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Chapter 7
Foreign Exchange
Rate Determination
Foreign Exchange Rate
Determination
• Chapter 6 described the international parity
conditions that integrate exchange rates with
inflation and interest rates.
• This chapter extends the discussion of
exchange rate determination to the other two
major schools of thought on the determination
of exchange rates:
– The balance of payments approach
– The asset market approach
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
7-2
Exhibit 7.1 The Determinants of Foreign
Exchange Rates
Parity Conditions
1.
2.
3.
4.
Relative inflation rates
Relative interest rates
Forward exchange rates
Interest rate parity
Is there a well-developed
and liquid money and capital
market in that currency?
Asset Approach
1.
2.
3.
4.
5.
6.
Relative real interest rates
Prospects for economic growth
Supply & demand for assets
Outlook for political stability
Speculation & liquidity
Political risks & controls
Spot
Exchange
Rate
Is there a sound and secure
banking system in-place to support
currency trading activities?
Balance of Payments
1.
2.
3.
4.
5.
Current account balances
Portfolio investment
Foreign direct investment
Exchange rate regimes
Official monetary reserves
Foreign Exchange Rate
Determination
• It is important to remember that these
three theories are not competing, but
rather are complementary to each other.
• Without the depth and breadth of the
various approaches combined, our ability
to capture the complexity of the global
market for currencies is lost.
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7-4
Foreign Exchange Rate
Determination
• In addition to gaining an understanding
of the basic theories, it is equally
important to gain a working knowledge
of how the complexities of international
political economy; societal and economic
infrastructures; and random political,
economic, or social events affect the
exchange rate markets.
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7-5
The Balance of Payments
(BOP) Approach
• The relationship between the BOP and exchange rates
can be illustrated by the use of a simplified equation
that summarizes BOP data:
Current
Account
Balance
Capital
Account
Balance
Financial
Balance
Reserve
Account
of
Balance
Balance
Payments
(X – M) + (CI – CO) + (FI – FO) + FXB = BOP
Where X = exports of goods and services, M = imports
of goods and services, CI = capital inflows, CO =
capital outflows, FI = financial inflows, FO = financial
outflows and FXB = official monetary reserves.
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7-6
The Balance of Payments
(BOP) Approach
• Fixed Exchange Rate Countries:
– Under a fixed exchange rate system, the
government bears the responsibility to ensure a
BOP near zero.
– To ensure a fixed exchange rate, the government
must intervene in the foreign exchange market and
buy or sell domestic currencies (or sell gold) to
bring the BOP back to near zero.
– It is very important for a government to maintain
significant foreign exchange reserve balances to
allow it to intervene in the foreign exchange market
effectively.
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7-7
Exhibit 7.3 Thailand’s Deteriorating Balance of
Payments, 1991-1998
25
20
Billions of US dollars
15
10
5
0
1991
1992
1993
1994
1995
1996
1997
1998
-5
-10
-15
-20
Current Account
Capital/Financial Account
Source: International Financial Statistics, International Monetary Fund, Washington DC, monthly.
7-8
The Balance of Payments
(BOP) Approach
• Floating Exchange Rate Countries:
– Under a floating exchange rate system, the
government of a country has no
responsibility to peg its foreign exchange
rate.
– The fact that current and capital account
balances do not sum to zero will
automatically (in theory) alter the exchange
rate in the direction necessary to obtain a
BOP near zero.
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7-9
The Balance of Payments
(BOP) Approach
• Managed Floats:
– Countries operating with managed floats, while still
relying on market conditions for day-to-day
exchange rate determination, often find it necessary
to take action to maintain their desired exchange
rate values.
– They seek to alter the market’s valuation of a
specific exchange rate by influencing the motivators
of market activity, rather through direct intervention
in the foreign exchange markets.
– The primary action taken by such governments is to
change relative interest rates.
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7-10
The Asset Market Approach
to Forecasting
• The asset market approach assumes that
whether foreigners are willing to hold claims in
monetary form depends on an extensive set of
investment considerations or drivers (among
others):
– Relative real interest rates
– Prospects for economic growth
– Capital market liquidity
– A country’s economic and social infrastructure
– Political safety
– Corporate governance practices
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7-11
The Asset Market Approach
to Forecasting
• Foreign investors are willing to hold securities
and undertake foreign direct investment in
highly developed countries based primarily on
relative real interest rates and the outlook for
economic growth and profitability.
• The asset market approach is also applicable to
emerging markets, however in these cases a
number of additional variables contribute to
exchange rate determination (previous slide).
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7-12
Disequilibrium: Exchange Rates
in Emerging Markets
• Although the three different schools of thought on
exchange rate determination (parity conditions, balance
of payments approach, asset approach) make
understanding exchange rates appear to be
straightforward, that it rarely the case.
• The large and liquid capital and currency markets
follow many of the principles outlined so far relatively
well in the medium to long term.
• The smaller and less liquid markets, however,
frequently demonstrate behaviors that seemingly
contradict the theory.
• The problem lies not in the theory, but in the relevance
of the assumptions underlying the theory.
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7-13
Illustrative Case: The Asian Crisis
• The roots of the Asian currency crisis extended
from a fundamental change in the economics of
the region, the transition of many Asian nations
from being net exporters to net importers.
• The most visible roots of the crisis were the
excess capital inflows into Thailand in 1996
and early 1997.
• As the investment “bubble” expanded, some
market participants questioned the ability of the
economy to repay the rising amount of debt
and the Thai bhat came under attack.
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7-14
Illustrative Case: The Asian Crisis
• The Thai government intervened directly
(using foreign currency reserves) and indirectly
by raising interest rates in support of the
currency.
• Soon thereafter, the Thai investment markets
ground to a halt and the Thai central bank
allowed the bhat to float.
• The bhat fell dramatically and soon other Asian
currencies (Philippine peso, Malaysian ringgit
and the Indonesian rupiah) came under
speculative attack.
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7-15
Illustrative Case: The Asian Crisis
• The Asian economic crisis (which was much
more than just a currency collapse) had many
roots besides traditional balance of payments
difficulties:
– Corporate socialism
– Corporate governance
– Banking liquidity and management
• What started as a currency crisis became a
region-wide recession.
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7-16
Illustrative Case:
The Russian Crisis of 1998
• The crisis of August 1998 was the culmination
of a continuing deterioration in general
economic conditions in Russia.
• From 1995 to 1998, Russian borrowers (both
government and non-governmental) had gone
to the international capital markets for large
quantities of capital.
• Servicing this debt soon became an increasing
problem, as it was dollar denominated and
required dollar denominated debt service.
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7-17
Illustrative Case:
The Russian Crisis of 1998
• The Russian current account (while a healthy
surplus of $15 - $20 billion per year) was not
finding its way into internal investment and
external debt service.
• Capital flight began to accelerate, and hard
currency earnings flowed out of the country.
• As the Russian rouble operated under a
managed float, the Central Bank had to
intervene in foreign exchange markets to
support the currency if it came under pressure.
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7-18
Illustrative Case:
The Russian Crisis of 1998
• During the month of August, 1998, the Russian
government continued to drain its reserves and
had increasing difficulties in raising additional
capital in support of its reserves on the
international markets.
• By mid-August, the Russian Central Bank
announced it would allow the rouble to fall,
postponed short-term domestic debt service
and initiated a moratorium on all repayment of
foreign debt owed by Russian banks and
private borrowers to avert a banking collapse.
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7-19
Illustrative Case:
The Argentine Crisis of 2002
• In 1991 the Argentine peso had been
fixed to the US dollar at a one-to-one rate
of exchange.
• A currency board structure was
implemented in an effort eliminate the
source inflation that had devastated the
nation’s standard of living in the past.
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7-20
Illustrative Case:
The Argentine Crisis of 2002
• By 2001, after three years of recession,
three important problems with the
Argentine economy became apparent:
– The Argentine Peso was overvalued
– The currency board regime had eliminated
monetary policy alternatives for
macroeconomic policy
– The Argentine government budget deficit –
and deficit spending – was out of control
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7-21
Illustrative Case:
The Argentine Crisis of 2002
• In January 2002, the peso was devalued as a
result of enormous social pressures resulting
from deteriorating economic conditions and
substantial runs on banks.
• However, the economic pain continued and the
banking system remained insolvent.
• Social unrest continued as the economic and
political systems within the country collapsed;
certain government actions set the stage for a
constitutional crisis.
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7-22
Forecasting in Practice
• Numerous foreign exchange forecasting
services exist, many of which are provided by
banks and independent consultants.
• Some multinational firms have their own inhouse forecasting capabilities.
• Predictions can be based on elaborate
econometric models, technical analysis of
charts and trends, intuition, and a certain
measure of gall.
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7-23
Forecasting in Practice
• Technical analysts, traditionally referred to as
chartists, focus on price and volume data to determine
past trends that are expected to continue into the future.
• The single most important element of technical
analysis is that future exchange rates are based on the
current exchange rate.
• Exchange rate movements can be subdivided into three
periods:
– Day-to-day
– Short-term (several days to several months)
– Long-term
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7-24
Forecasting in Practice
• The longer the time horizon of the forecast, the
more inaccurate the forecast is likely to be.
• Whereas forecasting for the long run must
depend on the economic fundamentals of
exchange rate determination, many of the
forecast needs of the firm are short to medium
term in their time horizon and can be addressed
with less theoretical approaches.
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7-25
Exhibit 7.12 Differentiating Short-Term Noise
from Long-Term Trends
Foreign currency per
unit of domestic currency
Technical or random events
may drive the exchange
rate from the long-term path
Fundamental
Equilibrium
Path
Time