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Coping with Exchange Rates
Week 2Professor Dermot McAleese
OUTLINE
Definitions
Exchange rate in practice
Exchange rate theories (PPP)
Capital flows and exchange rate volatility
Coping with exchange rate risk
EXCHANGE RATE
The exchange rate is defined as the price of a unit of foreign currency in terms of domestic currency.
The nominal effective exchange rate (EER) of a country A is A’s exchange rate vis-a vis other currencies weighted by their share in A’s trade.
Real effective exchange rate (REER) takes account of price level changes between trading partners by adjusting the nominal effective exchange rate by the ratio of foreign to domestic inflation.
EFFECT OF STERLING DEPRECIATION ON BRITISH EXPORTS TO US
S
S1
D
E1
E0
P0
P1
P2
X0 X1Quantity of British Exports
Price per unit in dollars
D
EFFECT OF STERLING DEPRECIATION ON US EXPORTS TO UK
S1
S
E0
D
M0M1
P0
P1
P2
D
E1
Quantity of US exports
Price per unit in sterling
DEPRECIATION OF STERLING
A depreciation of sterling will, other things being equal, lead to:
an increase in volume of UK exports
a reduction in the volume of UK imports
a fall in the dollar price and a rise in the sterling price of UK exports
a rise in the sterling price of UK imports
Effect of a devaluation is negative in the short run. It is followed by a positive longer term effect.
A
B
C
a b c Time
Current account £m
BoP
Surplus
Deficit
THE J-CURVE
PURCHASING POWER PARITY
Purchasing power parity (PPP) links movements in exchange rates to differences between price level in the domestic country and that of its major trading partners
Law of one price: if two goods are identical, they will sell at the same price
Arbitrage: process which ensures that the existence of any price differential between one country and another is exploited in order to make a riskless profit
PURCHASING POWER PARITY (PPP)
Absolute PPP - the exchange rate will be such that the general level of prices will be the same in every country
Pd = ER x Pf
Relative PPP - changes in the exchange rate are determined by the difference between relative domestic inflation rates in different countries
fd PPER %%%
Table. 1 PPP and actual ER for selected countries
Source: OECD, Main Economic Indicators (Paris, various editions); OECD, OECD Economic Outlook (Paris, various issues).
1985 1990 1995 1999 1985 1990 1995 1999
US 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Japan 273.00 144.00 94.00 114.00 222.00 195.00 170.00 161.00
UK 0.77 0.56 0.63 0.61 0.57 0.60 0.65 0.66
Euro zone n.a. n.a. n.a. 0.93 n.a. n.a. 0.93 0.94
PPPActual exchange rate
VERDICT ON PPP
It works well in the long run, especially in conditions of very large inflation differentials.
It provides a guide to the general trend in exchange rates, in particular where the main shocks underlying the trend are of monetary origin.
In a fixed exchange rate system inflation differences give a useful indicator of pressure for currency realignment
For the conduct of macroeconomic policy, it is an important reminder that the exchange rate and the price level cannot be divorced from each other.
BALANCE OF PAYMENTS AND MONETARY APPROACHES
Balance of payments approachfocus is more directly on the link between the trade/current account balance, modified to take account of long-term capital flows and movements in ER
allows for the possibility that ERs are affected by ‘real’ factors, as well as relative inflation rates (changes in growth rate, changes in composition of aggregate demand, equity and bond market performance, size of BD and public debt a government and political stability)
Monetary approachemphasises the role of money supply growth rates in the home
country relative to foreign countries
a restrictive monetary policy reduces money supply, raises interest rates, diminishes import demand and improves the current account
CAPITAL FLOWS AND EXCHANGE RATE VOLATILITY
International capital flows
FDI
private portfolio
private credit
other (public capital, aid, reserves,…)
Determinants of international portfolio capital movements
difference between interest rates at home and abroad
differences between expected returns at home and abroad
expectations about future exchange rates
INTEREST RATE PARITY
Uncovered Interest Rate Parity (UIP)
domestic interest rate less foreign interest rate = expected change in exchange rate
id – if = E( er)
Covered Interest Rate Parity (IRP)
there will be a close link between the forward exchange rate and difference in the interest rates
id – if = (f – s)/s
EXCHANGE RATE EXPECTATIONS
Fundamentals:
- inflation - GDP growth
- budget deficit - unemployment
- public debt - export growth
- interest rate - balance of payment
- past exchange rate changes
“Irrational impulses” and Contagion:
- bubbles - bandwagons and contagion
‘Capital markets have the heart of a lamb, the legs of a hare and the memory of an elephant.’
Prof. Luigi Enaudi
‘In 1973 the experts claimed that exchange rate fluctuations serve to automatically adjust the differences in industrial competitive power among countries. Now I am tempted to ask whether the experts were right in claiming this. What was not anticipated in 1973 was that freely fluctuating rates would spawn speculation and money trading. The resulting rates did not necessarily reflect competitive power or the fundamentals of national economies.
…….Money trading has a tendency to distort reality.’
Akio Morita Chairman Sony Corporation
“How to Renew the Global Economic Framework” International Economic Insights, Washington DC. March/April 1993 p. 25
STRATEGIES FOR COPING WITH EXCHANGE RATE RISK
Using the forward market A foreign exchange forward contract is an over-the-counter (OTC) transaction between a bank and its customer, whereby the bank agrees
to buy or sell a specified amount of currency at an agreed rate for delivery at a specified future date.
Options A foreign currency options contract gives the company the right to buy (call option) or sell (put option) a specified amount of foreign currency on or before a specified expiration date at a fixed strike price.
Hedges A company offsets an existing exposure in a given currency by taking an opposite position in that currency with the same or similar risk.
ADVERSE EFFECTS OF EXCHANGE RATE VOLATILITY
Large devaluation = more inflation
Competitive devaluation = damage trade relations
’Contagion’ problem
Sustained exchange rate misalignments –‘overshooting’
Increased uncertainty
Exchange Rate Regimes
Week 2, lecture 2
Lecture 2 week 2
The global exchange rate system
Floating exchange rate in theory and practice
Search for stability
Conclusions
EXCHANGE RATE ARRANGEMENTS
managed float13%
independent float 8%
other15%
pegged currencies
64%
End-1984 : 148 countries
Source: IMF International Financial Statistics
EXCHANGE RATE ARRANGEMENTS
other20%
pegged currencies
38%
managed float14%
independent float 28%
Source: IMF International Financial Statistics
End - 1999 : 184 countries
FEATURES OF THE PRESENT GLOBAL EXCHANGE RATE SYSEM
The word’s 3 major currencies, the US$, the yen and the euro are ‘independently floating’
A growing number of countries have adopted a flexible exchange rate regime
Yet 38% of currencies still linked at a fixed rate (‘pegged’) to another currency or basket of currencies and 14% more are ‘managed float’
Although countries with pegged currencies are numerous, their combined economic weight in world trade is modest
Movement towards ‘more extreme’ exchange rate regimes
“There are no major difficulties to prevent the prompt establishment by countries of a system of exchange rates freely determined in open markets, primarily by private transactions, and the simultaneous abandonment of direct controls over exchange transactions. A move in this direction is the fundamental prerequisite for the economic integration of the free world through multilateral trade.”
Milton Friedman, 1956
CHANGES IN THE EXCHANGE RATE AND PAYMENTS IMBALANCES
S0D1
D1
D0
D0
Q1Q0 Q*
E*
E0
Amount of Foreign Exchange
Exchange rate (domestic currency per unit of foreign currency)
EXCHANGE RATE DETERMINANTS
Supply of forex
Demand for forex
Equilibrium exchange rate
Direct and indirect effects of ER
Balance of payment deficit/surplus
Changes in ER over time
FLOATING EXCHANGE RATE
Advantages:
Increased autonomy in monetary policyLow foreign reserves requirementsNo more balance of payment and ER ‘crises’
Disadvantages:
Volatility inhibits trade and investmentDestabilising speculation exacerbates the problemDomestic stabilisation measures can be undermined
A key objection to floating exchange rates – and capital liberalisation -- is that the exchange rate market system is fundamentally flawed
…. Because of the problem and costs of CONTAGION
Exchange rate crises and contagionContagion a new subject in this context – though
banking literature has many references. Banking contagion arises where bank that is sound is rendered insolvent by reckless actions of other banks.
Exchange rate crises caused by record real interest rates in the US in the 1980s.
In the 1990s, contagion seen as a problem:– Mexico 1994-5 -- tequila effect– East Asian flu 1997-8– Russian virus 1998– Brazil 1999
What is Contagion?
•Fundamentals Based Contagion
•True Contagion
Fundamentals Based Contagion
Affected country linked to country with initial shock by trade or finance.
Which is more important? Trade or finance?
Finance Contagion more likely to be regional than global
Susceptibility to contagion non-linear – the more countries affected, the more vulnerable the rest.
‘True’ Contagion
Influence of ‘news’ about creditworthiness of a sovereign borrower on the spreads charged to others, after controlling for country-specific macro fundamentals
Crisis driven by herd behaviour (‘irrational’) and irrational
Excessive co-variation across countries in asset returns (debt or equity).
Co-movement is excessive if it persists after fundamentals (and idiosyncratic factors) have been allowed for.
That is, the existence of a crisis elsewhere increases the probability of a crisis at home, even when fundamentals are taken into account.
Theories of Contagion
• Trade links (Nurkse): crisis followed by a devaluation in one country leads to BP problems in trading partners (competitive devaluations). Hence high syncronisation of crises among countries that trade heavily with each other.
• But not merely a matter of bilateral trade between affected countries. Competitive position in 3rd country markets a more important factor.
The depreciation of the Mexican peso had a major effect on Argentina, but very little on Korea. This is not consistent with the trade linkages explanation of contagion. True Korea conducts little trade with Mexico. But only 1.7% of Argentina’s exports went to Mexico, yet “tequila effect” showed that devaluation of Mexican peso led to capital outflow from Argentina.
Financial assets
These models de-emphasise the role of of trade in gds and services and stress role of trade in financial assets. High fixed costs of gathering country-specific info gives rise to herding behaviour even when investors are rational. Financial market linkages, through banks and capital mrkts, an important element in propagating shocks.
Another channel of transmission comes from cross-market hedging.Calvo (1998) stresses role of liquidity. A leveraged investor facing margin calls needs to sell to less informed party (market for lemons problem). Tendency will be not to sell the asset whose price has collapsed but to sell other assets in the portfolio.
Still another caused by commercial banks. Japanese banks in Asia crisis exacerbate problem by calling loans and drying up credit lines in other countries. Commercial bank credit to the 5 affected countries (Indon, Kor, M, Philippines and Th) shifted from inflow of $50bn in 1996 to outflow $21bn in 1997
Countries with closed cap mrkts are shielded from financial
market type of contagion (India)-- hence the debate about the
desirability of capital liberalisation
SEARCH FOR STABILITY
Pegging to an anchor currency
A single currency