
-10
-20
Source: Datastream Source: Datastream
-40 -15
1992 1993 1994 1995 1996 1997 1998 1999 2000 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
The Increase in Investment Spending and the Dollar The Increase in U.S. Investment Spending
Has Given Rise to an Upward Revision
Increase in in the Dollars Long-Run Equilibrium Value
Future U.S.
Productivity
Real Exchange Rate
Growth Excess
Increase in Real S-I3 Investment
U.S. Spending
Appreciation
Investment of the S-I2
Structural
Spending Increase in U.S. Dollar Increase in
Capital Inflow Investment
(equal to the gap Spending
S-I1
between &
U.S. domestic q3
investment %
and savings)
q2
Upward Revision in the
Currencys Real Long-Run
Equilibrium Value
q1
$
CAB1
Source: Datastream
The Dollars Dramatic Rise in 1999-2000 May Have Been Driven by a Sudden
Upward Revision in the Dollars Real Long-Run Equilibrium Level
The dollars dramatic surge between the fall of 1999 and It was as if economists suddenly embraced the notion that
the fall of 2000 may have been propelled by an upward revi- the U.S. was now enjoying a productivity miracle, brought
sion in the market's expectations regarding the U.S. about by the "New Economy" phenomenon, and that the
economy's long-run growth prospects and a subsequent gains in productivity would be permanent. Quite likely, a
upward revision in the dollar's real long-run equilibrium value. literature search would show a quantum leap in the num-
ber of academic articles that appeared with the term "New
The U.S. economy had been growing faster than the Economy" in the title beginning in 1999. (For a discussion
Euroland economy for much of the 1990s, but it wasn't of the New Economy's impact on the FX market, see
until late in the decade that observers began to take no- Liesbeth Van de Craen and Peter Vanden Haute, The New
tice that "something special" was taking place that was Economy and the Foreign Exchange Market.)
distancing the U.S. from the rest of the world. As the ac-
companying charts show, in annual surveys from 1992-99, Assuming the marketplace embraced the same long-term
professional economists had been projecting a relatively views of the U.S. economy as those held by professional
bland long-term U.S. economic outlook, with real GDP forecasters, it is not hard to explain why the dollar rose 50
growth expected to average 2.5% per annum and produc- pfennigs versus the Deutschemark between autumn 1999
tivity expected to rise by a modest 1.5% per annum over and autumn 2000. We believe that the suddenly improved
each ensuing 10-year period. long-term growth outlook for the U.S. economy compelled
market participants to revise up sharply their notion of the
Normally, one would think that shifts in expectations re- dollar's real long-run equilibrium value. Indeed, the dollar's
garding the U.S. long-term growth outlook would take place rise from the autumn of 1999 to the autumn of 2000, which
gradually over a number of years. But in 1999, expecta- followed the upward revision in the U.S. long-term growth
tions seemed to change overnight. In the 2000 and 2001 outlook, roughly matched, in terms of magnitude, the rise
surveys, professional economists long-term projections that occurred in the prior 4 years.
were pushed up sharply. Economists were now forecast-
ing long-term U.S. real GDP growth of 3.3% and U.S. pro-
ductivity growth of 2.5% per annum.
Source: Datastream
1.60
110
1.40
100
Average
1.20
90
1.00
80
0.80
Source: Datastream Source: Datastream
70 0.60
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
500
0.90
400
0.80
300
0.70
200
0.60
100
Source: Datastream Source: Datastream
0 0.50
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02
1.00 40
Source: Datastream Source: Datastream
0.80 20
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 75 77 79 81 83 85 87 89 91 93 95 97 99 01
81
80
6 69 67
62 62
59 59
60 55 54
Source: OECD 51 50.1 49 Source: OECD
4
40 37
2
19
20 16
0 0
ce Italy pain nce den -11 any land land ugal way stria ium nds itz. ark .K. .S. ark ds en ay itz. ium nd nce any U.K. U-11 pain land Italy U.S.
ee S Fra we MU erm Ire Fin ort Nor Au elg erla Sw enm U U
nm rlan Swed Norw Sw Belg Finla Fra erm
Gr S E G P B th D De ethe G EM S Ire
Ne N
55 60
Source: OECD
50
40
45
40 20
35
0
Switz.
U.S.
U.K.
Chile
Norway
N.Z.
Italy
Austria
Belgium
Australia
Israel
Malaysia
Taiwan
Denmark
Mauritius
Costa Rica
Finland
Germany
France
Hungary
Greece
Spain
Estonia
Slovenia
Sweden
Korea
Iceland
Japan
Portugal
Canada
Ireland
Thailand
South Africa
Singapore
Netherlands
Hong Kong
30
ark ium en nce any ay y d d s 1 l n . .
nm Belg Swed Fra erm Norw Ital inlan relan rland U-1 rtuga Spai U.K U.S
De G F I the EM Po
Ne
Europes Real Labor Costs & Total Employment European and U.S. Total Employment
(1970 = 100) Real Labor Costs____ Total Employment---- (1984=100) Europe____ U.S.----
180 135
130
160
125
140 120
115
120
110
100
Source: OECD 105
80 100
1970 1975 1980 1985 1990 1995 1998 Source: OECD Economic Outlook
95
84 86 88 90 92 94 96 98 00 02e
Since the beginning of floating exchange rates, there have A simple model can be designed to explain why exchange
been a number of occasions when exchange rates have rates tend to overshoot. The model assumes that inves-
significantly overshot their long-run equilibrium path, ei- tors' expectations of exchange rates are driven by both
ther on the upside or the downside. We define an exchange- fundamental and technical considerations. Mathematically,
rate overshoot episode as one in which an exchange rate we can say that exchange rate expectations, eet, in time
deviates by more than +/- 20% from its long-run purchas- period t are driven by fundamental forces, fundt, and by
ing power parity path and/or where there exists a signifi- the past pattern of exchange-rate movements, et-1.
cant divergence between the actual trend in exchange rates
and some long-term, key determinantsuch as the trend It is further assumed that the market will assign weights
in real interest-rate differentials in the case of the Deut- to the relative importance that it attaches to the current
schemark, or the trend in relative monetary-base growth trend in fundamental forces, w, and to the past pattern of
rates in the case of the Japanese yen. exchange-rate movements, 1-w. Those weights are as-
sumed to vary over time, with the market assigning more
For the most part, long-term cycles have strong fundamen- weight to fundamentals and less weight to technicals, and
tal underpinnings. That is, we can find a strong positive vice versa, as fundamental and technical forces vary in
relationship between the long-term trend in exchange rates terms of influencing the path that currencies take. Ex-
and the long-term trend in some key fundamental indica- change-rate expectations can therefore be expressed as:
tor. What we find interesting, however, is that at the end
of a typical long-term dollar cycle there has been a ten- eet = w(fundt) + (1-w)et-1
dency for the dollar's value to overshoot its long-run fun-
damentally driven equilibrium path by rather large amounts.
Economic Fundamentals
Time
where:
e et = exchange-rate expectations
fundt = fundamental forces
et-1 = past pattern of exchange-rate movements
w = market-assigned weight to the importance of the current
trend in fundamental forces
1-w = market-assigned weight to the importance of the past pattern
of exchange-rate movements
Typically, in the early and middle stages of an extended tals is a permanent, and not just a temporary phenom-
exchange-rate cycle, the market tends to attach greater enon. At that point, market expectations will shift, result-
weight to the trend in economic fundamentals (i.e., w ing in greater weight being assigned to deteriorating fun-
rises). This is because the trend in exchange rates and the damental forces and less weight to the prospect that the
trend in key fundamental variables parallel each other quite exchange-rate overshoot will persist. It is at this stage that
closely. In the latter stages of an extended exchange-rate the unwinding of long speculative positions gives rise to a
cycle, however, there often occurs some disconnect be- rapid, and at times violent, correction of the exchange-rate
tween the trend in the exchange rate and the trend in key overshoot.
fundamental variables.
There have been several extraordinary episodes of major
What causes this disconnect to occur is the tendency of currency overshooting since the beginning of floating ex-
the market at the end of a long cycle to assign less weight change ratesthe Deutschemark in the mid-1980s, the
to fundamental forces and more weight to the prevailing yen in 1995 and 1998, and the dollar in general in 2000-02.
trend in exchange rates (i.e., 1-w rises). For instance, after In the case of the Deutschemark, there was a significant
a long cycle of currency appreciation, the market gets ac- disconnect between the trend in U.S./German real long-
customed to being long the appreciating currency and term interest-rate differentials and the DM/US$ exchange
tends to shrug off any adverse underlying fundamental rate towards the end of the dollar's remarkable run up-
developments as being just a temporary phenomenon. ward during its bubble period. There was simply no way to
Hence, the market will begin to attach less weight to the explain the dollar's surge in 1984-85 on the basis of real
deteriorating trend in fundamentals (i.e., w will gradually yield spreads, and this overshoot in the dollar's value was
fall) and more weight to the past favorable trend in the eventually corrected in 1985-87.
exchange rate (i.e., 1-w will gradually rise).
In the case of the yen, there was a similar disconnect be-
By attaching greater weight to expectations that the pre- tween the trend in U.S. and Japanese relative monetary-
vailing trend will remain strong and less weight to the de- base growth and the trend in the yen's value versus the
terioration of fundamental forces, the trend in exchange dollar in 1995 and again in 1998. The dollar overshot to the
rates and the trend in fundamentals becomes discon- downside in 1995 and overshot to the upside in 1998, and
nected. Eventually, a point will be reached when the mar- in both cases the overshoots were subsequently corrected.
ket finally recognizes that the deterioration in fundamen-
Market-Assigned Market-Assigned
Weight (w) Weight (1-w)
Source: Datastream
Source: Datastream
e2 C
e1 B
e0 A
QA QC QB Quantity of Dollars
Exchange-Rate Determination
in the Medium Term
The Yen and Japanese/U.S. Monetary Policies DM/US$ Exchange Rate and U.S./German
Yen/US$____ Japan/U.S. Monetary Base(ratio)---- Real Interest-Rate Differentials
180 1.50 (10-Year Bond Yields Less CPI)
DM/US$____ U.S. Less German Real Interest Rates(bp)----
3.50 600
1.40
160
400
3.00
1.30 200
140
2.50 0
1.20
-200
120
1.10 2.00 -400
100 -600
1.00 1.50
Source: Datastream -800
Note: Y2K Adjusted, Source: Datastream
Japan Reserve Require. Rate Change Adj. Series
80 0.90 1.00 -1000
89 90 91 92 93 94 95 96 97 98 99 00 01 02 75 77 79 81 83 85 87 89 91 93 95 97 99 01
Fisher Effect
According to the Fisher effect, the nominal interest rate, i,
in a given country will equal the real interest rate, r, plus e
iF - iD = pF - pD
e
Foreign-Domestic
Expected Forward
Inflation Discount
e
Differential e = iF - iD FD
e e
pF - pD
e e Foreign-Domestic
iF - iD = pF - pD Interest-Rate
Differential iF - iD = FD
iF - iD
DM/US$ Exchange Rate and U.S./German DM/US$ Exchange Rate and U.S./German
Real Interest-Rate Differentials Real Interest-Rate Differentials
(10-Year Bond Yields Less CPI, 1977-1990) (10-Year Bond Yields Less CPI, 1993-June 1999)
DM/US$____ U.S. Less German Real Interest Rates(bp)---- DM/US$____ U.S. Less German Real Interest Rates(bp)----
3.50 600 2.00 200
400 1.90
3.00 100
200 1.80
2.50 0 1.70 0
DM/US$ Exchange Rate and U.S./German DM/US$ Exchange Rate and U.S./German
Real Interest-Rate Differentials Real Interest-Rate Differentials
(10-Year Bond Yields Less CPI, July 1999-2000) (10-Year Bond Yields Less CPI, Aug. 2000-2002)
DM/US$____ U.S. Less German Real Interest Rates(bp)---- DM/US$____ U.S. Less German Real Interest Rates(bp)----
2.20 20 2.35 150
0 2.30 100
2.10
-20
2.25 50
-40
2.00 2.20 0
-60
2.15 -50
-80
1.90
-100 2.10 -100
Source: Datastream Source: Datastream
1.80 -120 2.05 -150
Jul-99 Oct-99 Jan-00 Apr-00 Jul-00 Aug-00 Nov-00 Feb-01 May-01 Aug-01 Nov-01 Feb-02
The Dollar & U.S. Short-Term Interest Rates The Dollar & U.S. Short-Term Interest Rates
(January 1972-August 1974) (January 1977-March 1980)
DM/US$____ 3-Month Euro-$ Rate(%)---- DM/US$____ 3-Month Euro-$ Rate(%)----
3.40 16 2.60 25
3.20 14
2.40 20
3.00 12
2.20 15
2.80 10
2.00 10
2.60 8
1.80 5
2.40 6
Source: Datastream Source: Datastream
2.20 4 1.60 0
1972 1973 1974 1977 1978 1979 1980
The Dollar & U.S. Short-Term Interest Rates The Dollar & U.S. Short-Term Interest Rates
(August 1986-December 1988) (1994-1995)
DM/US$____ 3-Month Euro-$ Rate(%)---- DM/US$____ 3-Month Euro-$ Rate(%)----
2.10 10 1.80 7
2.00 9 1.70
6
1.90 8 1.60
5
1.80 7 1.50
4
1.70 6 1.40
3.20 0
2.40
-200
3.00 -200
2.20
2.80 -400 -400
2.00
2.60 -600
-600
1.80
2.40 -800
Source: Datastream Source: Datastream
2.20 -1000 1.60 -800
1972 1973 1974 1977 1978 1979 1980
100
2.40 0
1.70
50
2.20 -50
1.60 0
Forward-Rate Bias
Numerous academic papers have investigated empirically Various interpretations have been offered to explain these
whether the forward exchange rate has served as a reli- anomalous findings. One view holds that currencies that
able unbiased predictor of the future spot exchange rate. trade at a forward discount are more risky than those that
The forward-rate predictor hypothesis is usually tested by trade at a forward premium. Hence, investors demand a
regressing the change in the exchange rate, et+k, on the higher risk premium to buy and hold such currencies, and
forward discount, FDt,k: the excess return earned by investing in such currencies
merely represents the reward for accepting higher risk.
et+k = a + (FDt,k) Another view holds that the market simply makes repeated
expectational errors, and that investors could exploit this
If the forward exchange rate were an unbiased predictor by trading against the implicit views expressed in the for-
of the future spot rate, estimates of the regression coeffi- ward exchange market.
cient, beta (), would be equal to 1.0. If = 1.0, then et+k
would be expected to equal FDt,k, on average, over time. Although excess returns could have been earned in the
past by investors who sought to exploit the "bias" in the
Interestingly, the academic evidence strongly rejects the forward discount, the risk/return tradeoff is not always at-
hypothesis that the forward exchange rate is an unbiased tractive for such strategies. Monthly returns can be and
predictor of the future spot exchange rate, with estimates often are quite volatile for single-currency trades. In fact,
of that are often significantly less than one. Indeed, single-currency trading strategies have not been attractive
has often been found to be less than zero. In a survey of enough to justify risking large sums to trade the bias. (A
75 published papers on the forward rate predictor hypoth- single-currency strategy consists of buying, or going long,
esis, the average estimate of was found to be - 0.88. only the highest yielding currency, i.e., the currency with
the largest forward discount, and funding it by borrowing
This startling finding has the following implication for cur- (or going short) only the lowest yielding currency, i.e., the
rency investment strategies. Currencies that trade at a for- currency with the largest forward premium.)
ward discount, on average, weaken less than the amount
implied by the forward discount. If anything, there has been Risk-adjusted excess returns from following diversified
a tendency for such currencies to appreciate, not depreci- multi-currency approaches to exploit the bias, however,
ate, over time. This means that the forward discount has have been more impressive. Adopting a diversified strat-
been a biased predictor of future changes in the spot ex- egy of going long the three highest-yielding currencies in
change rate. Hence, the term "forward discount bias." The the industrial world and funding that position by going short
opposite applies for currencies that trade at a forward pre- the three lowest-yielding currencies has yielded estimated
mium. From a strategy standpoint, if these findings on past Sharpe ratios averaging 0.7-0.8 for dollar, euro, and yen-
performance were to remain valid in the future, investors based investors. That is nearly double the Sharpe ratios
would stand to benefit by over-weighting currencies that generated by buying and holding the shares of the S&P
trade at a forward discount and under-weighting curren- 500 index. This basket approach to trading the forward dis-
cies that trade at a forward premium. count bias is the bedrock of Deutsche Bank's Forward-
Rate Bias trading system.
6.5 6
6.3
6.1
6 5.8 5.7
5.3 5 4.8
4.9 4.2 4.0
4.1 4 3.8
3.6
4 3.3
3.4
3
2.1
2 1.8 1.8
2
1
0.6
0.1
0 0
Norw
ay N.Z. U.S
.
Aus
t. .
U.K Canada enmark Euro Sweden zerland Japa
n
Norw
ay N.Z. Aus
t. U.K
. den ark Euro Canada zerland U.S
.
Japa
n
D Swit Swe Denm Swit
40 4
30 2
20
0
10
-2
0 Source: Datastream
-8.2 -7.1 -6.0 -5.0 -3.9 -2.8 -1.8 -0.7 0.3 1.4 2.5 3.5 4.6 5.0 -4
Monthly Excess Return(%) 1986 1988 1990 1992 1994 1996 1998 2000 2002
180
160
140
120
100
Source: Salomon Bothers Money Market Indices
80
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
600
500
400
300
200
Source: Datastream
100
1995 1996 1997 1998 1999 2000 2001 2002
Conventional wisdom holds that countries that run persis- Third, there is a general notion that there exists some limit
tent current-account surpluses will see their currencies on the ability of countries to run sizeable and persistent
appreciate over time, while countries that run persistent current-account deficits, because such deficits could lead
current-account deficits will see their currencies depreci- to an unending rise in debt owed by deficit countries to
ate over time. foreign investors. If foreign investors view the rise in ex-
ternal debt as unsustainable, they would reason that at
Current-account imbalances can affect exchange rates some point, a major depreciation of the deficit country's
through a variety of channels. First, the existence of major currency might be required to ensure that the current-ac-
external imbalances can influence the flow supply of and count deficit narrowed and that the external debt stabi-
demand for individual currencies and thereby directly in- lized at a level deemed sustainable.
fluence the paths that exchange rates take.
In such a manner, the existence of a large current-account
Second, major current-account imbalances can shift the imbalance will tend to alter the market's notion of what
residence of financial wealth among deficit and surplus level of the exchange rate constitutes a currency's real long-
nations, decreasing it in the former and raising it in the run equilibrium value, with ever-larger deficits and external
latter. Such shifts in the residence of financial wealth could debt levels giving rise to steady, downward revisions in
then lead to a shift in global asset preferences, which, in market expectations of the real long-run equilibrium ex-
turn, could influence the paths that exchange rates take. change rate.
Flow
Supply and Demand
for Foreign Exchange
External
Debt
Sustainability
Dollars Value
S$
A B
q1
C
q0
D$
QA QB Quantity of
Dollars
A B
q1
C
q0
q2 C
e
D $
i
D$
QA QE QB Quantity of
Dollars
U.S. Dollar
U.S. Dollar
Real Exchange Rate
Real Exchange Rate
S-I2 New Economy
Increase in S-I
Investment
Spending
S-I1
% $
q2 q1
New Economy Downward Revision in the
Dollars Real Long-Run
Upward Revision in the
Dollars Real Long-Run
% Equilibrium Value
q1 Equilibrium Value q2
$
CAB1
Current-Account/Exchange-Rate Linkages
and the Impact of Economic and Financial Disturbances
150 (20)
Related to this is the fact that Japan's cumulative current-
account surpluses have allowed Japanese investors to (30)
acquire a rising claim on U.S. assets. To induce Japanese 100
(40)
investors to acquire and hold onto those rising dollar claims,
Source: Datastream
either U.S. interest rates needed to rise relative to those in 50
77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
(50)
Japan, or the dollar needed to fall versus the yen to make
dollar assets appear cheaper to Japanese investors, or
some combination of the two was required. The evidence
indicates the dollar bore the brunt of this adjustment. The The Yen and Japans Current-Account Balance
accompanying chart shows that the yens long-term trend Yen/US$(reverse scale)____ Current Acct( tr.)----
(50) 20
moved sympathetically with the ratio of Japan's interna-
tional investment position relative to the U.S. international (100) 15
investment position, as a percentage of their respective
GDPs. (150) 10
There are essentially three ways that the U.S. can narrow
its large current-account deficit. First, the U.S. could pur- Correcting the U.S. Current-Account Imbalance
via Tighter Fiscal and Monetary Policies
sue policies that encourage domestic savings and/or dis-
courage domestic investment, perhaps via a tighter fiscal
and/or tighter monetary policy. Such policies would con- Saving-Investment, S-I2
tribute to a leftward shift of the savings-investment (S-I) Exports-Imports
schedule in the diagram on the right. As illustrated, U.S.
domestic demand would need to be pared back, perhaps S-I1
significantly, to restore sustainable balance to the U.S. ex-
ternal account. S-I 0
Y Y Y F
0
Output
A second way to eliminate the unsustainable portion of
the U.S. current-account deficit would be to engineer a C C
A A
Ex-Im1
A third way to eliminate the unsustainable portion of the
Ex-Im0
U.S. current-account deficit would be to combine belt-tight-
ening and dollar-depreciation initiatives. A modest belt-tight-
ening move on the fiscal and monetary policy front could
shift the S-I curve to the left to S-I3, while a modest dollar Correcting the U.S. Current-Account Imbalance
depreciation could work to shift the export-import curve to via Tighter Fiscal/Monetary Policies
the right to Ex-Im3. The combination of these two policy plus a Weakening of the Dollar
actions would leave the equilibrium level of output un-
Saving-Investment,
changed while narrowing the U.S. current-account deficit Exports-Imports
to a sustainable level.
S-I3
S-I 0
Y F
0
Output
C C
Ex-Im3
A A
Ex-Im0
Greater financial integration of the world's capital markets Foreign direct investment (FDI) and portfolio capital flows
and the increased freedom of capital to flow across na- were highly positive for the dollar and negative for the euro
tional borders have increased the importance of financial in the past few years. As shown in the table below,
flows in the determination of exchange rates. The rise in Euroland's overall balance of payments was in huge defi-
the dollar's value in recent years was largely driven by citbecause of sizable FDI and portfolio outflows from
strong increases in the demand for U.S. assets by over- Eurolandwhich is in stark contrast to the U.S. and Japa-
seas investors. For example, Euroland investors had been nese overall balance of payments surpluses.
structurally underweight equities for a long time, but be-
ginning in the late 1990s they started to shift their portfo- Although the U.S. has seen its current-account deficit
lio allocations away from bonds and toward equities. Within double between 1998 ($217 billion) and 2000 ($435 bil-
their rising equity holdings, European investors also made lion), the U.S. over the same period was the recipient of
the decision to increase the percentage allocated to U.S. massive FDI and portfolio inflows, which exceeded the size
equities and reduce the percentage allocated to Euroland of the U.S. current-account deficit. As a result, the U.S.
equities. Overall, there was a marked rise in European in- overall balance of payments swung from a deficit of $43
vestors' demand for U.S. equities in 1999-2001 that helped billion in 1998 to a surplus of $52 billion in 2000.
lift the dollar versus the euro.
In contrast, Euroland saw its current account swing from
Foreign demand for Japanese equities has also played a a surplus to a deficit position, while FDI and portfolio flows
role in influencing the medium-term direction of the yen. recorded large outflows as well. As a result, Euroland ran
The yen's weakness over the 1995-98 period coincided overall balance of payments deficits averaging $173-$183
with declining foreign demand for Japanese equities, and billion per annum in 1998-2000, which weighed heavily on
the yen's subsequent rebound in late 1998 and in 1999 the euro during this period.
coincided with a rise in foreign demand for Japanese equi-
ties. The drop-off in foreign demand for Japanese equities
in 2000-01 coincided with a sharp decline in the yen's value.
European Investor Demand for U.S. Equities The Japanese Yen and
and the U.S. Dollar/Euro Exchange Rate Foreign Investor Demand for Japanese Equities
(12-Month Moving Sum of Net Equity Purchases) (12-Month Moving Sum of Net Equity Purchases)
European Net Purchases(US$ bn.)____ US$/Euro(reverse scale)---- Yen Effective Rate____ Foreign Net Purchases(US$ bn.)----
200 (0.80) 180 140
(1) "There is evidence that equity flows matter for the euro-
dollar rate, but not for the yen-dollar rate." Traditional Underlying Factors
(2) Relative expected current and future growth rates de- Long-Term Interest Differential Significant Significant
(Marginally)
rived from Consensus Economic Forecasts are cor-
rectly signed and statistically significant in explaining Short-Term Interest Differential Insignificant Insignificant
the euro, but not the yen. Relative Current Growth Insignificant Insignificant
(4) Bilateral current-account trends vis--vis the U.S. are Relative Stock Returns Insignificant Insignificant
not statistically significant in explaining either the Relative Expected Growth Significant Insignificant
euro's or the yen's trend. However, the IMF notes that Note: Coefficients of regression of change in the logarithm of the U.S. dollar exchange
rate on a constant and the contemporaneous value of the explanatory variable using
when multilateral, and not bilateral, current-account quarterly data since 1988. Significant denotes that the variable was both statistically
positions were investigated, there was some evidence significant and had the correct sign. All other variables were not statistically significant.
of a positive effect of current-account trends on ex- Source: Robin J. Brooks, Hali Edison, Manmohan S. Kumar, Torsten M. Slok,
"Exchange Rates and Capital Flows", International Monetary Fund, Research
change rates. Department Series, Working Paper, No. 01/190, May 2000, available on the IMF's
Web site (www.imf.org).
(5) "There is little evidence that merger and acquisition
flows are important for exchange-rate determination.
The coefficients on net foreign direct-investment (FDI)
flows are correctly signed, but statistically insignifi- The IMF concluded that its findings were "supportive of
cant for both the euro and yen." These results are con- the new conventional wisdom that net equity flows are
sistent with the view that "the majority of cross-bor- important for the euro-dollar exchange rate, although long-
der merger and acquisition flows are financed through term interest-rate differentials also appear to matter. For
share-swaps that have no immediate impact on the the yen, however, there is little evidence that net equity
demand for currencies." flows have been an important determinant of the bilateral
(6) "Net bond flows appear to have no significant effect exchange rate with the U.S. dollar." The IMF noted that the
on the euro- or yen-dollar rate." importance of equity flows for the euro might stem from
the fact that European investors might have been diversi-
(7) "The movements of the euro-dollar and yen-dollar ex- fying their portfolios away from intra-European investments
change rates are significantly correlated with the long- to U.S. equity investments. The IMF warned that if such
term interest-rate differential, but not their short-term portfolio adjustments are not yet complete, then the euro
equivalent." The IMF did note, however, that in the case could remain weak for some time until European portfo-
of the euro, the explanatory power of the long-term lios are completely rebalanced.
spread is weaker than that for equity flows.
Given the historically weak relationship between equity- Source: BIS Quarterly Review, August 2000
market trends and exchange rates, why has the foreign-
exchange market become so fixated on equity-market de-
velopments? One reason may be that in the late 1990s
the correlation between the Dow Jones Industrial Aver- Correlation of U.S. Equity Prices & the Dollar
age and the dollar was in fact highly positively correlated (Rolling Six-Mo. Correlation of Log Differences
of Daily Dow Jones Ind. & US$ Trade Wgt Indices)
(even though the long-run correlation between the Dow Correlation Coefficient (Month-end Values)
Jones index and the dollar has averaged close to zero). 0.5
The high correlation in the late 1990s may have led market 0.4
observers to believe that this trend would continue into
0.3
the future. This proved not to be the case over the 2000-01
period, however, as the correlation between the Dow Jones 0.2
index and the dollar plummeted. 0.1
0.0
-0.1
-0.2
Source: Datastream
-0.3
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
The Dollar and U.S. Equity Prices The Dollar and U.S. Equity Prices
(1990-1995) (1995-2002)
US$ Index____ S&P 500 Index---- US$ Index____ S&P 500 Index----
95 650 120 1600
600
1400
110
90 550
1200
500 100
85 450 1000
400 90
800
80 350
80
600
300
Source: Datastream Source: Datastream
75 250 70 400
1990 1991 1992 1993 1994 1995 1995 1996 1997 1998 1999 2000 2001 2002
The Yen and Japanese Equity Prices The Yen and Japanese Equity Prices
(1990-1995) (1996-2002)
Yen/US$(reverse scale)____ TOPIX Index---- Yen/US$(reverse scale)____ TOPIX Index----
(60) 3000 (100) 1800
(80)
(110) 1600
2500
(100)
(120) 1400
(120) 2000
(130) 1200
(140)
1500
(140) 1000
(160)
Source: Datastream Source: Datastream
U.S. Annual Net FDI and the Dollar U.S. Quarterly Net FDI and the Dollar
(Net Foreign Direct Investment, 4-Qtr. Mov. Sum) (Net Foreign Direct Investment)
(1988-2002) (1995-2002)
Annual Net FDI(US$ bn.)____ US$ Index---- Quarterly Net FDI(US$ bn.)(bars) US$ Index(line)
250 110 140 110
120
200 105
100 100
150 100
80
100 95 60
90
50 90 40
20
0 85
0 80
-50 80
-20
Source: Datastream
Source: Datastream
-100 75 -40 70
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 1995 1996 1997 1998 1999 2000 2001 2002
Merger & Acquisition Flows and the Dollar Estimates of the Effect of M&A Flows
(Cumulative Net Flow from Euroland to the U.S.)
(1998-2002) on the U.S. Dollar/Euro Exchange Rate
M&A Flows(US$ bn.)(bars) US$/Euro(reverse scale)(line)
300 (0.80) (January 1999-September 2001)
Source: Bloomberg, Datastream
250 Coefficient
(0.90) (t-Statistic)
200
(1.00)
Current and Lagged M&A Flows into Euroland +0.346
150
(1.55)
(1.10)
100 Current and Lagged M&A Flows into U.S. -0.481*
(1.20) (-2.52)
50 Note: * denotes that the variable was statistically significant and had the correct sign.
Source: Ingo Fender and Gabriele Galati, The Impact of Transatlantic M&A Activity
0 (1.30) on the Dollar/Euro Exchange Rate, BIS Quarterly Review, December 2001.
1998 1999 2000 2001 2002
billion in 1996, just prior to the Asian financial crisis of 1997. 116.8
Since then, private capital flows to emerging markets have
100
plummeted, with the 2000 inflow amounting to only $9.0
69.6
billion. 59.6
50
20.1
8.9
0
1993 1994 1995 1996 1997 1998 1999 2000 2001e
Banking Flows into Emerging Markets Bond Flows into Emerging Markets
(US$ bn.) (US$ bn.)
60 70
51.9 Source: World Bank 62.3
45.6
60
40
30.9 32.2 49.6
50
20 16.3 40.9
40 36.7 38.1
9.3
5.0 4.1 30.7 29.5
30
0
-6.1
20 16.9
-20 11.0 11.1
9.5
-23.3 10
Source: World Bank -32.3
-40 0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001e 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001e
Equity Flows into Emerging Markets FDI Flows into Emerging Markets
(US$ bn.) (US$ bn.)
60 200
Source: World Bank Source: World Bank 184.4
178.3
51.0 50.9 172.5
166.7 168.2
50 48.9
150
40 130.8
35.2 36.1
34.5
106.8
30.1
30 100 90.0
66.6
20 18.5
15.6
14.1 50 47.1
35.7
10 7.6
0 0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001e 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001e
The Latin American Debt Crisis and the Surge of the Dollar1982-85
The 1997-2001 episode did not mark the first time that One reason the dollar might have overshot its equilibrium
capital flight from emerging markets has played an impor- level in 1982-85 was that the U.S. had become a major
tant role in contributing to a major rise in the dollar's value. recipient of massive capital flight from Latin America fol-
A similar development occurred in the first half of the 1980s lowing the onset of the Latin American debt crisis in 1982.
when the dollar underwent a dramatic upside overshoot Evidence on Latin American capital flight and dollarization
that could not be adequately explained by U.S., European, ratios indicates that a large and sustained increase in the
or Japanese economic fundamentals. demand for dollars by Latin American residents occurred
at that time.
30
40
30
20
20
10
10
0 0
1979 1980 1981 1982 1983 1984 1985 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85
80 80
60 60
40 40
20 20
0 0
70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85
60
40
20
0
1980 1981 1982 1983 1984 1985
Net Foreign Direct Investment in the U.S. Net Foreign Purchases of U.S. Corporate Bonds
(US$ bn.) Quarterly(bars) Annual(line) (US$ bn.) Quarterly(bars) Annual(line)
200 400
100 400
150 300
80
300
100 200 60
200
50 100 40
100
20
0 0
0 0
Source: Datastream Source: Datastream
-50 -100
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
How a Surge in U.S. Investment Spending U.S. Current-Account Deficit and the
Typically Affects the Dollar U.S./German Short-Term Interest-Rate Spread
Currt Acct Deficit/GDP(%)____ U.S.-German 3-Mo. Rates(bp)----
and U.S./Foreign Real Yield Spreads 5 600
U.S. Dollar
(a) Real Exchange Rate 4 400
S-I2 200
Surge in 3
Investment
Spending 0
S-I1 2
-200
%
q2 1
Upward Revision in the -400
Dollars Real Long-Run
Equilibrium Value
q1 0
$ -600
Source: Datastream
-1 -800
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
CAB1
(b)
U.S./Foreign 4
200
Real Yield Spreads
3
0
2
% -200
(rUS - rF)2 Typical Rise in 1
U.S. Real Interest Rates
Necessary to Attract
(rUS - rF)1 Additional Capital Inflows -400
& (from point A to B). 0
$
Source: Datastream
-1 -600
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
But the 1995-2000 Structural
Shift in Capital Inflows (from U.S. Capital Flows1
US Capital Flow1 to US Capital Flow2)
Allowed Real Interest-Rate Spreads
to Remain at (rUS-rF)1. U.S. Capital Flows2
Our understanding of the impact that monetary and fiscal Fiscal policy's impact on the exchange rate is a bit am-
policy changes have on exchange rates owes much to the biguous. If capital is highly mobile, an expansionary fiscal
pioneering work of Robert A. Mundell and J. Marcus policy will likely give rise to an appreciation of the domes-
Fleming. The Mundell-Fleming (MF) model has become tic currency. If capital is relatively immobile, then an ex-
the textbook standard that most students today use to pansionary fiscal policy could lead to a decline in the do-
study the role of monetary and fiscal policy in an open mestic currency's value. This is because an expansionary
economy. fiscal policy typically results in a rise in domestic interest
rates and an increase in economic activity. The rise in do-
In the MF model, the degree of capital mobility plays a mestic interest rates should attract an inflow of capital from
pivotal role in determining the exchange rate's response abroad, which should be positive for the domestic currency,
to a change in fiscal or monetary policy. For example, an but at the same time, the consequent rise in domestic
expansionary monetary policy will lead to a depreciation economic activity will contribute to the deterioration of the
of the domestic currency in large part because the induced trade account, which should be negative for the domestic
decline in domestic interest rates will generate an outflow currency.
of capital that puts downward pressure on the domestic
currency. The more sensitive capital flows are to changes Whether the exchange rate rises or falls in response to a
in interest rates, the greater will be the outflow of capital fiscal expansion will depend on how sensitive capital flows
in response to the interest-rate decline. Hence, the more are to changes in interest rates. If capital flows are highly
mobile capital is, the more the currency will depreciate in mobile, the induced inflow of capital from abroad should
response to a monetary expansion. dominate the deterioration in trade, and thus the domes-
tic currency will tend to appreciate in value. If capital flows
are relatively immobile, the opposite will be the case.
Increase in Deterioration
Domestic of
Economic Trade
Activity Balance
Domestic Overall Depreciation
Expansionary Balance of of
Monetary Payments Domestic
Policy Deficit Currency
Decrease in Capital
Domestic Outflow
Interest Rates
Trade-Balance
Increase in Deterioration Deterioration Depreciation
Domestic of Dominates of
Economic Trade Capital Inflow Domestic
Activity Balance Currency
Domestic Overall
Expansionary Balance of
Fiscal Payments
Policy (?) Appreciation
Increase in Capital Capital Inflow of
Domestic Inflow Dominates Domestic
Interest Rates Deterioration of Currency
Trade Balance
High Capital
LM1
Mobility
A A
i0 i0
B B
i1 i1 B
IS1
E0 A E0
A
B E1 B
E2 E2 B
B B High Capital
i1 i1 Mobility
A A
i0 i0
IS1
IS01
E2 B
A
E0 E0 A
B
E1 E1 B
Am b igu ous
LM3
LM2
LM1
Interest Rate Interest Rate
LM1
LM0
LM0
i3 i3 D
C
i2 i2 C
B
i1 i1 B
B
i0 A i0
A
IS1
IS0 IS1
IS0
Y0= Y2 Y1 Output G Y3 Y2 Y0 Y1 OutputROE
Eurolands Budget Deficit and the Euro Euroland Real Short-Term Rates & the Euro
Budget Deficit/GDP(%)(bars) US$/Euro(line) (Three-Month Euro Deposit Rate less CPI)
7 1.40 Euroland Real 3-Mo. Rate(%)____ US$/Euro----
10 1.60
6
1.30
5 8
1.40
1.20
4
6
3 1.10
1.20
2 4
1.00
1 1.00
0.90 2
0
Source: OECD Economic Outlook Source: Datastream
-1 0.80 0 0.80
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
(a ) (b)
LM0
LM1
A r01 A
r0
B
r1 C r1 C
IS0
IS1
Y0 Y1 Output E1 E0 Euros Value
Japans Monetary/Fiscal Policy Mix Debate and the Yens Value in 1999-2000
The Japanese yens response to changing monetary/fiscal
policy conditions during 1999-2001 provides another ex- Posens Solution for Resolving
Japans Economic Problems
ample of the influence of policy mixes on exchange rates.
In 1998-99, a number of prominent economists offered A Massive Fiscal Stimulus
LM1
LM2
A B
r1
IS2
Y1 Y3 Output
IS1
LM2
LM1
C r3 C
r3
B
r2
r1
A r1 A
IS2
Y1 Y4 Y2 Output E1 E2 Yens Value
IS1
Japans Monetary/Fiscal Policy Mix in 2001-02 and the Value of the Yen
The 1999-2000 period of yen strength ended when Japan's
fiscal/monetary policy mix swung back in the direction of Monetary/Fiscal Policy Mix and the
significant fiscal restraint and aggressive monetary ease Determination of Exchange Rates
in 2001-2002. Such a policy mix is normally bearish for a
currency, but this policy mix was especially bearish for the
yen, given the magnitude of the policy changes that were Expansionary Restrictive
Monetary Monetary
implemented. Policy Policy
Given that Japan is presently saddled with huge budget Japans Fiscal Policy Trends
deficits, a large outstanding stock of government debt, and (Changes in Structural Budget Balance as % GDP)
(Percentage Point Change)
adverse demographics that are expected to wipe out the 1.5
social security system's surpluses, the Japanese govern-
1.0
ment will need to pursue relatively restrictive policies, not
just in 2002, but for several years to come while it puts its 0.5
fiscal house in order. Such a policy stance should exert Contractionary Fiscal Policy
0.0
downward pressure on the yen, not just in 2002, but for Expansionary Fiscal Policy
many years to come. -0.5
-1.0
Japan's monetary-policy stance is adding to this down-
ward pressure on the yen's value. Japan's monetary policy -1.5
became highly reflationary in late 2001 as economic con- Source: OECD, IMF Estimates
20
10
Source: Datastream
-10
89 90 91 92 93 94 95 96 97 98 99 00 01 02
Historically, changes in monetary policy have had a pro- The monetary approach asserts that changes in the sup-
found impact on exchange rates. In the case of the dollar, ply of and demand for money are the primary determi-
relatively easy monetary policies pursued by the U.S. dur- nants of exchange-rate movements. Although the mon-
ing the Carter Administration contributed to a sharp de- etary approach is widely regarded as an incomplete theory
cline of the dollar in 1977-78. The dramatic tightening in of exchange-rate determination because it ignores other
U.S. monetary policy by the Volcker-led Federal Reserve in important explanatory variables, it nevertheless correctly
the early 1980s helped drive the dollar dramatically higher warns that the pursuit of overly expansionary monetary
between 1981 and 1985. In the case of the yen, a rela- policies will exert downward pressure on a currency's
tively tight monetary policy by the Bank of Japan in the value, and vice versa.
early 1990s contributed to a major strengthening of the
yen during that period. Then beginning in 1995 and con- The monetary model of exchange-rate determination can
tinuing until 1998, the Bank of Japan pursued an extraordi- be derived from a basic model of the demand for money.
nary easy monetary policy that contributed to a weaker If it is assumed that purchasing power parity (PPP) holds
yen. More recently, the Bank of Japan has been engaging at all times, the equilibrium exchange rate can be shown
in a very dramatic easing in monetary policy and the yen to be completely determined by trends in relative money-
has fallen commensurately. Finally, in the case of many supply growth, relative GDP growth, and relative interest-
emerging-market currencies, overly easy monetary poli- rate differentials. According to the monetary model, a rela-
cies have often been the catalyst for currency-crisis epi- tive increase in domestic monetary growth, a relative de-
sodes. crease in domestic GDP growth, and a relative rise in do-
mestic interest rates will exert downward pressure on a
domestic currency's value.
(1) mS = mD = m = p + b1y - b2i Money supply and demand Domestic Price Level
as a function of prices,
output, and interest rates
m1 m0 e0 e1
The Direct Effect of Money-Supply Changes How Real Economic Forces Influence Exchange Rates
on Exchange Rates in the Flexible-Price Monetary Model
in the Flexible-Price Monetary Model of Exchange-Rate Determination
of Exchange-Rate Determination
Change in Change in
Real Change in Change in
Change in Real
Change in Change in Price Exchange
Economic Money
Money Price Exchange Level Rate
Activity Demand
Supply Level Rate
2 6
Restrictive 4
0
Accommodative
2
-2
0
-4
-2
Source: Datastream Source: Datastream
-6 -4
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
Japans GDP Implicit Price Deflator Japans Real Short-Term Interest Rate
Year-over-Year % Change (Three-Month Euro- Rate less Core Inflation)
4 %
3
3
2
2
1
1
0
0
-1
-1
-2 -2
Source: Datastream Source: Datastream
-3 -3
89 90 91 92 93 94 95 96 97 98 99 00 01 02 1995 1996 1997 1998 1999 2000 2001 2002
A variety of other indicators were also suggesting that BoJ Another indicator suggesting that BoJ policy was too tight
policy was actually quite tight over the 1998-2000 period. in 1998-2000 was the rising trend in real short-term inter-
For example, if one accepts the monetarist proposition that est rates. With Japan's GDP deflator falling and nominal
"inflation is always and everywhere a monetary phenom- short-term interest rates stable at around zero percent, this
enon", then it must also be true that deflation is always had the effect of driving Japan's real short-term interest
and everywhere a monetary phenomenon. If so, the exist- rates higher on a trend basis. A declining money multiplier
ence of outright deflation in Japan would be evidence that and weak broad money-supply growth were also indica-
BoJ policy had been too tight. Indeed, Japan's GDP defla- tive of an overly tight monetary-policy stance. The tighten-
tor had been declining for nearly four years and had fallen ing of credit conditions in Japan in 1998-2000, including
to -2%, a near record pace of outright deflation. the decline in Japanese bank lending, the decline in Japa-
nese banks' willingness to lend, and the steady erosion in
equity prices and land values, were still more signs of fi-
nancial restraint.
4.5
28
4.0
26 3.5
3.0
24 2.5
2.0
22
1.5
Source: Datastream Source: Datastream
20 1.0
89 90 91 92 93 94 95 96 97 98 99 00 01 02 1995 1996 1997 1998 1999 2000 2001 2002
30
10
20
10 5
0
-10 0
-20
-5
-30
Source: Datastream Source: Datastream
-40 -10
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
40,000
110
35,000
100
30,000
25,000 90
20,000
80
15,000
70
10,000
Source: Datastream Source: Datastream
5,000 60
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
Why Monetary and Credit Conditions in Japan Became Too Tight in the
Past Decade
Monetary policy typically affects economic activity through When nominal short-term interest rates are zero, monetary
a variety of channels: (1) an interest-rate channel, (2) a bank- policy can still be effective if the money supply is expanded
lending or credit channel, (3) an exchange-rate channel, (4) at a sufficiently rapid rate so as to raise the expected infla-
an inflation-expectations channel, and (5) a wealth-effect tion rate. A higher expected inflation rate will then lower
channel. Under normal circumstances, an easier monetary the real short-term interest rate, even if nominal rates are
policy will lead to lower short-term interest rates, and as zero. In theory, those lower real interest rates should stimu-
lower short rates are transmitted to lower rates across the late investment spending as outlined in the conventional
entire yield curve, investment spending will tend to rise. interest-rate channel. Many outside observers have rec-
If, however, nominal short-term interest rates are already ommended that the Bank of Japan engineer a quantitative
at zero, as has been the case in Japan, an easier policy easing in policy and adopt a positive inflation target. But
stance will not be able to drive short-term interest rates Japan's deflationary pressures remain intact, thereby ren-
any lower, thereby rendering the interest-rate channel in- dering the inflation-expectations channel inoperative over
effective. the last decade.
The bank-lending channel in Japan has also been rendered Finally, the wealth-effect channel in Japan has not been
ineffective as the Bank of Japan's attempt to ease policy operative for some time now. Normally, an easier mon-
has been blunted by the financial problems besetting the etary policy can be transmitted to the domestic economy
banking industry. Indeed, since Japanese bank lending has through rising equity prices and real estate values, which
outright contracted in the past four years, this channel has then increases net wealth and, in turn, helps boost con-
been effectively closed. And if bank share prices are any sumption. But with the Tokyo stock market and real estate
indication of what is in store, the banking system's prob- values down significantly on a trend basis, there has been
lems are not likely to go away anytime soon. a trend decline in net financial wealth over time. Indeed,
the inability of equity and real estate prices in Japan to
The exchange-rate channel has also failed to operate prop- rally raises questions whether monetary policy has been
erly in Japan. Normally an easy monetary policy gives rise truly easy even when interest rates are near zero.
to a depreciation of the exchange rate and that, in turn,
contributes to a rise in net exports and therefore economic With the traditional channels of monetary policy not func-
activity. Up until recently, the yen was fairly strong, sug- tioning properly, the Bank of Japan's policy actions have
gesting that monetary policy in Japan had been tight in not been as accommodative as would have been the case
the first place. Given the yens firmness in 1999-2000, it is under normal conditions. The end result of all this is that
obvious that this channel did not function properly during the Bank of Japan has been too tight, perhaps inadvert-
that period. However, the yens weakness in 2001-02 may ently, and this gave rise to a stronger-than-desired Japa-
render this channel more effective in the future. nese yen.
Rise in
Expansionary Equity Prices Rise in Increase in
Wealth Effect
Monetary Value of Economic
Channel
Policy Rise in Land & Financial Wealth Activity
Housing Prices
Adapted from Frederick Mishkin, The Channels of Monetary Transmission: Lessons for Monetary Policy,
NBER Working Paper, No. 5464, February 1996.
The portfolio-balance model posits that exchange rates are In the portfolio-balance model, global investors are as-
determined by the supply of and demand for all financial sumed to hold a diversified portfolio of domestic and for-
assets. The monetary model is actually a subset of the eign bonds. Their desired allocation to domestic and for-
broader portfolio-balance model in that the monetary model eign bonds is assumed to vary in response to changes in
narrowly focuses on the supply of and demand for money expected return and risk considerations. In the portfolio-
as the key determinant of exchange-rate movements. The balance framework, a steady increase in the supply of do-
portfolio-balance model broadens the menu of assets that mestic bonds outstanding, generated by a continued wid-
can determine the path that exchange rates take. In addi- ening of the government budget deficit, will be willingly
tion to relative changes in money supply and demand, the held only if asset holders are compensated in the form of
portfolio-balance model focuses on relative changes in bond a higher expected return or risk premium. The higher risk
supply and demand (domestic as well as foreign) as key premium could come in the form of higher domestic inter-
determinants of exchange-rate movements. est rates or an immediate decline in the domestic
currency's value, or some combination of the two. The
major insight one draws from this is that in the long run,
governments that run large budget deficits on a sustained
basis will eventually see their currencies decline in value.
Portfolio-Balance Model
Transmission Mechanism
Increase in
Domestic
Interest
Increase in Rates
Increase
Supply of in
Government
Risk
Debt
Premium
Outstanding Decline in
Domestic
Currencys
Value
The Supply and Demand for Domestic Bonds and the Risk Premium
1 1
0
0
Supply of e1 e0 Domestic
Source: Rosenberg (1996)
Domestic Bonds Currencys Value
Increase in
Domestic
Interest
Rates
Cumulative Rising Increase
Current-Account Net External in
Deficits Debt Ratio Risk Premium
Decline in
Domestic
Currencys
Value
Risk Premium
on U.S. Assets U.S. Net External Debt D
S
D 1
S
D 1 D 2
Foreign Demand
for
US$-Denominated
Assets
B
2
A
1
The trend in the outstanding external debt as a percent- Using the sustainability criterion to determine a currency's
age of GDP would rise without limit, unless this was off- real long-run equilibrium level, the equilibrium real exchange
set by a rising trade surplus as a percentage of GDP. In the rate could be defined as that rate that will ensure a stable
absence of an improving trade position, the market would net external debt/GDP ratio in the long run. One would
be faced with the task of adding more and more risky debt then expect to find a positive (negative) relationship be-
of the deficit country to its portfolios. At some point, the tween a currency's real value and the trend in the net ex-
market would probably demand a higher risk premium to ternal asset (liability) position of that country, and long-run
induce it to buy and hold onto that rising debt. Eventually, equilibrium would be attained only when the net invest-
there may come a time when the market perceives the ment position stabilized. Obtsfeld and Rogoff (1994) pro-
debt of the deficit country as so risky that it refuses to add vide evidence suggesting that there has been a significant
any more of that debt to its portfolios. positive relationship between an increase in a country's
net foreign asset position as a percentage of GDP and the
trend in its real effective exchange rate for 15 OECD coun-
tries.
40%
Norway
30%
Debt
Service 20%
Japan
Germany
10% Italy France
Netherlands Spain
Sweden Denmark
0% Canada
U.K.
Finland
-10% U.S. Belgium
Australia
-20%
-0.15 -0.10 -0.05 0.0 0.05 0.10 0.15
Change in Net Foreign Assets/GDP Ratio
Source: Obstfeld and Rogoff (1994).
0
0
-500
-500
-1000
-1000
-1500
-1500
-2000
Source: Datastream Source: Datastream
-2000 -2500
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00
2 B
D G
4 A
1
F
C E
3
Shifts in Equity Market Capitalization Ratios & the Trend in Exchange Rates
Analysts attribute the rise in the dollar's value versus the While it is true that both the U.S. and Euroland equity mar-
euro in the second half of the 1990s to a wide range of kets rallied strongly in the second half of the 1990s, U.S.
factors including strong productivity gains in the U.S., struc- equity-market capitalization as a percentage of GDP rose
tural shifts in portfolio flows from Euroland to the U.S., in- by a larger amount than the comparable capitalization ra-
creased M&A flows from Euroland to the U.S., structural tio in Euroland. According to the IMF, U.S. market capitali-
rigidities in Euroland, "New Economy" forces in the U.S., zation rose from about 80% of GDP in 1994 to 160% in
relative economic growth rates, policy mixes, and euro- 1999, while the comparable capitalization ratio in Euroland
changeover risk. The portfolio-balance model offers an ad- rose from 30% of GDP to 90% of GDP. Thus, the capitali-
ditional explanationthe increase in wealth generated by zation ratio in the U.S. rose a full 100%, while Euroland's
the U.S. equity-market rally in the second half of the 1990s capitalization rose just 60%. Since U.S. households have
and its impact on U.S. domestic demand. a higher propensity to consume out of equity wealth than
do their Euroland counterparts, the greater increase in U.S.
wealth relative to Euroland had a larger impact on the rise
in U.S. demand relative to Euroland demand in the second
half of the 1990s.
Relative
Relative Relative
Increase in Relative Relative Capital
Rise in U.S. Rise in
U.S. Equity Increase Rise in Inflow
Household U.S.
Market in U.S. Real into U.S.
Propensity Aggregate
Capitalization U.S. Wealth Interest Rate
to Consume Demand
Ratio
Rise in
U.S. Dollars
Value
Euro-Denominated Share of
International Debt Issues
(Percentage of Total Issues in All Currencies)
(%) Constant Currency Values____ Current Currency Values----
28
26
Adapted from Guy Meredith,
"Why Has the Euro Been So Weak?", IMF
Source: Detkon and Hartmann (2000)
24
22
20
18
16
1994 1995 1996 1997 1998 1999 2000
Increase in
Euro-Denominated
Borrowing
by Non-Residents
Capital Decline in
Outflow Euros
from Value
Euroland
Increased
Investment in
Non-Euro Assets
by Euroland
Residents
There is no universal agreement among economists on vestors would need to be induced to buy and hold that
the role that fiscal policy plays in the determination of ex- debt through higher domestic interest rates, an immedi-
change rates. The reason for disagreement is that fiscal ate decline in the domestic currency's value, or some com-
impulses are transmitted to exchange rates through a vari- bination of the two.
ety of channels, some of which generate positive influ-
ences on a currency's value, while others generate nega- Perhaps one could combine the Mundell-Fleming and port-
tive influences. folio-balance models into a single integrated framework
by asserting that a stimulative fiscal policy is likely to be
For example, in the Mundell-Fleming model, an expansion- positive for a currency in the short run, but negative in the
ary fiscal policy typically gives rise to higher domestic in- long run. After the currencys initial appreciation during the
terest rates and an increase in domestic economic activ- period when the stimulative fiscal policy is put into place,
ity. The rise in domestic interest rates will induce a capital budget deficits will rise and total debt outstanding will grow.
inflow that should contribute to a rise in the domestic As the government's debt obligation rises, the market will
currency's value, but the consequent rise in domestic eco- begin to wonder how that debt will be financed, and if the
nomic activity will also contribute to a deterioration of the mountain of debt is sizable, the market may believe that
trade account, which should put downward pressure on pressure will eventually be brought to bear on the central
the domestic currency's value. How sensitive capital move- bank to monetize the debt. That clearly would lead to a
ments are to the rise in domestic interest rates will deter- rapid reversal of the initial currency appreciation.
mine whether the induced capital inflow will dominate the
deterioration of the trade balance or vice versa. Alternatively, the market may believe that the government's
fiscal stance will eventually have to shift toward signifi-
In the portfolio-balance model, a steady string of rising bud- cant restraint to restore longer-run balance to its fiscal po-
get deficits will result in a rising stock of government debt sition. A reversal of the fiscal stance that initially drove the
outstanding. If risk-averse investors balk at buying and currency higher would, by definition, set forces in motion
holding an ever-rising stock of government debt, then in- for a reversal of the initial currency appreciation.
120 4
The U.S. 1981 tax bill included cuts in marginal tax rates
for individuals and investment tax credits and accelerated 110 3
depreciation allowances for corporations to help spur busi- 100
ness investment. From an exchange-rate determination 2
standpoint, the business-oriented tax cuts helped boost 90
the dollar's real long-run equilibrium value because they 80
Source: Datastream
1
76 77 78 79 80 81 82 83 84 85 86 87 88 89 90
made U.S. industry more competitive. But the dollar got
its real boost when U.S. government spending soared at
the same time that taxes were cut. That pushed the U.S.
budget deficit as a percentage of GDP from 1.6% up to a U.S./German Real Interest-Rate Differentials
high of 6.1% in just four years in the early 1980s. Along and the U.S. Federal Budget Deficit
(1977-1987)
with an extremely tight monetary policy during the early U.S.-German Real 10-Yr.(bp)____ Budget Deficit as a % of GDP----
1980s, this helped drive U.S./European real yield spreads 600 6
up sharply, thereby sending the dollar up sharply as well.
400 5
140
7
130
120 6
110
100 5
90
4
80
Source: Datastream
70 3
74 76 78 80 82 84 86 88 90 92 94 96 98 00 02
long slump. Japan already has the industrial world's larg- 7.8
8
est government debt outstanding as a percentage of GDP, 7.0 7.1
6.7 6.7
and that debt burden seems certain to mount in future 6.2 6.0
6.5
6
years, according to OECD projections. Even those debt 5.3
projections probably understate Japan's true debt burden 4.5 4.7
4.0
by a sizeable amount, given Japan's seriously under-funded 4 3.5
3.1
social security and public pension systems, as well as other 2.5
off-balance-sheet liabilities that the government will be 2
2.0
1.6
1.4 1.5
obliged to underwrite. 0.7
0
83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
The path for Japanese debt is clearly not sustainable. In
the long run, the Japanese government will have to do
what every other government in the industrial world has
had to do when faced with a similar set of circumstances. Japans Mounting Debt Problem
That is, the Japanese government will have to engineer a (Assuming Unchanged Fiscal Policies)
Net Debt(% of GDP) Assuming 3.5% Real Interest Rate____ 1.5%----
multi-year plan of fiscal consolidationeither by raising 300
taxes and/or by curtailing government spendingto bring
the budget deficit/GDP ratio down to sustainable levels. 250
2.0
1.0
Expansionary
0.0
Restictive
-1.0
Source: OECD Economic Outlook
-2.0
91 92 93 94 95 96 97 98 99 00 01e 02e 03e 04e
Eurolands Budget Deficit and the Euro Canadas Budget Deficit and the C$
Budget Deficit/GDP(%)(bars) US$/Euro(line) Budget Deficit/GDP(%)(bars) C$/US$(reverse scale)(line)
7 1.40 10 (1.20)
6 8
1.30
5 (1.30)
6
1.20
4
4
3 1.10 (1.40)
2
2
1.00
0
1 (1.50)
0.90 -2
0
Source: OECD Economic Outlook Source: OECD Economic Outlook
-1 0.80 -4 (1.60)
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Australias Budget Deficit and the A$ Swedens Budget Deficit and the Krona
Budget Deficit/GDP(%)(bars) US$/A$(line) Budget Deficit/GDP(%)(bars) Skr/US$(reverse scale)(line)
8 0.80 15 (5)
0.75 (6)
6
10
0.70 (7)
4
0.65 5 (8)
2
0.60 (9)
0
0
0.55 (10)
Source: OECD Economic Outlook Source: OECD Economic Outlook
-2 0.50 -5 (11)
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Is a strongly growing domestic economy bullish or bear- One could combine the conclusions drawn from these two
ish for a currency? According to the monetary model of models by arguing that in the short/medium run, a strongly
exchange-rate determination, an increase in domestic eco- growing domestic economy should be bullish for a domes-
nomic activity will give rise to an increase in the demand tic currency because increases in economic activity are
for domestic money, and the increased demand for money often associated with attractive investment opportunities
(everything else being equal) should then lead to an ap- that should attract significant inflows of capital from abroad.
preciation of the domestic currency. In contrast, in the But in the long run, the balance of payments may place a
Mundell-Fleming and Balance of Payments Flow models, constraint on how rapidly a domestic economy can grow
an increase in domestic economic activity will give rise to relative to growth overseas. If strong domestic demand
an increase in import demand, which should cause the gives rise to a significant deterioration of the trade bal-
trade balance to deteriorate. The deterioration of the trade ance that is deemed unsustainable, then either domestic
balance should then exert downward pressure on the do- demand will have to be restrained or the domestic
mestic currency. currency's real value will have to fall to bring the trade/
current-account imbalance back to sustainable levels.
Increase in Increase in
Increase in
Domestic Domestic
Demand
Economic Currencys
for Money
Activity Value
Trends in economic activity have been a key determinant The trend in the euro has also been found to be highly
of exchange-rate trends in recent years. In the case of the correlated with the difference in U.S./Euroland expected
dollar, the trends in the U.S. unemployment rate and U.S. GDP growth rates since the euro's inception in 1999.
consumer confidence were, until recently, highly correlated
with the trend in the dollar. However, in both cases, there
was a disconnect between those economic indicators and
the dollar in 2001.
U.S. Unemployment and the Dollar U.S. Consumer Sentiment and the Dollar
(1995-2002) (Conference Board Consumer Confidence Index)
U.S. Unemployment Rate(%)____ US$/Euro---- Consumer Confidence Index____ US$/Euro(reverse scale)----
6.0 1.50 160 (0.80)
1.40 (0.90)
5.5 140
1.30 (1.00)
5.0 120
1.20 (1.10)
1.10 (1.20)
4.5 100
1.00 (1.30)
4.0 80
0.90 (1.40)
Source: Datastream Source: Datastream
3.5 0.80 60 (1.50)
1995 1996 1997 1998 1999 2000 2001 2002 1994 1995 1996 1997 1998 1999 2000 2001 2002
5 105
100
4
95
3
90
2
85
1 80
Source: Datastream
0 75
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Other currencies have also exhibited a tendency to move Finally, in the case of Australia, the A$'s fortunes have of-
in tandem with relative economic performances. For in- ten been tied to global economic prospects, with strong
stance, there has been a close relationship in recent years global growth positive for the A$ and vice versa. Evidently,
between the yen and the OECD's leading indicator of Japa- strong global growth boosts the world's demand for com-
nese economic activity, with weaker Japanese growth modities, which is positive for Australia's trade balance,
prospects negative for the yen and vice versa. In the case and thus the A$.
of the British pound, the ratio of German/U.K. unemploy-
ment rates has served as a good guide to sterling's pros-
pects. All things being equal, a decline (rise) in the U.K.
unemployment rate relative to the German unemployment
rate has been bullish (bearish) for sterling.
The Yen & Japans Leading Economic Indicator U.K./German Unemployment and the Pound
(OECD Composite Leading Indicator for Japan) German/U.K. Unemployment Rate(ratio)____ DM/----
Yen/US$(reverse scale)____ Leading Indicator(%)---- 3.5 3.40
(80) 8
3.20
(90) 6 3.0
3.00
(100) 4
2.5
2.80
(110) 2
2.60
(120) 0 2.0
6 20
4
10
2
0
0
-10
-2
-4 -20
Source: Datastream
-6 -30
89 90 91 92 93 94 95 96 97 98 99 00 01 02
It is not too difficult to unearth the reasons for the dollar's appears to be shared by many economists. However, what
rising trend over the past six years. The U.S. grew two to is open to dispute is: (1) by how much did the dollar's real
three times faster than either the German or Japanese long-run equilibrium value actually rise, and (2) did the
economies, with 'New Economy' forces in the U.S. widely dollar's rise in 2000-01 push it above its new long-run equi-
credited for the relative strength of the U.S. economy, and librium level?
thus the dollar.
(Note that the German economy did not fare much better
According to the New Economy view, the surge in U.S. than Japan over the past 10 years. Given that the 1990s
investment spending and the consequent rise in U.S. pro- have often been characterized as Japan's lost decade, they
ductivity helped push U.S. growth significantly above the could just as easily have been characterized as Germany's
pace of overseas growth, which, in turn, raised the dollar's lost decade as well.)
real long-run equilibrium value versus the euro. This view
U.S. 2.7 4.0 2.7 3.6 4.4 4.3 4.1 4.1 1.2 2.3 3.3
Germany -1.1 2.3 1.7 0.8 1.4 2.0 1.8 3.0 0.6 0.9 1.2
Japan 0.5 1.1 1.5 3.6 1.8 -1.0 0.7 2.2 -0.4 -1.0 0.9
Source: IMF
The argument most often made to justify official interven- Numerous empirical studies have been conducted to as-
tion in the FX markets is that the exchange rate is simply sess whether intervention operations have a statistically
too important a price to be left to the market. Intervention significant and quantitatively important impact on exchange
advocates contend that financial markets cannot be trusted rates. In most studies, the results have been negative. In
to get the exchange rate "right". They argue that interven- those cases where a statistically significant relationship
tion is necessary to keep exchange rates broadly in line between intervention and exchange rates has been found,
with their long-run fundamental equilibrium value. Thus, it has generally been the case that the impact was not
the case for intervention relies largely on the belief that quantitatively important, i.e., the effect of the intervention
the authorities can do a better job than the market in terms effort was neither sizable nor lasting. The major reason for
of driving exchange rates towards their long-run equilib- such findings is that intervention operations are typically
rium value. This assumes that government officials have small relative to the volume of foreign exchange that
better information and greater knowledge than the mar- changes hands on a daily basis in the FX markets. Daily
ket, which, of course, is highly debatable. intervention efforts typically average in the hundreds of
millions or perhaps only several billion. This contrasts with
No precise rules govern the conduct of FX intervention, average daily FX turnover of $1.2 trillion. While episodes of
but the IMF has established guidelines to prevent one successful intervention can be found, no systematic rela-
country from unfairly manipulating its exchange rate to gain tionship exists between official intervention efforts and the
an unfair advantage over others. trend in exchange rates.
FX market may fail to use "all" existing information. Simple smoothing operations to limit erratic short-
FX market may be dominated by noise (trend-fol- run fluctuation in exchange rates.
lowing) traders. Counter excessive speculation or market overreac-
Excessive speculation. tion to news.
Excessive risk aversion (shortage of speculation). Trend-breaking operation to put an end to an unde-
sirable uptrend or downtrend in a currency's value.
FX market may be using a defective model of ex-
change-rate determination. Counter excessive risk aversion.
Market perceptions of the future may be flawed or Intervention to target a currency's value to some
inappropriately skewed. specific level or range.
FX market may be pre-occupied with extraneous Intervention to prevent large and persistent
information. misalignments.
Administration/Period Policy
Nixon 1969-71 Benign neglect.
1971-73 Cut dollar loose from gold.
Devaluated dollar.
Dollar Over/Undervaluations & U.S. Intervention Dollar Over/Undervaluations & U.S. Intervention
(1976-1980) (1981-1986)
% Over/Under PPP Level(DM/US$)(line) Intervention(US$ mn.)(bars) % Over/Under PPP Level(DM/US$)(line) Intervention(US$ mn.)(bars)
60 6000 60 6000
40 4000 40 4000
20 2000 20 2000
Source: Federal Reserve Bank, Datastream Source: Federal Reserve Bank, Datastream
-40 -4000 -40 -4000
1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986
Dollar Over/Undervaluations & U.S. Intervention Dollar Over/Undervaluations & U.S. Intervention
(1987-1998) (DM/US$ PPP Estimates, 1998-2002)
% Over/Under PPP Level(DM/US$)(line) Intervention(US$ mn.)(bars) % Over/Under PPP Level(DM/US$)(line) Intervention(US$ mn.)(bars)
60 6000 40 2000
30 1500
40 4000
20 1000
20 2000
10 500
Dollar Overvalued--Sell Dollars
0 0 Dollar Overvalued -- Sell Dollars
Dollar Undervalued--Buy Dollars 0 0
Dollar Undervalued -- Buy Dollars
Japans Foreign Exchange Reserves & the Yen The Yen & Japanese Short-Term Interest Rates
Reserves(US$(bn.)(bars) Yen/US$(line) (Three-Month Euro-Deposit Rates)
500 160 (1980-1998)
Source: Datastream Yen/US$____ 3-mo. Rate(%)----
300 20
400
140
250
15
300
200
120
10
200
150
100
100 5
100
Source: Datastream
0 80 50 0
1994 1995 1996 1997 1998 1999 2000 2001 2002 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
E0 E2
Third, sterilized intervention that alters the supply of do- q0
mestic bonds relative to the supply of foreign bonds in
private portfolios can also have a direct impact on the
medium-term trend in exchange rates. Intervention oper-
ating through that channel can be effective only if the vol- D
ume of intervention is sizable relative to the stock of pub- D
licly traded domestic and foreign bonds held in private Quantity of Foreign Exchange
portfolios.
via
Monetary
Channel Multiple
Change in
Expansion of
Monetary
Domestic
Base
Money Supply
Change in
Nonsterilized
Exchange
Intervention
Rate
Expectations Change in
of Future Expected
Monetary Future
Growth Exchange Rate
Change in
Foreign
Interest Rate
Change in
Risk
Premium
Sterilized Change in
Intervention Exchange
Rate
Change in
Expectations
Expected
of Future
Future
Monetary
Exchange
Growth
Rate
Market
Efficiency
Channel
Revision
of Market
Change in
Central Bank Expectations
Exchange
Intervention of Future
Rate
Convey Official Exchange
Intention of Rate
Superior
Future
Information
Monetary-Policy
Channel
Actions
to the Market
Traders
Adjust Their Change in
Central Bank Short-Run Exchange
Intervention Currency Rate
Positions
Note: This section draws, in part, from Michael Rosenbergs Currency Crises in Emerging Markets, Merrill Lynch, 1998.
greatly. One school of thought contends that currency cri- 500 180
ses tend to be precipitated by deteriorating economic fun-
damentals. If so, and the trend in those economic funda- 400 160
mentals weakens steadily and predictably, then it should
300 140
be possible to construct an early-warning system to an-
ticipate when a currency might be vulnerable to a specu- 200 120
lative attack.
100 100
Source: Datastream
An alternative school of thought argues that while evidence 0 80
Jan-97 Apr-97 Jul-97 Oct-97 Jan-98 Apr-98 Jul-98 Oct-98
of deteriorating economic fundamentals might explain a
relatively large number of currency collapses, there might
also be cases where economies with relatively sound fun-
damentals could see their currencies come under attack Capital Flows into Emerging Markets
(Net Private Capital Flows)
because of a sudden adverse shift in market sentiment or (US$ bn.)
mood swing that is totally unrelated to economic funda- 250
233.2
mentals. If attacks can occur out-of-the-blue when eco- Source: IMF World Economic Outlook,
205.7 December 2001
nomic fundamentals are not offering any warning of an 200
impending attack, then there may simply be no way for
fundamental-based models to predict the onset of currency 150 145.6
151.3
crises.
116.8
100
69.6
59.6
50
20.1
8.9
0
1993 1994 1995 1996 1997 1998 1999 2000 2001e
Policy (a)
Variable
or
Financial
Shock
0 Time
(b)
Economic
Fundamentals
(+)
A
0 Time
(-)
(c)
Nominal
Exchange
Rate A
Time
Economic
Fundamentals
B
A
Time
Nominal
Exchange
Rate
B
Time
Uncertainty about the Future Course of Economic Fundamentals A Sudden Deterioration in Economic Fundamentals
Makes It Difficult to Pinpoint When an Attack Might Occur Could Trigger a Speculative Attack with Little Advance Warning
Economic Economic
Fundamentals Fundamentals
A
B
C
Time Time
A A
"Gray Area"
(Vulnerable to Attack but Not Inevitable)
1000
800
600
400
200
Source: Datastream
0
01-Jul-96 30-Aug-96 31-Oct-96 01-Jan-97 04-Mar-97 05-May-97 04-Jul-97
The Longer a Fixed Exchange-Rate Regime Stays Intact, The Markets Assessment of the Risk of an Imminent
the Less Weight Investors Assign to the Likelihood of a Crash Currency Crisis Might Differ Greatly from the True Risk
Market-Assigned Probability of a
Weight to the Currency Crisis
Likelihood of a
True Probability
Currency Crash of a Crisis
Widening Gap
Between
Perception & Reality
Real
Exchange Rate
D
q Inflation Inertia and
Excessive Surge
C in Capital Inflows
q1
Rise in Real Long-Run
B Equilibrium Exchange Rate
q0 Time
Correction of
Initial Undervaluation
A
Inflation
Differential
pEM-pUS
Time
Nominal
Exchange
Rate
e0 eEM
Time
Real qEM
Exchange
Rate
Time
Nominal Real
Exchange-Rate Exchange-Rate
Appreciation Appreciation
Real Excess
Appreciation Returns
Increase
Surge in Expectation
in
Capital of
Foreign-Exchange
Inflow Additional
Reserves
Above-Average
Returns
Increase
Increase Lower
in
in Budget
Economic
Money Supply Deficit
Activity
Excessive Surges in Capital Inflows Investors and Borrowers Are Often Caught Leaning the Wrong Way
Often Plant the Seeds of Future Currency Crises at the Time of an Exchange-Rate Collapse
Real
Appreciation Net Long Positions
in Emerging-Market A
Currency
Increase in
External Indebtedness
Equity and/or
Excessive Surge Property Bubble
in Currency
Capital Inflow Crisis Time
Excessive Growth
in Domestic Credit
Current-Account
Deficit
Over-investment
in Risky Projects
Time
0.25 0.23
0.20
Source: Goldfajn and Valdes (1996).
0.15
0.11 Economic
Fundamentals
0.10
0.06
0.05 A
Time
0.00
0.00
15 20 25 30 35
Real Currency Appreciation(%)
-0.3
-0.5
-1
-1.1
-1.4 -0.8
-1.0
-1.7
-2
-1.5 -1.5
-1.6
-3
-2.0
-3.5 -3.5 -2.1
-4
-2.5 -2.5
-4.3
Source: OECD Economic Outlook, June 1998 Source: OECD Economic Outlook, June 1998.
-5 -3.0
1987 1988 1989 1990 1991 1992 1987 1988 1989 1990 1991 1992
-1.0 -1.0
-1.1
-1.6
-2.0 -2.0 -2.0
-2.7
-3.0 -2.9 -3.0
While current-account imbalances may have played an 1971-92 period, and found that current-account imbalances
important role in triggering the Mexican peso and Asian were not statistically significant in predicting currency
currency crises in the 1990s, most international econo- crashes. Sachs, Tornell, and Velasco (1996) found that cur-
mists would argue that the violent character of those cur- rent-account imbalances were not helpful in determining
rency-crisis episodes could be explained only by financial- which currencies were vulnerable to contagion effects fol-
sector weaknesses, and not by external-balance consider- lowing the Mexican peso collapse in 1994-95. However,
ations. Goldstein et al. (2000) and the IMF (1998) found that cur-
rent-account deficit/GDP ratios have, on average, been sig-
What does the empirical evidence suggest about the role nificantly larger in periods leading up to a crisis than dur-
of current-account imbalances in triggering currency cri- ing tranquil periods. The latter results suggest that current-
ses in emerging markets? Frankel and Rose (1996) exam- account imbalances may have some predictive power in
ined the fundamental forces that triggered currency anticipating currency crises.
crashes in over 100 emerging-market countries over the
-2
-2
-4 -3.8
-2.8
-4.8 -4.9 -5.1
-4 -6
-4.6
-8 -7.8
-6 -5.8
-6.7
-10 -9.9
-7.1
Source: OECD Economic Outlook, June 1998. Source: National government data.
-8 -12
1990 1991 1992 1993 1994 1992 1993 1994 1995 1996 1997
-2
-1
-4 -1.5
-1.7
-2
-5.1
-6 -5.7 -5.6 -2.3
-2.4
-3
-8 -8.0 -8.1
-3.4 -3.4
Source: National government data. Source: National government data.
-10 -4
1992 1993 1994 1995 1996 1997 1992 1993 1994 1995 1996 1997
-1 -1.0 -1.6
-1.3 -2
-2 -1.8 -1.8
-3
-3
-4
-4
-4.4 -4.5
-4.6 -4.7
-5 -4.8 -5
Source: OECD Economic Outlook, June 1998. Source: National government data.
-5.6
-6 -6
1992 1993 1994 1995 1996 1997 1992 1993 1994 1995 1996 1997
e=-M (1)
If a central bank attempted to monetize a large budget With both D and M rising at the same rate, the rise in M
deficit by expanding domestic credit, D, that would lead to would no longer be consistent with the maintenance of a
a corresponding rise in the monetary base, M, unless the stable exchange rate. Once M starts to expand, the ex-
central banks holdings of reserves, R, were run down by change rate would begin to decline at the same rate that
an amount equal to the rise in D. If the central bank's hold- M is rising. In practice, if forward-looking investors saw
ings of foreign-exchange reserves, R, were run down by that the central banks FX reserves were falling to danger-
an amount equal to the increase in domestic credit, D, the ously low levels, they would, in all likelihood, wage an at-
monetary base would be held constant and the nominal tack on the vulnerable currency prior to point t1 being
exchange rate would remain fixed. reached.
5 4.9 4.9
4.2
4 3.6
3.5
2 1.8
0
il
Chile Braz Argentina Mexic
o pines Thailand donesia Kore
a
Philip In
Real A
Interest
Rate
Time
Economic
Activity
A
Time
Nominal
Exchange
Rate
Time
US$ Value
of Dollar-
Denominated
Debt
Time
Local-Currency
Value
of Dollar-
Denominated
Debt
Time
Nominal
Exchange
Rate
Time
Source: Rosenberg (1998)
the hearts of foreign creditors, and foreign funds are with- vice their debts. Note that right up until the time of a specu-
held, the emerging-market currency could come under lative currency attack, a highly indebted nation may not
heavy downward pressure. If so, the local-currency value show any visible signs of economic weakness. Once an
of the short-term foreign-currency debt could soar, possi- attack takes place and the local-currency value of short-
bly throwing otherwise viable local entities into insolvency. term foreign-currency debt soars, the trend in economic
fundamentals is shown to suddenly deteriorate as firms
The importance of short-term foreign-currency debt as a go bankrupt, banks fail, and the government's fiscal bal-
measure of financial vulnerability is highlighted by the fact ance deteriorates.
that debt crises played an important role in the currency
crises in both Mexico and Asia. Indeed, the buildup of a A country's economic vulnerability might not reveal itself
large volume of short-term foreign-currency debt by the prior to a debt-induced attack, and there may be few signs
public sector in Mexico and the private sector in Asia is suggesting that an attack is imminent. An emerging-mar-
widely credited with planting the seeds of the Mexican ket economy might successfully leverage off of relatively
peso and Asian currency crises. In both situations, the lo- cheap short-term foreign-currency debt and post an im-
cal-currency value of the foreign-currency debt soared as pressive growth performance for a long while without trig-
the peso and Asian currencies came under heavy down- gering a crisis, much as Asia did in the decade leading up
ward pressure. to the crisis in 1997. In fact, Asia's solid growth performance
might have deluded the majority of market participants into
The local-currency value of foreign-currency debt is highly believing that Asia's underlying fundamentals were sound
sensitive to changes in the exchange rate. A sudden sharp when, in fact, they were all the time vulnerable if the value
depreciation of an emerging-market currency will instantly of the Asian currencies, for whatever reason, suddenly
raise the local-currency value of all short-term foreign-cur- declined.
rency-denominated debt, and by so doing, will dramati-
cally increase the burden of servicing that debt. As indebt- This has important implications for modeling currency cri-
edness soared in Mexico and Asia, default risk rose sharply ses in emerging markets. Signs of fundamental economic
and, as a result, overseas private capital was no longer deterioration may not be visible going into a crisis. While
forthcoming. With no funds forthcoming, the trend in eco- evidence of deteriorating fundamentals may be useful in
nomic fundamentals deteriorated suddenly and markedly. predicting certain currency crises, there may be few reli-
able guideposts available to predict when a debt-driven
The stylized diagram below demonstrates that a sharp rise currency crisis might occur. A large foreign-currency debt
in the local-currency value of short-term foreign-currency burden may be a sign of currency vulnerability in the long
debt places a nation's economy in a vulnerable position if run, but there may simply be no way of knowing before-
soaring debt burdens make it difficult for local firms to ser- hand when an attack might actually be waged.
Local-Currency
Value of Dollar-
Denominated
Debt
A
Time
Economic A
Fundamentals
A
Time
Excessive Surges in Capital Inflows Banking Crises Often Lead Currency Crises
Often Plant the Seeds of a Future Banking Crisis
Decline in
Asset Economic
Bubble Activity
Price
Bursts Dramatically
Bubble
Easier Decline in
Monetary Central
Policy Banks
Costly
Increase in Banking Holdings Currency
Surge in Bank Fiscal Crisis
Questionable Crisis of
Capital Lending Bailout
and Risky Foreign-
Inflow Boom Exchange
Loans Increase in Reserves
Non- Banking
performing Crisis Decline in
Over- Loans Credibility
consumption of Existing Capital
and Exchange- Flight
Over- Rate
investment Regime
Bilateral
Trade Linkages
Trade with a
Common Third Party
Crisis Crisis
in Common in
Country A Lender Country B
Level of
Market Liquidity
Global Reduction in
Appetite for Risk
Fourth, a general decline in global investors' appetite for According to a recent IMF analysis of emerging-market
risk might generate contagion among emerging-market contagion effects, trade linkages probably played a small
currencies if investors reduce their exposure to all risky role in the spread of currency crises from one country to
assets. This typically occurs during times of global finan- another in the 1990s. In contrast, financial linkages appear
cial or economic stress. to have played a larger role, particularly through changes
in investor risk appetite and the existence of common lend-
Finally, if policymakers in an individual emerging market ers.
abandon the defense of a pegged exchange rate because
the cost of defending the exchange rate against attack
proves to be too great, then this action might contain infor-
mation on the ability and willingness of policymakers in
other countries to withstand the pressures of speculative
attacks.
Sources: IMF World Economic Outlook (December 2001); Kaminsky and Reinhart (2000); Kumar and Persaud (2001); and Glick, and Rose, 1999.
1 Exposure through bilateral trade is measured by the share of the countrys total exports destined to the initial crisis country.
2 Trade with a common third party in the same commodities is measured as the percentage of total exports competing with the top exports of initial crisis country.
3 For a discussion of how Bank of International Settlements data can be used to identify common bank lender clusters, see Kaminsky and Reinhart (2000).
For bonds, see J.P. Morgans EMBI+ weights.
4 Market liquidity is roughly proxied by the countrys representation (its share) in the global mutual funds emerging market portfolio.
High, moderate, and low classifications are comparisons with respect to other emerging markets.
5 For a description of the methodology used to estimate risk appetite, see Kumar and Persaud (2001).
Symptoms Indicators
Real Exchange Rate Overvaluation Behavior of real exchange rate relative to trend,
exports, imports, trade balance.
Terms of Trade Shock Price of exports, price of imports, commodity prices.
Current Account Imbalance Real exchange rate, savings, investment.
50
40
40
30
30
20
20
DBAC Trigger Level
DBAC Trigger Level
10
10
Source: Deutsche Bank Alarm Clock Source: Deutsche Bank Alarm Clock
0 0
Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02
40
15
30
10
20
DBAC Trigger Level
5
Source: Deutsche Bank Alarm Clock 10
DBAC Trigger Level
Source: Deutsche Bank Alarm Clock
0 0
Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02
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