Eiteman/Stonehill/MoffettMultinationalBusinessFinance,SixteenthEdition

Chapter9:ForeignExchangeRateDeterminationandIntervention

Copyright?2023PearsonEducation,Inc.

Copyright?2023PearsonEducation,Inc.

Copyright?2023PearsonEducation,Inc.

Chapter9

ForeignExchangeRateDeterminationandIntervention

9.1 ExchangeRateDetermination.Whatarethethreebasictheoreticalapproachestoexchangeratedetermination?

Thethreemajorschoolsofthoughtare(1)purchasingpowerparity,(2)balanceofpaymentsapproach,and(3)assetmarketapproach.

PurchasingPowerParityApproach.Themostwidelyacceptedofallexchangeratedeterminationtheories,thetheoryofpurchasingpowerparity(PPP)statesthatthelongrunequilibriumexchangerateisdeterminedbytheratioofdomesticpricesrelativetoforeignprices,asexplainedinChapter6.PPPisboththeoldestandmostwidelyfollowedoftheexchangeratetheories,andmosttheoriesofexchangeratedeterminationhavePPPelementsembeddedwithintheirframeworks.

BalanceofPaymentsApproach.AfterPPP,themostfrequentlyusedtheoreticalapproachtoexchangeratedeterminationisprobablythatinvolvingthesupplyanddemandforcurrenciesintheforeignexchangemarket.Theseexchangerateflowsreflectcurrentaccountandfinancialaccounttransactionsrecordedinanation’sbalanceofpayments,asdescribedinChapter3.Thebasicbalanceofpaymentsapproacharguesthattheequilibriumexchangerateisfoundwhenthenetinflow(outflow)offoreignexchangearisingfromcurrentaccountactivitiesmatchesthenetoutflow(inflow)offoreignexchangearisingfromfinancialaccountactivities.

AssetMarketApproach.Theassetmarketapproach,sometimescalledtherelativepriceofbondsorportfoliobalanceapproach,arguesthatexchangeratesaredeterminedbythesupplyanddemandforfinancialassetsofawidevariety.Shiftsinthesupplyanddemandforfinancialassetsalterexchangerates.Changesinmonetaryandfiscalpolicyalterexpectedreturnsandperceivedrelativerisksoffinancialassets,whichinturnalterrates.

9.2 PurchasingPowerParityInadequacy.Themostwidelyacceptedtheoryofforeignexchangeratedeterminationispurchasingpowerparity,yetithasproventobequitepooratforecastingfuturespotexchangerates.Why?

AlthoughPPPseemstopossessacoreelementofcommonsense,ithasproventobequitepooratforecastingexchangerates(atleastintheshorttomediumterm).Theproblemsareboththeoreticalandempirical.Thetheoreticalproblemslieprimarilywithitsbasicassumptionthattheonlythingthatmattersisrelativepricechanges.Yetmanycurrencysupplyanddemandforcesaredrivenbyotherforces,includinginvestmentincentives,economicgrowth,andpoliticalchange.Theempiricalissuesareprimarilyindecidingwhichmeasuresorindexesofpricestouseacrosscountries,inadditiontotheabilitytoprovidea“predictedchangeinprices”withthechosenindexes.

9.3 DataandtheBalanceofPaymentsApproach.Statisticsonacountry’sbalanceofpaymentsareusedbythebusinesspressandbusinessitselfforpredictingexchangerates,buttheacademicprofessionishighlycriticalofthepractice.Why?

Criticismsofthebalanceofpaymentsapproacharisefromthetheory’semphasisonflowsofcurrencyandcapitalratherthanonstocksofmoneyorfinancialassets.Relativestocksofmoneyorfinancialassetsplaynoroleinexchangeratedeterminationinthistheory,aweaknessexploredinthefollowingdiscussionofmonetaryandassetmarketapproaches.

Curiously,whilethebalanceofpaymentsapproachislargelydismissedbytheacademiccommunitytoday,thepractitionerpublic—marketparticipantsincludingcurrencytradersthemselves—

9.4 SupplyandDemand.Whichofthethreemajortheoreticalapproachesseemstoputthemostweightintoargumentsonthesupplyanddemandforcurrency?Whatisitsprimaryweakness?

Themonetaryapproachfocusesonchangesinthesupplyanddemandformoneyastheprimarydeterminantofinflation.Changesinrelativeinflationratesinturnareexpectedtoalterexchangeratesthroughapurchasingpowerparityeffect.Themonetaryapproachthenassumesthatpricesareflexibleintheshortrunaswellasthelongrun,sothatthetransmissionmechanismofinflationarypressureisimmediateinimpact.

Aweaknessofmonetarymodelsofexchangeratedeterminationisthatrealeconomicactivityisrelegatedtoaroleinwhichitonlyinfluencesexchangeratesthroughchangesinthedemandformoney.Themonetaryapproachisalsocriticizedforitsomissionofanumberoffactorsthataregenerallyagreeduponbyareaexpertsasimportanttoexchangeratedetermination,including(1)thefailureofPPPtoholdintheshorttomediumterm;(2)moneydemandappearstoberelativelyunstableovertime;and(3)thelevelofeconomicactivityandthemoneysupplyappeartobeinterdependent,notindependent.

9.5 AssetMarketApproachtoForecasting.Explainhowtheassetmarketapproachcanbeusedtoforecastfuturespotexchangerates.Howdoestheassetmarketapproachdifferfromthebalanceofpaymentsapproach(listedinExhibit9.1anddetailedinChapter3)toforecasting?

Theassetmarketapproachassumesthatwhetherforeignersarewillingtoholdclaimsinmonetaryformdependsonanextensivesetofinvestmentconsiderationsordrivers.Thesedriversincludethefollowing:

Relativerealinterestratesareamajorconsiderationforinvestorsinforeignbondsandshort-termmoneymarketinstruments.

Prospectsforeconomicgrowthandprofitabilityareanimportantdeterminantofcross-borderequityinvestmentinbothsecuritiesandforeigndirectinvestment.

Capitalmarketliquidityisparticularlyimportanttoforeigninstitutionalinvestors.Cross-borderinvestorsarenotonlyinterestedintheeaseofbuyingassets,butalsointheeaseofsellingthoseassetsquicklyforfairmarketvalueifdesired.

Acountry’seconomicandsocialinfrastructureisanimportantindicatorofthatcountry’sabilitytosurviveunexpectedexternalshocksandtoprosperinarapidlychangingworldeconomicenvironment.

Politicalsafetyisexceptionallyimportanttobothforeignportfolioanddirectinvestors.Theoutlookforpoliticalsafetyisusuallyreflectedinpoliticalriskpremiumsforacountry’ssecuritiesandforpurposesofevaluatingforeigndirectinvestmentinthatcountry.

Thecredibilityofcorporategovernancepracticesisimportanttocross-borderportfolioinvestors.Afirm’spoorcorporategovernancepracticescanreduceforeigninvestors’influenceandcausesubsequentlossofthefirm’sfocusonshareholderwealthobjectives.

Contagionisdefinedasthespreadofacrisisinonecountrytoitsneighboringcountriesandothercountriesthathavesimilarcharacteristics—atleastintheeyesofcross-borderinvestors.Contagioncancausean“innocent”countrytoexperiencecapitalflightwitharesultingdepreciationofitscurrency.

Speculationcancauseaforeignexchangecrisisormakeanexistingcrisisworse.Wewillobservethiseffectthroughthethreeillustrativecasesthatfollowshortly.

9.6 TechnicalAnalysis.Explainhowtechnicalanalysiscanbeusedtoforecastfuturespotexchangerates.

Technicalanalysts,traditionallyreferredtoaschartists,focusonpriceandvolumedatatodeterminepasttrendsthatareexpectedtocontinueintothefuture.Thesinglemostimportantelementoftechnicalanalysisisthatfutureexchangeratesarebasedonthecurrentexchangerate.Exchangeratemovements,similartoequitypricemovements,canbesubdividedintothreeperiods:(1)day-to-daymovement,whichisseeminglyrandom;(2)short-termmovementsextendingfromseveraldaystotrendslastingseveralmonths;(3)long-termmovements,whicharecharacterizedbyupanddownlong-termtrends.Long-termtechnicalanalysishasgainednewpopularityasaresultofrecentresearchintothepossibilitythatlong-term“waves”incurrencymovementsexistunderfloatingexchangerates.

9.7 Intervention.Whatisforeigncurrencyintervention?Howisitaccomplished?

Foreigncurrencyinterventionistheactivemanagement,manipulation,orinterventioninthemarket’svaluationofacountry’scurrency.Ashortlistoftheinterventionmethodswouldincludedirectintervention,indirectintervention,andcapitalcontrols.

DirectIntervention.Thisistheactivebuyingandsellingofthedomesticcurrencyagainstforeigncurrencies.Thistraditionallyrequiredacentralbanktoactlikeanyothertraderinthecurrencymarket—albeitabigone.Ifthegoalweretoincreasethevalueofthedomesticcurrency,thecentralbankwouldpurchaseitsowncurrencyusingitsforeignexchangereserves,atleasttotheacceptablelimitsthatitcouldenduredepletingitsreserves.

IndirectIntervention.Thisisthealterationofeconomicorfinancialfundamentalsthatarethoughttobedriversofcapitaltoflowinandoutofspecificcurrencies.Thiswasalogicaldevelopmentformarketmanipulationgiventhegrowthinsizeoftheglobalcurrencymarketsrelativetothefinancialresourcesofcentralbanks.Themostobviousandwidelyusedfactorhereisinterestrates.Followingthefinancialprinciplesoutlinedinthepreviousdiscussionofparityconditions,higherrealratesofinterestattractcapital.Ifacentralbankwishesto“defenditscurrency,”forexample,itmightfollowarestrictivemonetarypolicy,whichwoulddriverealratesofinterestup.

9.8 InterventionMotivation.Whydogovernmentsandcentralbanksinterveneintheforeignexchangemarkets?Ifmarketsareefficient,whynotletthemdeterminethevalueofacurrency?

Historically,aprimarymotiveforagovernmenttopursuecurrencyvaluechangewastokeepthecountry’scurrencycheapsothatforeignbuyerswouldfinditsexportscheap.Thispolicy,longreferredtoas“beggarthyneighbor,”gaverisetomanycompetitivedevaluationsovertheyears.Ithasnot,however,fallenoutoffashion.

Alternatively,thefallinthevalueofthedomesticcurrencywillsharplyreducethepurchasingpowerofitspeople.Iftheeconomyisforced,foravarietyofreasons,tocontinuetopurchaseimportedproducts(e.g.,petroleumimportsbecauseofnodomesticsubstitute),acurrencydevaluationordepreciationmayprovehighlyinflationaryandintheextreme,impoverishthecountry’speople(asinthecaseofVenezuela).

Itisfrequentlynotedthatmostcountrieswouldliketoseestableexchangeratesandtoavoidtheentanglementsassociatedwithmanipulatingcurrencyvalues.Unfortunately,thatwouldalsoimplythattheyarealsohappywiththecurrentexchangerate’simpactoncountrylevelcompetitiveness.

9.9 DirectInterventionUsefulness.Whenisdirectinterventionlikelytobethemostsuccessful?Andwhenisitlikelytobetheleastsuccessful?

Directinterventionwastheprimarymethodusedformanyyears,butbeginninginthe1970s,theworld’scurrencymarketsgrewenoughthatanyindividualplayer,evenacentralbank,couldfinditselfwithinsufficientresourcestomovethemarket.Onesolutiontothismarketsizechallengehasbeentheoccasionaluseofcoordinatedintervention,inwhichseveralmajorcountries,oracollectivesuchastheG8ofindustrializedcountries,agreethataspecificcurrency’svalueisoutofalignmentwiththeircollectiveinterests.

9.10 InterventionDownside.Whatisthedownsideofbothdirectandindirectintervention?

Althoughtherearenophysicallimitstotheabilityofcentralbankstoselltheirowncurrency(theycouldtheoreticallycontinueto“printmoney”endlessly),centralbanksarecautiousinthedegreetowhichtheymaypotentiallychangetheirmonetarysuppliesthroughintervention

Becauseindirectinterventionusestoolsofmonetarypolicy,afundamentaldimensionofeconomicpolicy,themagnitudeandextentofimpactsmayreachfarbeyondcurrencyvalue.Overlystimulatingeconomicactivity,orincreasingmoneysupplygrowthbeyondrealeconomicactivity,mayproveinflationary.Theuseofsuchbroadbasedtoolslikeinterestratestomanipulatecurrencyvaluesrequiresadeterminationofimportance,whichinsomecasesmayinvolveachoicetopursueinternationaleconomicgoalsattheexpenseofdomesticeconomicpolicygoals.

9.11 CapitalControls.Arecapitalcontrolsreallyamethodofcurrencymarketintervention,ormoreofadenialofactivity?HowdoesthisfitwiththeconceptoftheimpossibletrinitydiscussedpreviouslyIChapters2and6?

Thisistherestrictionofaccesstoforeigncurrencybygovernment.Thisinvolveslimitingtheabilitytoexchangedomesticcurrencyforforeigncurrency.Whenaccessandexchangeispermitted,tradingtakesplaceonlywithofficialdesigneesofthegovernmentorcentralbank,andonlyatdictatedexchangerates.

Often,governmentswilllimitaccesstoforeigncurrenciestocommercialtrade:forexample,allowingaccesstohardcurrencyforthepurchaseofimportsonly.Accessforinvestmentpurposes—particularlyforshorttermportfoliosinwhichinvestorsaremovinginandoutofinterestbearingaccounts,purchasingorsellingsecuritiesorotherfunds—isoftenprohibitedorlimited.TheChineseregulationofaccessandtradingoftheChineseyuanisaprimeexampleoftheuseofcapitalcontrolsovercurrencyvalue—achoicewithintheframeworkoftheimpossibletrinity.Inadditiontothegovernment’ssettingthedailyrateofexchange,accesstotheexchangeislimitedbyadifficultandtimelybureaucraticprocessforapproval,andlimitedtocommercialtradetransactions.

9.12 AsianCrisisof1997andDisequilibrium.WhatwastheprimarydisequilibriumatworkinAsiain1997whichlikelycausedtheAsianfinancialcrisis?Doyouthinkitcouldhavebeenavoided?

TherootsoftheAsiancurrencycrisisextendedfromafundamentalchangeintheeconomicsoftheregion,thetransitionofmanyAsiannationsfrombeingnetexporterstonetimporters.Startingasearlyas1990inThailand,therapidlyexpandingeconomiesoftheFarEastbeganimportingmorethantheyexported,requiringmajornetcapitalinflowstosupporttheircurrencies.Aslongasthecapitalcontinuedtoflowin—capitalformanufacturingplants,damprojects,infrastructuredevelopment,andevenrealestatespeculation—thepeggedexchangeratesoftheregioncouldbemaintained.Whentheinvestmentcapitalinflowsstopped,however,crisiswasinevitable.

ManyanalystsarguethatifthegovernmentsoftheseFarEastnationshadgivenuptheirpeggedexchangeratesearlier,themarketadjustmentwouldhavebeenmadegraduallyovertimeastheireconomieschanged.Expectinggovernmentstogiveuponpeggedexchangerates,particularlywhentheystillviewedtheireconomiclife-bloodtobeexports,isnot,however,veryrealistic.

9.13 FundamentalEquilibrium.Whatismeantbythetermfundamentalequilibriumpathforacurrencyvalue?Whatisnoise?

Itappearsfromdecadesoftheoreticalandempiricalstudiesthatexchangeratesdoadheretothefundamentaltheoriesoutlinedinthischapter(namelypurchasingpowerparityandinterestrateparity).Fundamentalsdoapplyinthelongterm.Thereis,therefore,somethingofafundamentalequilibriumpathforacurrency’svalue.

Italsoseemsthatintheshortterm,avarietyofrandomevents,institutionalfrictions,andtechnicalfactorsmaycausecurrencyvaluestodeviatesignificantlyfromtheirlong-termfundamentalpath.Thisissometimesreferredtoasnoise.Clearly,therefore,wemightexpectdeviationsfromthelong-termpathnotonlytooccur,buttooccurwithsomeregularityandrelativelongevity.

9.14 Argentina’sFailure.WhatwasthebasisoftheArgentineCurrencyBoard,andwhydiditfail,in2002?

By2001crisisconditionshadrevealedthreeveryimportantunderlyingproblemswithArgentina’seconomy:(1)theArgentinepesowasovervalued;(2)thecurrencyboardregimehadeliminatedmonetarypolicyalternativesformacroeconomicpolicy;and(3)theArgentinegovernmentbudgetdeficit,anddeficitspending,wasoutofcontrol.

Thepesohadindeedbeenstabilized.Butinflationhadnotbeeneliminated,andtheotherfactorswhichareimportantintheglobalmarket’sevaluationofacurrency’svalue—economicgrowth,corporateprofitability,etc.hadnotnecessarilyalwaysbeenpositive.Theinabilityofthepeso’svaluetochangewithmarketforcesledmanytobelieveincreasinglythatitwasovervalued,andthattheovervaluationgapwasrisingastimepassed.

9.15 TermForecasting.Whatarethemajordifferencesbetweenshort-termandlong-termforecastsforafixedexchangerateversusafloatingexchangerate?

Shorttermforecastsaretypicallymotivatedbyadesiretohedgeareceivable,payable,ordividendforperhapsaperiodofthreemonths.Inthiscasethelongruneconomicfundamentalsmaynotbeasimportantastechnicalfactorsinthemarketplace,governmentintervention,news,andpassingwhimsoftradersandinvestors.Accuracyoftheforecastiscriticalsincemostoftheexchangeratechangesarerelativelysmalleventhoughthedaytodayvolatilitymaybehigh.

Forecastingservicesnormallyundertakefundamentaleconomicanalysisforlongtermforecasts,andsomebasetheirshorttermforecastsonthesamebasicmodel.Othersbasetheirshorttermforecastsontechnicalanalysissimilartothatconductedinsecurityanalysis.Theyattempttocorrelateexchangeratechangeswithvariousothervariables,regardlessofwhetherthereisanyeconomicrationaleforthecorrelation.Thechancesoftheseforecastsbeingconsistentlyusefulorprofitabledependsonwhetheronebelievestheforeignexchangemarketisefficient.Themoreefficientthemarketis,themorelikelyitisthatexchangeratesare“randomwalks,”withpastpricebehaviorprovidingnocluestothefuture.Thelessefficienttheforeignexchangemarketis,thebetterthechancethatforecastersmaygetluckyandfindakeyrelationshipthatholds,atleastfortheshortrun.Iftherelationshipisreallyconsistent,however,otherswillsoondiscoveritandthemarketwillbecomeefficientagainwithrespecttothatpieceofinformation.Exhibit9.9summarizesthevariousforecastingperiods,regimes,andtheauthors’opinionsonthepreferredmethodologies.

9.16 ExchangeRateDynamics.Whatismeantbythetermovershooting?Whatcausesit,andhowisitcorrected?

Assumethatthecurrentspotratebetweenthedollarandtheeuro,asillustratedinExhibit9.9inthetext,isS0.TheU.S.FederalReserveannouncesanexpansionarymonetarypolicythatcutsU.S.dollarinterestrates.Ifeuro-denominatedinterestratesremainunchanged,thenewspotrateexpectedbytheexchangemarketsonthebasisofinterestdifferentialsisS1.Thisimmediatechangeintheexchangerateistypicalofhowthemarketsreacttonews,distincteconomicandpoliticaleventsthatareobservable.Theimmediatechangeinthevalueofthedollar/euroisthereforebasedoninterestdifferentials.

Astimepasses,however,thepriceimpactsofthemonetarypolicychangestartworkingtheirwaythroughtheeconomy.Aspricechangesoccuroverthemediumtolongterm,purchasingpowerparityforcesdrivethemarketdynamics,andthespotratemovesfromS1towardS2.AlthoughbothS1andS2wereratesdeterminedbythemarket,theyreflectedthedominanceofdifferenttheoreticalprinciples.Asaresult,theinitiallowervalueofthedollarofS1isoftenexplainedasanovershootingofthelonger-termequilibriumvalueofS2.

9.17 ForeignCurrencySpeculation.Theemergingmarketcrisesof1997–2002wereworsenedbecauseoframpantspeculation.Dospeculatorscausesuchcrisisordotheysimplyrespondtomarketsignalsofweakness?Howcanagovernmentmanageforeignexchangespeculation?

“Hotmoney”isatermusedtodescribefundsheldinonecurrency(country)thatwillmoveveryquicklytoanothercurrencyassoonasitisdeemedweak.Suchaquickflowwillcreatesevereshort-termpressuresontheexchangerate,forcingdepreciationoradevaluation.Thisrunonthecurrencymaycauseotherstoalsotrytoexchangetheirlocalcurrencyholdingsforforeignmoney,aggravatingthealreadyapparentweakness.

Ifacurrencyisfundamentallyweak,aspeculatorsuchasGeorgeSorosmayleadaflightfromthatcurrency.Hewillsucceedifheiscorrectinhisassessmentofthefundamentals,butifheisinerror,hewillloseonthespeculation.IntheMalaysiansituation,Soroscorrectlyassessedthesituation,andbymovingfirstwasprobablyinstrumentalinsettinginmotionunderlyingfactorsthatwouldhaveinfluencedexchangeratesinanycase—possiblyatalaterdate.Inotherwords,Sorosdidnotcausethecurrencycrisisinafundamentalsense,buthemaywellhavecaused(andadvanced)thetimingofwhatwouldhaveoccurredeventuallyinanycase.

9.18 CrossRateConsistencyinForecasting.Explainthe