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Emerging Financial Markets
4: Macroeconomic Inconsistencies
Prof. J.P. Mei
Exchange Rate Determination I
 Purchasing
Power Parity: The Law of One
price for the same good all over the world
(Absolute PPP)
– Assumption: Free and frictionless trade (no
transaction cost, taxes, and uncertainty)
– PPP is often violated in reality but tend to correct
itself when large deviations occur.
 The
Construction of the Big Mac Index (which
currency is over-valued?)
2
Exchange Rate Determination I
 Purchasing
Power Parity with Inflation
(Relative PPP)
s = ID - IF [s = (S1 - S0 )/ S0, S=$/F] (1)
1. Relative PPP is based on Absolute PPP.
2. High inflation economy should have
depreciating currency.
 This explains Why the Hong Kong dollar is
vulnerable (Plot US and HK inflation)
 50% of the deviation from Relative PPP gets
corrected within 5 years.
The Big Mac Index
Prices as of December 1998
Local currency under(-)/over(+) valuation against the dollar (in percent)
30
10
$2.63
-10
$2.99
$2.45
$2.17
-30
$1.90
-50
$1.13
Prices in
are the dollar
equivalent of a "Big Mac"
$1.20
-70
Malaysia
China
Mexico
Source: The Economist , December 19, 1998.
Taiwan
Brazil
U.S.
Germany
Inflation Differential among US, Thailand, and Hong Kong
200
FROM 1-15-90 TO 1-15-01 M ONTHLY INDEXED
180
160
140
120
100
80
1990 1991 1992 1993 1994 1995 1996 1997 1998 19992000 2001
TH CPI NADJ
HK CPI (A) NADJ
US CPI - ALL ITEMS SADJ
HIGH 162.0 9-15-00 LOW 100.0 1-15-90 LAST 161.4
HIGH 189.1 5-15-98 LOW 100.0 1-15-90 LAST 175.6
HIGH 136.5 11-15-00 LOW 100.0 1-15-90Sourc
LASTe:
136.5
DATASTREAM
3
55
FROM 1-1-91 TO 1-26-00 WEEKLY
50
45
40
35
30
25
20
15
10
5
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
THAI BAHT TO US $ - EXCHANGE RATE
HONG KONG $ TO US $ - EXCHANGE RATE
Sourc e: DATASTREAM
Exchange Rate Determination II
 Domestic
Fisher Relation: rD =r +E(ID)
 Law of One Price =>International Fisher
Relation:
rD - rF =E(ID) -E(IF) , or E(s)= rD - rF (2)
1. Interest rate differential is determined by difference
in inflation expectation. High inflation economy should
have higher rates.
2. Expected exchange rate change is determined by
Interest rate differential. High interest country should
expect to see a weaker currency in the future.
4
Exchange Rate Determination III
 Interest
Rate Parity (Arbitrage condition)
F = S0 * (1+rD )/(1+ rF ) or f = rD - rF
(3)
1. Forward rate is determined by the spot rate and
interest differentials.
2. Serious violation of IRP would lead to arbitrage profit
3. If F >>SF (synthetic forward), sell forward, buy SF
(borrow $, sell $ spot, lend FX)
4. If F <<SF, buy forward, sell SF
5. Thai government’s money losing machine: Forward
market operation to keep the forward rate high.
5
Interest Rate Differentials
30
FROM 1-3-92 TO 3-31-99 WEEKLY
25
20
15
10
5
0
1992
1993
1994
1995
1996
1997
1998
1999
HONG KONG INTERBANK 1 MONTH - MIDDLE RATE
THAILAND INTERBANK 1 MTH (BB) - OFFERED RATE
US INTERBANK 1 MTH (LDN:BBA) - OFFERED RATE
HIGH 16.82915 8-28-98 LOW 2.75000 7-10-92 LAST 6.37946
HIGH 28.000 1-9-98 LOW 5.250 2-12-99 LAST 5.250
HIGH 6.12500 12-2-94 LOW 3.00000 10-2-92
LAST
4.93969
Source:
DATASTREAM
Notes on Exchange Rate Determination
 RER
tend toward PPP in the very long run.
 Short run deviation from PPP are large and
volatile (Indonesia and Thailand).
 Deviation from PPP suggests segmentation in
international goods markets. There is a large
buffer within which nominal exchange rate can
move without producing immediate response in
relative domestic prices. (i.e., Big Mac price
can remain low in Indonesia for quite a while.)
7
What went wrong in Thailand

Poor Export to Short-term Debt Coverage Ratio

Loss of Competitive Strength and Foolish Property
Market Speculation Relatively Small Reserves

Large foreign currency debt led corporation to
dramatically increase their demand of foreign
currencies.
Operational Errors:

Lack of Political Will to Defend the Currency

Inconsistency in Implementing the Defense

Reckless Forward Market Operation