We consider in this chapter three international indicators: international trade and payments, exchange rates, and foreign and domestic interest rates. This will be fleshed out in greater detail later in the course, but I think it's worth taking a look now.
Trade Balance, Current Account and Capital Flows: Balance of Payments Accounts
We start with international trade. We've seen that one measure of an economy's net trade with the rest of the world is included in the national income and product accounts, net exports. By this measure, there was a large deficit during the 1980s, and more recently closer to balanced trade; see Figure 1. There's another popular measure, reported monthly, that indicates that the US is still running a large deficit: the merchandise trade balance, often called simply the trade balance. This measure is less comprehensive than net exports, focusing on trade in physical goods like cars. It ignores trade in services, where the US typically runs a substantial surplus. These services range from legal and financial products, to custom computer software, to engineering services provided by Americans to foreign buyers, to foreign "purchases'' of US education. The merchandise trade deficit, then, is only part of the story. Even worse, the merchandise trade balance ignores the sophisticated services in which the US has a marked comparative advantage (and generally a substantial surplus, too).
Another common measure of international payments is the current account, which we denote CA. This measure is more comprehensive than net exports, and includes net interest payments on foreign borrowing and lending and miscellaneous "transfers'' between countries. Our three measures of net US transactions with other countries are pictured in Figure 1 as fractions of GDP. Therefore in summary:
Current Account Transactions:
1. Merchandise Balance = Exports - Imports of Goods
2. Net Exports (Trade Balance, NX) = Merchandise Balance plus Net Exports of Services (or Balance on Goods and Services)
3. Current Account Balance (CA) = Trade Balance + Net Factor Income from Abroad ( = NX + i NFA)
[Technical Note: in addition to net exports and the net factor income from abroad, the CA includes also another item, the net Unilateral Transfers. These are the gifts and grants that the country received or gave to the rest of the world. So formally, we have: CA = NX + i NFA + Net Unilateral Transfers].
The current account measures the flow of cash arising from trade and transfers. It also measures, indirectly, the economy's international financing requirement. If (say) the US has a 100 billion dollar current account deficit, then it must raise 100 billion through some combination of selling US assets abroad and borrowing from foreign sources. The point (and this is one of the central messages of the course) is that the cash flows measured by the current account are mirrored by equal and offsetting financial cash flows, which we refer to as the capital account. The issue is exactly analogous to the organization of the statement of cash flows for a firm (as seen in Table 1). A firm with a negative net cash flow from operations (we see the reverse in the table) must balance this with an equal and opposite source of cash from financial transactions. The only new feature of the accounts for a country is the statistical discrepancy, a sign that the numbers collected by the government have some mistakes in them somewhere.
As shown in Chapter 1, we can use the current account to keep track of changes in the economy's financial position vis a vis the rest of the world. If NFA is the net stock of foreign assets held by people in the United States (US ownership of foreign assets, net of foreign ownership of US assets), then (excepting changes in asset valuation) changes in NFA are equal to the current account:
NFAt+1 = NFAt + CAt .
In fact, the net foreign assets at the beginning of next period (t+1) must be equal to those in period t plus total national income (GNP) minus the part of national income that is consumed (C and G) or invested (I):
NFAt+1= NFAt + GDPt + it x NFAt - Ct - Gt - It = NFAt + CAt
Note that another way of seeing the relation between the current account and the net foreign assets of the country is to see the link between the current account of the BP (that records current transactions, i.e. trade in goods and services and the interest payments on net foreign assets) and the capital account of the BP (that records capital transactions, i.e. the purchase and sale of foreign assets). In particular, we will show that the sum of the current account (CA) and capital account (KA) of the balance of payments is equal to the change in the official foreign reserves of the country (d(FAX) or:
CA + KA = d(FAX) (1)
Intuitively, the above expression makes sense. Suppose, for a moment, that the change in official foreign reserves is zero (d(FAX)=0) so that the overall balance of payments (the sum of the current and capital account is zero):
To see why the above expression must be true, note that if we have a current account deficit, say CA = -50 < 0), we need a capital inflow (net new borrowing) from the rest of the world to finance this CA imbalance. Since we are borrowing from the rest of the world, the increase in our foreign debt is a capital inflow (as foreign residents are buying domestic securities, bonds, equities, or extend bank credit/loans to domestic agents). Therefore, a current account deficit (CA= -50 <0) is associated by a matching and equivalent positive capital inflow (KA = 50 >0) that is represented by a positive item in the Capital Account of the balance of payments (KA = 50 >0). Since the capital inflow is equal to the negative of the CA deficit (KA = 50= - CA = -(-50)), we get that CA+KA =0.
Now let us introduce official foreign reserves (of the central bank). Suppose next that the country is running a $50b current account deficit that needs to be financed with an equivalent net capital inflow. Suppose, however, that foreign agents are willing to lend only $30b to the domestic economy, i.e. the positive capital inflow (KA) is only $30b. Then, the only way that the country can finance its current account deficit (its excess of imports over exports) is to run down its official foreign assets (i.e. the reserves of the central banks). In other terms, if foreign agents are not willing to lend funds to domestic agents to finance the excess of imports over exports, the domestic agents will go to the central bank, purchase foreign currency from the central banks that they pay for buy paying with domestic currency (money); then, they will use this foreign currency to pay for the excess of imports over exports. This set of transactions will lead to a reduction in the stock of official foreign assets (foreign reserves) of the central bank. The change in the stock of official foreign reserves (d(FAX)) will therefore be equal to excess of the current account deficit relative to the capital inflow or:
d(FAX) = CA + KA =
-20 = -50
To derive more formally the above balance of payments identity (1) note that:
NFA = Foreign Assets (FA) - Foreign Liabilities (FL) =
= Domestic Assets Abroad - Foreign Assets in the Domestic Country =
= Foreign Assets held by Domestic Residents - Foreign Debt owed by Domestic Residents
Let us first distinguish between assets and liabilities of the private sector and the government sector:
FA = FAP + FAX
FL = FLP + FLG
where FAP are the foreign assets of the private sector and FAX are the
foreign assets of the government sector (the official foreign reserves
of the country that are usually held by the central bank, a government
agency). Similarly, the total foreign debt of the country FL is the sum
of the foreign debt of the private sector (FLP) and the foreign debt of
the government (FLG).
Let us now define private capital outflows and capital inflows as:
Change in Private Sector Foreign Assets = Private Capital Outflows = FAPt+1 - FAPt = Change in assets the private sector buys/holds abroad (including the change in loans we make to foreigners)
Change in Private Sector Foreign Liabilities = Private Capital Inflows = FLPt+1 - FLPt = Change in liabilities (foreign debt) that the private sector owes to foreigners
Similarly, define government capital outflows and capital inflows as:
Change in Government Sector Foreign Assets = FAXt+1 - FAXt = Change in the official foreign reserves of the government sector
Change in Government Sector Foreign Liabilities = Government Capital Inflows = FLPt+1 - FLPt = Change in liabilities (foreign debt) that the government owes to foreigners
Now, we define the capital account of the balance of payments (KA) as:
Capital Account of BP (KA) = Private Capital Inflows + Government Capital Inflows - Private Capital Outflows
CAt = NFAt+1 - NFAt = [(FAt+1 - FLt+1)- (FAt - FLt+1)]
= - [(FLPt+1 - FLPt) + (FLGt+1 - FLGt)
- (FAPt+1- FAPt)] + (FAXt+1- FAXt)
= - KAt + d(FAX)t
This implies that:
CAt + KAt = d(FAX)t
Note also that the overall balance of payments, including the changes in official foreign reserves, is by accounting identity, always equal to zero:
BPt = CAt + KAt - d(FAX)t
In fact, when the current account is in a surplus (CA>0), we are on net accumulating foreign assets: therefore the capital account is in a deficit (KA < 0) and/or we are increasing our official foreign reserves (d(FAX)>0). Total capital outflows (including the government accumulation of foreign assets) are greater than capital inflows. When the current account is in a deficit (CA<0), we are on net decumulating foreign assets (or increasing our net foreign liabilities): therefore the capital account is in a surplus (KA>0) and/or we are losing official foreign reserves (d(FAX)<0). The overall balance of payments must, by accounting definition, be always equal to zero because any current account transaction has and equal and corresponding transaction in the capital account or the official reserves of the country.
To give an example, consider the case of Korea in 1996 (all data
in billions of US dollars):
Equivalent line in IMF
Trade Balance on Goods -15.3 78acd
Trade Balance on Services -5.3 78add - 78aed
Overall Balance on Goods and Services -20.6 78afd
Net Foreign Income From Abroad:
Income paid -5.3 78ahd
Income received +2.8 78agd
Balance on Goods, Services and Income -23.1 78aid
Net (Unilateral) Current Transfers
78ajd - 78akd
Transfers made -4.3 78akd
Transfers received +4.4 78ajd
Current Account (CA):
78ald = 78afd +(78ajd-78akd)
Capital Account (KA):
+24.4 = 43.6 - 19.2 (Cap. Inflows - Cap. Outflows)
Foreign Portfolio investments in Korea
(foreign purchases of Korean stocks and bonds)
(mostly foreign lending to Korean banks)
Foreign Direct Investment into Korea 2.3 78bed
Unreported Capital Inflows
(Errors and Omissions line of BP accounts)
Other Capital Account Items
Capital Outflows: -19.2
Portfolio investments by Korean abroad
(Korean purchases of foreign stocks and bonds)
(mostly lending by Korean banks to foreign agents)
FDI by Korean firms in other countries -4.4 78bdd
Other Capital Account Items
Change in the Official Foreign Reserves
1.4 = -23.0 + 24.4
(of the Korean Central Bank) d(FAX)
Note: the total stock of Foreign Reserves of Korea at the end of 1995 was $32.6 while the total stock of Foreign Reserves at the end of 1995 was $34.0; the difference between the two $1.4b represent the increase in the stock of reserves between the end of 1995 and the end of 1996. Note also that in the IMF Balance of Payments accounts, an increase in foreign reserves (line 79dad) is formally shown with a minus sign since it represents an increase in foreign assets (a capital outflow that, by BP accounting practice, takes a negative sign).
Note: if you look into the Balance of Payments Statistics published by the IMF in its publication International Financial Statistics, the capital account of the BP is given by the sum of two accounts, what the IMF calls the Financial Account and the Capital Account. Since the Capital Account items (as defined by the IMF) are minor capital account transactions, the IMF's Financial Account items represent most of what we have called here the Capital Account of the BP.
Another example based on US Balance of Payments accounting practices:
US in 1988 (see the table
in the Economic Report of the President) and Table
CAt = NFAt+1 - NFAt = - KAt + d(FAX)t
-122 = -145 - (-23) = - (-122)
CAt = - [(FLt+1- FLt) - (FAt+1- FAt)] = - KAt + d(FAX)t
-122 = - [(1918-1648) - (1773-1625)] = - 122
-122 = - [270 - 148] = -122
Current Account Balance = -122 (Actual 1988 figure: -127 giving a statistical discrepancy of $5 b))
Capital Account + Change in Official Reserves = +122
Private and Government Capital Inflows: 270
Private Capital Outflows: 146.3
Change in Official Foreign Reserves: 1.7
As a result of substantial current account deficits over the last fifteen years, the US had a net foreign asset position of about -500 billion at the end of 1993. This tells us that the US is a debtor nation, but the magnitude is small relative to the total value of US assets (between 10 to 20 trillion, depending on what you include).
The sustainability of current account deficits and large foreign debt: the role of the capital account
In Chapter 1, we discussed in detail the conditions under which a large current account deficit is sustainable by considering the real variables that determine the current account. In summary, a current account deficit is less sustainable when GDP growth is low, budget deficits are high (negative government savings), private savings rate are low, investment rates are low or in the wrong sectors, openness is low and the CA deficit is high relative to GDP. Here we will consider a number of other Foreign exchange reserves and the debt burden. The current account deficit is an imbalance between national saving and investment out of current income that needs to be financed by a capital inflow or accumulation of debt. The ability to sustain deficits will be affected by the country’s stock of international assets. An existing large burden of international debt will make it more difficult to finance a current account imbalance. Moreover, a large debt-servicing burden can easily exhaust export revenues and preclude imports of investment goods that are needed for growth. In such a case, the debt burden can create a trap that inhibits any growth policies. For this reason, many transition and developing countries are eager to reschedule sovereign debt obligations. Similarly, the existence of large foreign exchange reserves will facilitate the financing of the current account deficit especially when the country is pegging its exchange rate and needs foreign reserves to credibly fix its exchange rate. Foreign exchange reserves and a small external debt burden reduce the risk of unsustainability and enable a country to finance a current account deficit at lower cost. The real rate paid (in hard currency terms) on the country’s debt is an indication of the market’s evaluation of the country risk premium or its ability to sustain a current account deficit. financial variables that affect in an important way the sustainability of the large current account deficits.
1. The composition and size of the capital inflows. The composition of the capital inflows necessary to finance a given current account deficit is an important determinant of sustainability. Short-term capital inflows are more dangerous than long-term flows and equity inflows are more stable than debt-creating inflows. In this regard, a current account deficit that is financed by large foreign direct investment (FDI) is more sustainable than a deficit financed by short-term "hot money" flows that may reversed if market conditions and sentiments change. Among the debt-creating inflows, those from official creditors are more stable and less reversible in the short-run than those coming from private creditors; those taking the form of loans from foreign banks are usually less volatile than portfolio inflows (bonds and non-FDI equity investments). However, as the 1997 Asian experience suggests, a large stock of short-term loans from foreign banks may lead to a debt crisis if a panic ensuing a currency crisis leads foreign bank to refuse to roll-over the loans that come to maturity. Finally, the currency composition of the foreign liabilities of the country matters as well. While foreign currency debt may lead to greater capital inflows at a lower interest rate than borrowing in domestic currency (as risk averse investors concerned about inflation and exchange rate risk will prefer foreign currency denominated assets), foreign currency debt may end up exacerbating an exchange rate crisis as a real depreciation leads to an increase in the real burden of foreign debt. This is exactly what happened in Asia in 1997 where the currency crisis turned into a debt crisis as the depreciation of the currencies led to a rapid and dramatic increase in the domestic currency burden of foreign-currency denominated debt.
Note also that is not unusual to observe very large capital inflows that are even larger than the current account deficit, as in Asia in the eraly 1990s. While in the short-run such inflows enhance sustainability as they finance the current account imbalance and lead to an increase in the foreign reserves of the central bank, over time they may contribute to unsustainability for two reasons. First, such large inflows are likely to be associated with the accumulation of reversible portfolio investments ("hot money"). Second, capital inflows in excess of the current account deficit may lead to a nominal currency appreciation that could erode the competitiveness of the country’s exports and thus its ability to stem increases in the current account deficit.
2. Foreign exchange reserves and the debt burden. The current account deficit is an imbalance between national saving and investment out of current income that needs to be financed by a capital inflow or accumulation of debt. The ability to sustain deficits will be affected by the country’s stock of international assets. An existing large burden of international debt will make it more difficult to finance a current account imbalance. Things are particularly fragile when, as in Mexico in 1994 and in Asia in 1997, a large fraction of the foreign debt consists of short-term liabilities that have to be rolled-over in the short-run. If currency crisis leads to a panic in the financial markets, international creditors may be unwilling to roll-over these loans and the currency crisis can turn into a debt crisis where the country risks to default on its foreign debt liabilities. The existence of large foreign exchange reserves will facilitate the financing of the current account deficit especially when the country is pegging its exchange rate and needs foreign reserves to credibly fix its exchange rate. Foreign exchange reserves and a small external debt burden reduce the risk of unsustainability and enable a country to finance a current account deficit at lower cost. The real rate paid (in hard currency terms) on the country’s debt is an indication of the market’s evaluation of the country risk premium or its ability to sustain a current account deficit.
3. Fragility of the financial system. The soundness of the domestic financial system, particularly the banks, has bearing on a country’s ability to sustain a current account deficit. Capital inflows require a large intermediation role of domestic banks. In fact, as bond and security markets are not very well developed in many emerging economies (for example in Asia), a large chunk of the capital inflows financing current account deficits are intermediated by the domestic banking system. Since firms often cannot borrow directly in international capital markets, they borrow from domestic banks that in turn borrow from foreign financial intermediaries.
The trouble, however, is that domestic banking crises are common in developing and emerging economies. More often than not they are the direct result of bad lending practices, often due to political influences on bank lending or the requirement that banks (which are often state owned) allocate credit to sustain state owned enterprises. The problem is exacerbated when the banks source of funds is borrowing from abroad in hard currencies. A collapse of the banking system has several immediate consequences. Uncertainty and instability concerning the payments system will quickly stem the inflow of foreign capital necessary to finance current account deficits. Thus, banking sector fragility can easily be the proximate cause of an unsustainable current account deficit and a debt crisis, as suggested by the experiences of Korea, Indonesia and Thailand in 1997-98.
4. Political instability and uncertainty about the economic environment.
Political instability or mere uncertainty about the course of economic
policy will have much the same consequences as banking sector instability.
The threat of a change in regime or of a regime that is not committed to
sound macroeconomics policies can reduce the willingness of the international
financial community to provide financing for a current account deficit.
Thus, a deterioration in expectations about the political and financial
environment can contribute to a balance of payments and exchange rate crisis,
especially when economic fundamentals are not very sound. Such shifts
in expectations can occur quickly and sometimes without much warning.
Moreover, political instability may lead to larger budget deficits that,
in an open economy, will lead to larger current account deficits
Nominal and Real Exchange Rates and the PPP
Exchange rates. Our second international topic is the exchange rate: the price of foreign currency. We use the convention that prices of foreign currency, like most prices in this course, are expressed in dollars. This leads to the confusing result that increases in the exchange rate are decreases in the value of the dollar, but we'll get used to that soon enough. Note that, the financial sector convention is to define the exchange rate of the US $ as units of foreign currency per units domestic currency (daily data are shown at this link), i.e. Yen per US dollars, that is the opposite of the convention we follow here ($ per Yen). (If you are still confused, you can use an on-line Currency Convertor). So,
The Exchange Rate is the Dollar Price of Foreign Currency
S$/YEN = Dollars needed to buy one Yen (say 8.6 US cents)
S$/DM = Dollars needed to buy one DM (say $ 0.67)
If S increases the Dollar is Depreciating (it takes more $ to buy one unit of foreign currency).
If S decreases the Dollar is Appreciating (it takes less $ to buy one unit of foreign currency).
The Exchange Rate is the Foreign Currency Price of a US $
SYEN/$ = Yen needed to buy one Dollar (say 116 Yen = 1 / 0.008) (see Figure 2)
SDM/$ = DM needed to buy one US $ (say 1.49 DM= 1/0.67) (see Figure 3)
The striking thing about these prices (exchange rates) is how variable they are. (See the Minneapolis Fed home page for weekly updated Charts of U.S. exchange rates relative to a basket of currencies for the 1995-1997 period). One of the reasons that the exchange rate is important is that it's closely related to the prices of foreign and domestic goods. For example, let P be:
P = price in dollars of a unit of a domestic good (one gallon of gasoline, say $1.20)
and, let Pf be:
Pf = price in units of foreign currency of the same good in a foreign country (say DM 2.0)
Which good is more expensive ? The price in $ of a unit of the domestic good is P ($1.20) while the price in dollars (P$f) of a unit of the foreign good is equal to its price in foreign currency (Pf = DM 2) times the exchange rate of the dollar relative to the foreign currency (S = 0.67):
P$f = S Pf = 0.67 x 2 = 1.34
Therefore, the relative price of the foreign good to the domestic good (expressed as RER) is the ratio,
RER = S Pf / P = 1.34 / 1.20 = 1.166
where S is the (spot) exchange rate. In this example the good in Germany is 16.6% more expensive (when expressed in the same currency) than the same good in the U.S.
Often we would use price indexes, like CPI's or GDP deflators, representing baskets of goods rather than individual goods. In this case the ratio RER is referred to as the real exchange rate. It indicates how expensive, on average, foreign goods are relative to domestic goods.
If you thought domestic and foreign goods were very similar, and there were few barriers to trade, then you might expect that when expressed in the same currency their price should be equal. In this case the real exchange rate would be equal to one and show no variation.
In fact, if the price ratio ever differed from one (as in the example above), then buyers in Germany would only buy in the cheap country (the US), driving up prices there until foreign and domestic prices were equal. Thus prices of foreign and domestic goods, expressed in a common currency, should be about the same, leading the real exchange rate to stay around one. This theory, applied to the baskets of goods underlying aggregate price indexes, is referred to as purchasing power parity, (or PPP) since the purchasing power of a dollar is predicted to be the same in both countries. In other terms, if the goods are identical in both countries and there are no barriers to trade, we would expect that:
P = S Pf
In the example above we had instead:
P =1.20 < S Pf =1.34
So how, can we reach a PPP equilibrium when the relative price differs from unity ? There are three alternative ways the equilibrium can be restored if we are away from PPP:
1. German prices could fall from DM 2 to DM 1.79 so that
P = 1.20 = S Pf = 0.67 x 1.79
2. US prices may go up from $1.20 to $ 1.34 so that
P = 1.34 = S Pf = 0.67 x 2.00
3. The Dollar/DM exchange rate could appreciate from 0.67 to 0.60 so that
P = 1.20 = S Pf = 0.60 x 2.00
In practice, all of the three effects may be at work in reality. In fact, as initially German prices are above US ones (when expressed in $), Germans will buy less German goods and demand more of the same good in the US; these two forces will lead to lower prices in Germany (a lower Pf ) and higher prices in the US (a higher P). Also, as Germans try to buy more US goods, they have to sell DM in the foreign exchange market in order to buy the dollars required to pay the US good. This is the mechanism through which the dollar appreciates and the DM depreciates when we have deviations from the PPP. The simultaneous working of the three effects will eventually lead to the restoration of the PPP.
So what is the evidence on the PPP ? If the PPP holds, the real exchange rate (RER) should be equal to one and constant over time. In fact,
RER = S Pf / P = P / P = 1 (if the PPP holds).
However, we find, when we compute RER using consumer price indexes, that it varies a lot: prices of (say) Mercedes in particular, and goods in general, are often much different in Germany and the US, and between any two other countries, as well. At least in the short-run, the theory of purchasing power parity is a poor approximation. Moreover, most of the variation is related to movements in the spot rate S. Both of these features are evident in Figure 4 and Figure 5. In Figure 4 we see that there have been, indeed, large movements in real exchange rates. In Figure 5 I have divided the real exchange rate into two components. The ratio P/Pf is the solid line and the spot rate S is the dashed line. If PPP were true, the two lines would be the same (as PPP implies S = P/Pf). In fact they're much different. What that means from a business point of view is that fluctuations in currency prices can wreak havoc on the dollar value of foreign sales, since in general the foreign prices don't change to compensate. For that reason, an important part of international business is methods of reducing exposure to currency risk: financial hedging with options and forwards, matching the currency denomination of revenues and expenses, and so on. There are several courses at Stern devoted to precisely this issue.
We will discuss in more detail in later chapters the reasons why the PPP does not hold, at least in the short-run. To anticipate the issues note that, in our example above, we assumed that the domestic and foreign goods were identical (a gallon of gasoline). However, the RER represents basket of domestic and foreign goods that can be very different. For example, a Mercedes car is very different from a GM or Ford car so that we would not expect that prices in the same currency of similar but differentiated products would be equalized.
However, while the PPP may not be holding in the short-run, it should tend to hold in the long-run: if German prices are systematically higher than U.S. ones, at some point they will have to fall or US prices will have to go up, or the US $ will have to appreciate (or all of the above).
To understand the important role of the exchange rate as an adjustment mechanism for relative prices and the trade balance, note the following two points:
1. A depreciation (appreciation) of the domestic exchange rate makes foreign imported goods more expensive (cheaper) when priced in domestic currency. So a currency depreciation (appreciation) will lead to a reduction (increase) in the demand for imported goods as these goods become more expensive (cheaper). This reduction (increase) in the demand for imports should improve (worsen) the US trade balance.
2. A depreciation (appreciation) of the domestic exchange rate makes domestic goods exported abroad cheaper (more expensive) when priced in a foreign currency. So a currency depreciation (appreciation) will lead to a increase (decrease) in the foreign demand for US goods, i.e. an increase (decrease) in US exports as these goods become cheaper (more expensive) in foreign markets. This increase (decrease) in the US exports will improve (worsen) the US trade balance.
The above principles work through the effects of changes in the exchange rate on the price in $ of imported goods and the price in foreign currency of US exports.
1. A US Dollar appreciation decreases the price in US $ of imported goods (P$f ) since:
P$f =S Pf . So, a $ appreciation (an decrease in S) will decrease P$f .
P$f = S Pf = 0.67 x 2 = 1.34
P$f = S Pf = 0.60 x 2 = 1.20
1. A US Dollar appreciation increases the price in foreign currency (DM) of US goods exported abroad (PDM ) since:
PDM = P / S. So, a $ appreciation (an decrease in S) will increase PDM.
PDM = P / S = 1.20 / 0.67 = 1.79
PDM = P / S = 1.20 / 0.60 = 2.00
Of course, the converse is true as well: a US $ depreciation makes the price in $ of imported goods more expensive and the price in foreign currency of US exports cheaper.
The above analysis suggests that a depreciation of the nominal exchange rate (S) will lead to an increase in the relative price of foreign to domestic goods, i.e. it will lead to a depreciation of the real exchange rate (RER). In fact,
RER = S Pf / P = P$f / P
If we take the price in own currency of domestic and foreign goods (P and Pf ) as given, a nominal depreciation of the exchange rate will also be a real depreciation.
Note that, if the PPP was holding both in the short-run and the long-run, a nominal depreciation of the domestic currency would not lead to a depreciation of the real exchange rate. For given foreign prices of foreign goods, a depreciation of the nominal exchange rate would increase proportionally by the same amount the price of imported goods and the price of domestic goods leaving the real exchange rate unaffected. In this regard, the PPP can be interpreted both as a theory of the determinant of the exchange rate and as a theory of the determinant of the domestic price level (or inflation rate). As a theory of the exchange rate, the PPP can be written as:
S = P / Pf
or, we write the expression above in percentage rates of change:
dS/S = dP/P - dPf/Pf
where dx/x is the percentage rate of change of variable x. In the level form, the expression above says that the exchange rate will be more depreciated if the domestic price level is higher than the foreign one. In the rate of change form (relative PPP), the expression says that the exchange rate will depreciate at a % rate equal to the difference between domestic and foreign inflation. For example, if domestic inflation is 10% while foreign inflation is 4%, the domestic currency should depreciate on average by 6%.
The PPP, as a theory of the determinants of the exchange rate, considers the causality between P and S as going from domestic inflation to exchange rate depreciation: high inflation causes high depreciation rates. As a theory of the determinants of the domestic inflation, instead, the PPP considers the causality as going from the exchange rate to domestic inflation:
dP/P = dS/S + dPf/Pf
The expression above implies that, for given foreign inflation, the domestic inflation rate will be equal to the foreign inflation rate plus the 'exogenous' rate of depreciation of the domestic currency. For example, if foreign inflation is 4% and the domestic currency is depreciated by 20%, domestic inflation will be equal to 24%.
Of course, if the PPP does not strictly holds (at least in the short-run), the RER will not be always equal to one and constant and a depreciation of the nominal exchange rate will also depreciate the real exchange rate. By how much will the real exchange rate depreciate if the nominal exchange rate depreciates by x% ? If the domestic price level was completely independent of the nominal exchange rate, the domestic inflation rate would be totally unaffected by a nominal depreciation. In this case, the real exchange rate would depreciate by x% as well. Of course, this is an extreme case where the increase in the price of imported goods caused by the nominal depreciation does not affect at all the price of domestic goods.
If an x% nominal depreciation leads to an increase in domestic inflation (but by less than the x% implied by the PPP), the real exchange rate will depreciate but, by less than x%. In fact, by definition:
dRER/RER = dS/S + dPf/Pf - dP/P
For example, take Mexico in 1995. Foreign (US inflation) was 3% while the Mexican Peso depreciated during the year by about 107%. If the Mexican inflation in 1995 has remained at the 1994 level (about 8%), the 107% nominal depreciation would have corresponded to a real depreciation of 102% (107 + 3 - 8). However, the large devaluation of 1995 led to an increase in the inflation rate (as the increase in the price of imported goods led to a surge of domestic price and wage inflation). As the inflation rate surged to 48% in 1995, the nominal depreciation of the Peso of 107% corresponded to a smaller real depreciation of 52% (107 + 3 - 48). So the nominal devaluation was effective in changing the relative price of imported to domestic goods (the RER) in Mexico and led to an improvement in the external balance of the country: the Mexican trade balance had been in a deficit of 20b US $ in 1994 while it showed a surplus of 3b US $ in 1995.
The above analysis suggest that a currency devaluation is a double sided sword:
1. On one side, it leads to a real depreciation that makes imported goods more expensive, domestic exports cheaper abroad and leads to an improvement of the trade balance via a fall in imports and an increase in exports.
2. On the other side, a nominal depreciation leads to an increase in
domestic inflation that dampens the effect of the nominal devaluation on
the real exchange rate. The faster domestic inflation adjusts to the change
in the exchange rate (i.e. the closer we are to the PPP in the short-run),
the smaller will be the real depreciation following a nominal depreciation,
the smaller will be the improvement in the trade balance and the bigger
the increase in domestic inflation.
Fixed Exchange Rates, Real Exchange Rate Appreciation and Current Account Deficits.
We have discussed above and in Chapter 1 the conditions under which a current account deficit may or may not be sustainable. We have now to consider the role of exchange rates and real exchange rate appreciation. A real exchange rate appreciation (from large capital inflows or any other reason) may cause a loss of competitiveness (as imports become cheaper and exports more expensive) and a structural worsening of the trade balance which makes the current account deficit less sustainable. Although the investment-saving imbalance, rather than a real appreciation, is the proximate source of a current account deficit, the current account deficit may be less sustainable when accompanied by a real exchange rate appreciation that leads to a misaligned currency value. Specifically, a real appreciation may lead to an increase in consumption (of imported goods) and increased imports of capital goods for investment that result in a worsening of the current account.
Specifically, the large and growing current account imbalances in Asia in the 1990s leads to the question of whether such imbalances were partly due to a loss of competitiveness associated with a real appreciation of the exchange rate. In fact, various measures suggest that many of the countries in Asia whose currencies collapsed in 1997 had experienced significant appreciation of their real exchange rates in the 1990-96 period.
According to one view (the misalignment hypothesis), the real appreciation observed in Asia in the 1990s was in part the consequence of the choice of the exchange rate regime (fixed exchange rates) and the ensuing capital inflows; therefore, it represented a loss of real competitiveness. If this view is correct, the large and growing current account imbalances were be caused in part by the real appreciation of the currency. This would also imply that the growing current account imbalances were not sustainable and had to be reversed only through a process of nominal and real deprecation of the currency, as the one that occurred in 1997.
The above discussion suggests two questions:
1. Were the growing current account imbalances observed in Asia partly casued by movements of the real exchange rate of these countries?
2. Was the real appreciation caused by the choice of the exchange rate regime?
1. Regarding the first question, the data for Asia suggest that the degree of overvaluation of the real exchange rate was correlated with worsening of the current account: countries with more overvalued currencies (such as Thailand and Malysia) generally experienced a larger worsening of the current account; while countries such as China and Taiwan that had experienced a real depreciation had current account surpluses. An exception was Korea that had large and increasing current account deficits while its currency had depreciated in real terms in the 1990s.
2. Regarding the second question, in the case of Asia the real appreciation was clearly partly the consequence of the choice of the exchange rate regime, essentially a fixed peg to the U.S. dollar. Such a peg led to large capital inflows attracted by favorable interest rate differentials and the expectation of low exchange rate risk given the policy of stable currency value. Such inflows prevented currency depreciations even if domestic inflation was higher than world inflation and at times led to nominal currency appreciation; this, in turn led to a real appreciation that was partly the cause of the large and growing current account imbalances.
While such policy of pegging the exchange rate ensured in many Asian countries ensured the stability of the nominal exchange rate relative to the US currency, it also had the consequence that change in the nominal and real value of the dollar relative to the Japanese Yen and the European currencies had the consequence of affecting the real exchange rate of the Asian currencies pegged to the US dollar. Specifically, the dollar was on a downward nominal trend relative to the yen and mark betweeen 1991 and 1995 reaching a low of 80 yen per dollar in the spring of 1995. During that period, the Asian currencies pegged to the U.S. experienced a real depreciation of their currencies, as they were depreciating relative to the Japanese and European currencies. However, after the spring of 1995, the dollar started to rapidly appreciated relative to most world currencies (the yen/dollar rate went from 80 in the spring to 1995 to over 125 in the summer of 1997, a 56% appreciation). As a consequence, the Asian currencies that were tied in nominal terms to the dollar also experienced a very rapid real appreciation.
Note also that a real appreciation of the currency will occur when the exchange rate is pegged and used as a nominal anchor for monetary policy (as it has been in most Asian countries) if the initial domestic inflation rate is above the world one and it does not converge rapidly to the world infaltion rate. In fact, while fixing the exchange rate is a fast way to disinflate an economy starting with a higher inflation rate, pegging the exchange rate will not reduce the inflation rate instantaneously to the world level. The reasons why inflation will not fall right away to the world level are several; 1) PPP does not hold exactly in the short tun since domestic and foreign goods are not perfectly substitutable. So domestic firms will reduce the inflation rate when the exchange rate is pegged but may not push it immediately down to the world level. 2) Non-tradable goods prices do not feel the same competitive pressures as tradable goods prices, thus inflation in the non-traded sector will fall only slowly. 3) Since there is significant inertia in nominal wage growth, wage inflation might not fall right away to the world level. Many wage contracts are backward looking and the adjustment of wages will occur slowly. Also, in countries where there is formal indexation of nominal wages, wage inflation is based on past (higher) inflation rather than current (lower) inflation; so this inertia in the wage setting in the economy means that wage inflation will remain above the world rate.
If domestic inflation does not converge immediately to the world level when the exchange rate parity is fixed, a real appreciation will occur over time. This appreciation of the real exchange rate implies a loss of competitiveness of the domestic economy: exports become more expensive relative to imported goods; this worsens the trade balance and the current account over time. Even small differentials between domestic and foreign inflation rates can compound rapidly into a substantial real appreciation. Therefore, the problem of anti-inflation stabilization policies that use the fixed exchange rate as the policy tool to fight inflation is that fixed rates lead to a real exchange rate appreciation and to a significant worsening of the current account. While the Asian countries had not experienced the large inflation rates of some Latin countries, their inflation rates were usually above those of the OECD group; therefore a policy of pegged parities might have contributed to the real appreciation observed in the 1990s.
Note that, while a real appreciation is more likely to occur (and persist) when the currency is pegged to a fixed exchange rate, misalignments of the real exchange rate may also occur under a regime of managed floating exchange rates unless the central bank follows a crawling peg policy of targeting the real exchange rate. Nominal and/or real appreciation under a managed float may occur as a result of large capital inflows. Such inflows may have diverse causes:
1. Optimism about an economy that has successfully started to stabilize and structurally reform its economy.
2. Short-term speculative capital flowing to countries with interest rates higher than world rates and fixed exchange rates.
In both instances, speculative capital inflows may prevent the nominal depreciation of the currency necessary to maintain a stable real exchange rate in the presence of persistent differentials between domestic and foreign inflation.
Technical Caveat: Attempts to prevent a nominal appreciation through foreign exchange intervention (in the absence of capital controls) may not be able to prevent the real appreciation. If the interventions are not sterilized, monetary growth will increase and lead to higher domestic inflation that in turn causes a real appreciation; if they are sterilized, domestic interest rates remain high, capital inflows continue and the pressure towards a nominal appreciation persist. This is why controls on capital inflows have been suggested as a way to stem inward inflows causing the real appreciation of the domestic currency.
For more on the causes and effects of real appreciations, read Chapter
8 of the lecture notes.
Interest Rates and Exchange Rates
We also see substantial differences in interest rates across countries. In late January of 1992, for example, the rate on three-month eurodollars at Bankers Trust was 4.19% (annual rate). [This differs a little from the 3-month treasury bill rate of 3.83 on the same date because T-bills are exempt from state and local taxes, banks are riskier than the federal government, and the rates are computed somewhat differently.] The analogous rate on Deutschemark-denominated deposits at the same bank was 9.52%, a large premium. You might guess that this reflects the market's expectation that the DM would fall in value relative to the dollar, and eat up the interest difference in currency losses. That would be a good guess, but you'd be wrong. As we'll see shortly, you are generally better off (for major currencies) investing in the higher interest rate security, even though the interest is paid in a different currency.
The Covered Interest Parity Condition (CIPC)
We'll start with a relation called covered interest parity condition, which says that interest rates denominated in different currencies are the same once you "cover'' yourself against possible currency changes. The argument follows the standard logic of arbitrage used endlessly in finance. Let's compare two equivalent strategies for investing one US dollar. The first strategy is to invest one dollar in a 3-month eurodollar deposit. After three months that leaves me with (1+i) dollars, where i is the dollar rate of interest expressed as a quarterly rate (the annualized rate of 4.19% divided by 4).
The second investment strategy has a number of steps. The first is to convert the dollar to DMs, leaving us with 1/S DMs if S is the spot exchange rate in $/DM. The second step is to invest this money in a 3-month DM deposit, earning the quarterly rate of return if (f for foreign again). Here if is the annualized rate of return 9.52% divided by 4. That leaves us with (1+if)/S DMs after three months. We could convert at the spot rate prevailing three months from now, but that exposes us to the risk that the DM will fall. An alternative is to sell DMs forward. In January 1992 we know we will have (1+if)/S DMs that we want to convert back to dollars. With a three-month forward contract, we arrange now to convert them at the forward rate F expressed, like S, as $/DM. This strategy leaves us with (1+if)F/S dollars after three months.
Thus we have two relatively riskless (to the extent that Bankers Trust, the source of these numbers, pays off on its deposits) strategies, one yielding (1+i), the other yielding (1+if)F/S. Which is better? Well, if either strategy had a higher payoff, you could short one and go long the other, earning extra interest with no risk. Of course, Bankers Trust isn't in the business of letting you take their money this way, so they make sure that these prices are set so that the returns are equal:
(1 + i) = ( 1 + if) F/S
It's not hard for them to do, since all of these markets are pretty much run by banks, who are not in the business of giving money away. We call this equation (and those like it for other maturities) the covered interest parity condition (CIPC).
Example. Here's what the numbers looked like in January 1992. As we said, i= (4.19 % divided by 4), if = (9.52% divided by 4), S=0.6225 (62 cents per DM), F=0.6114 (so it's cheaper to buy DMs forward than spot). You can verify that covered interest parity works up to the accuracy of our numbers. That's generally the case: unless you're a big player and can manage the bid/ask spread to your advantage, you can view this relation as the truth. It's not often that economics works this well, so remember this. The covered interest parity can be also written in a simpler form. In fact:
(1 + i) = ( 1 + if) F/S = ( 1 + if) [ 1 + (F-S)/S] = ( 1 + if) [ 1 + fp] = (1 + if+ fp + if fp)
where fp (the forward premium) is the percentage difference of the forward rate from the spot rate. Since the term (if fp) is close to zero, this parity condition becomes approximately:
i = if + fp
i.e. the domestic interest rate is equal to to the foreign rate plus the forward premium. This gives you a simple rule: if the domestic interest rate is above the foreign rate by x%, the forward exchange rate (for the maturity equivalent ot the interest rate) will be above (i.e. depreciated relative to) the spot rate by x%.
Note that, as long as there are no restrictions on international capital flows and as long as the domestic and foreign asset have the same risk characteristics, the covered interest parity condition must always hold purely as a no-arbitrage condition. In fact, if the CIPC was not holding it would be possible for agents to make a potentially infinite amount of pure arbitrage (i.e. riskless profits). To see that, consider the following example based on actual data from February 13, 1997. That day we had:
iu = 5.5% on a 3-month Eurodollar deposit (annualized rate)
ij = 0.5% on a 3-month Euroyen deposit (annualized rate)
SYEN/$ = 124.4 (Spot Yen per dollar exchange rate)
FYEN/$ = 122.85 (3-month forward exchange rate)
Therefore on that day the CIPC was holding as:
(1+ 0.005/4) = (1+ 0.055/4) 122.85/124.4
Suppose now that, for some reason, that day we had FYEN/$ = 124.4 rather than the actual 122.85 rate. In this case the CIPC would have not held that day since:
(1 + ij ) > ( 1 + iu) FYEN/$ / SYEN/$.
We will show that in that case a forward arbitrage strategy would have led to unlimited riskless profits. Such strategy is as follows:
1. Borrow in Japan an amount of Yen equal to 124.4 billion at a 0.5% (annualized) interest rate for 3 months (quarterly rate of 0.125% = 0.5%/4)
2. Buy US$ spot with your 124.4b Yen to get $ 1b.
3. Invest the $ 1b in a 5.%% US T-bill for three months (3-month return is 1.38% = 5.5% /4).
4. Sell $ 1.00125 b [= $1b (1+ 0.00125)] forward to buy forward Yen
in an amount equal to
Yen 124.55b (=124.4 (1+0.00125)). You need these Yen in 3-months to pay back your Yen borrowings with interest.
Then, in 3 months:
The return on the US investment is $ 1.0138b (= $1b (1 + 0.0138))
Use $ 1.00125 b to pay for your forward Yen contract and pay pack your Yen borrowing
Net Arbitrage Profits from the entire operation: $ 1.0138b - $ 1.00125 b = $ 12.55 million
Now if you borrow then times more your arbitrage profits would be $125.5m rather than 12.55m; and so on.
This cannot be an equilibrium as every investor will have an incentive to follow the forward arbitrage strategy described above. As every investor will do the same:
Sell $ forward
Buy Yen Forward
We would get an appreciation of the Forward Yen/$ rate down from 124.4 to 122.85, the equilibrium rate that restores the CIPC. In fact, when:
FYEN/$ = 122.85, Arbitrage Profits are Zero as:
ij - iu = = (FYEN/$ - SYEN/$)/SYEN/$ .
0.125% -1.38% = -1.25% = (122.85 - 124.4)124.4 = -1.25%
Therefore, the instantaneous behavior of all agents in the foreign exchange
rate market guarantees that the CIPC hold moment by moment; otherwise,
free riskless arbitrage opportunities would be available.
The Uncovered Interest Parity Condition (UIPC)
If you cover your foreign positions with a forward contract, that sense there's no point worrying about whether to invest in dollars or DMs. But what if, in strategy two, you converted at the spot rate in a quarter (three months form now) and took your chances on the exchange rate? Your return would then be
(1+itf) St+1 / St ,
where by St+1 is the spot rate a quarter (3 months) from now.
Suppose now that agents are risk-neutral, i.e they care only about expected returns. Then, expected return on investing in a domestic asset for a period (a quarter) is (1 + i) while the expected return (as of today time t) of investing in a foreign asset is:
where is the expectation I have today (time t) of what the spot exchange rate will be a quarter (3 months) from now. Now, if agents are risk-neutral and care only about expected returns, the expected return to investing in a domestic asset must be equal to the (uncertain as of today) expected return on investing in the foreign asset. This is what is called the uncovered interest parity condition (UIPC):
(1+it ) = (1+itf) E(St+1) / St ,
where E(xt+1) again means the expectation today (t) of the value at time t+1 of the variable x. Note that this is not a riskless arbitrage opportunity as the ex-post future spot rate may be different from what we expected it to be. Rearranging the expression above, we can rewrite the uncovered interest parity condition as:
i = if + dSe/S = if + (E(St+1) - St)/St.
where dSe/S is the expected percentage depreciation of the domestic currency. Again, this gives us a simple rule: if the UIPC holds, a x% difference between the interest rate at home and abroad must imply that investors expect that the domestic currency will depreciate by x%.
Given that covered interest parity works, uncovered interest parity amounts to saying that the forward rate today (delivery of currency at time t+1) is the market's expectation of what the spot rate will be a period from now:
ft = E(St+1).
More generally, since forward contracts can be signed for any maturity:
Ftt+k = E(Ft+k)
where Ftt+k is the
forward rate today for delivery of currency at time t+k and E(St+k)is
today's market's expectation of what the spot rate will be t+k periods
from now. [For some forecasts (expectations) of future exchange rates you
can check out the home page of Olsen &
To see why the UIPC should hold when agents are risk-neutral consider the following example based on the previous example. Suppose that:
iu = 5.5% on a 3-month Eurodollar deposit (annualized rate)
ij = 0.5% on a 3-month Euroyen deposit (annualized rate)
SYEN/$ = 124.4 (spot Yen per dollar rate)
FYEN/$ = 122.85 (3-month forward exchange rate)
In this case, the CIPC holds and if the expected future exchange rate E(St+1) happens to be equal to the current forward rate of 122.85, the UIPC holds as well. However, suppose now that investors expect the future spot rate at time t+1 to be higher than the current forward rate, i.e.:
Et YEN/$(St+1) = 127 > FYEN/$t = 122.85
Then, consider the following Forward Speculation strategy:
Buy $1b forward at the rate 122.85 Yen/$ that is equivalent to:
Sell Yen 122.85b forward at the rate 122.85 Yen/$.
Then, in 3 months, if the actual St+1 turns out to be 127 Yen/$:
1. Buy Yen 122.85b with $ 0.967b (at a spot rate of 127)
2. Receive $ 1b from your forward contract
3. Make a profit of $ 37 million (= 1000m - 967m)
So if the expected future exchange rate is above the current forward rate, all risk-neutral investors have an incentive today (time t) to buy $ forward and sell Yen forward (as in the forward speculation strategy described above). This, however, will lead right away to a depreciation of the time t forward exchange rate Yen per Dollar (FYEN/$) from its initial value of 122.85. This depreciation of the forward rate will continue until:
FYEN/$ = Et YEN/$(St+1) = 127
Once the forward rate has depreciated to 127, the UIPC is restored again. This example shows that, if agents are risk-neutral, forward speculation always guarantees that the UIPC should hold in equilibrium.
Note however that, unlike forward hedging that relies on the CIPC to
cover you from the risk of unexpected changes in the future exchange rate,
forward speculation is risky. In fact, suppose that the actual future spot
rate turns out to be different from the one you expected; in particular,
suppose that the actual St+1 turns out to be 120 Yen/$ rather
than the expected 127.
Then, you will lose money from your forward speculation strategy since you will need $ 1.023b to buy the Yen 122.85b you owe (given your forward contract) and you will receive back only $1b from the forward contract. Therefore you will suffer a loss equal to 23m ($1,000m - $1,023m). Therefore, whether you make a profit or lose money from forward speculation depend on the actual realization of the future exchange rate (relative to the current forward rate):
If FYEN/$ < SYen/$,t+1 you profit if you bought $ forward
If FYEN/$ > SYen/$,t+1 you
lose if you bought $ forward
Evidence on the UIPC
The expectations hypothesis (UIPC together with the CIPC) implies that, if the forward rate is less than the current spot rate (Ft < St) so that domestic interest rate are lower than foreign interest rate, we should expect the spot rate to appreciate: E(St+1) < St. What is the evidence on the uncovered interest parity condition. Is is true that when domestic interest rates are above (below) foreign ones, the exchange rate will depreciate (appreciate) ?
Consider again the UIPC; it implies that the expected depreciation of a currency is equal to the differential between domestic and foreign interest rates:
dSe/S = i - if
Now, we know from the Fisher Condition (see Chapter 2) that high interest rates can be due to two factors: high real rates or high expected inflation. So, substituting the Fisher Condition we get:
dSe/S = (r - rf) + (p - pf)
Consider now two cases:
1. Domestic real interest rate are equal to foreign interest rates. In this case, the domestic nominal interest rate can be above the foreign rate only if the domestic country is expected to have a higher inflation rate than the foreign country. In this case, it makes sense to believe that higher interest rate at home will lead to a currency depreciation. In fact, by the PPP, higher inflation is associated (sooner or later) with a currency depreciation and the higher interest rate at home reflects only the higher expected inflation of the home country. This implication seems to be confirmed by the data: countries with high inflation have, on average, higher nominal interest rates than countries with lower inflation and, on average, the currencies of such high inflation countries tend to depreciate at a rate close to the interest rate (or inflation) differential relative to low inflation countries.
2. Domestic inflation is equal (or close to) the foreign inflation rate. In this case higher interest rates at home do not reflect higher domestic inflation but rather higher real interest rates due for example to a tight monetary policy by the central bank. In this case, we would expect that high domestic interest rates will be associated with an appreciating currency (as the high interest rates lead to an inflow of capital to the high yielding country). In fact, the history of the last twenty years (when the major countries switched from the Bretton Woods system of fixed exchange rates to the current system of market based rates) suggests that, for period of time when US inflation is close to the German one, the US appreciates (relative to the DM) when US interest rates are above the German ones. This is a contradiction of the UIPC but it reflects the effect of high real interest rates on currency values. See a recent discussion by the chief currency economist for Morgan Stanley for an argument based on this yield effect.
This brings us back to the question of whether the difference in dollar
and DM rates reflects a prediction that the DM will fall. The expectations
hypothesis says yes. But 20 years of experience with floating exchange
rates for major currencies suggests that we should expect, instead, a rise
in the DM. That means that our uncovered investment in DMs not only earns
a higher rate of interest, but we can expect, on average, a bonus as the
DM rises in value! In short, good rules of thumb are (i) high interest
rate currencies (of countries with low inflation) generally increase in
value and therefore (ii) expected returns are higher in the high interest
rate currency. Right now you'd probably do better to invest in $ bonds,
rather than DM bonds. Many financial firms have international money market
funds that do precisely that.
Determinants of Exchange Rate
The UIPC holds only when agents are risk-neutral and therefore care only about expected returns rather than the riskiness of the assets. However, if agents are risk-averse, they will require a higher return (a risk premium in order to hold an assets that is considered to be more risky than another one. In the presence of the a risk premium the interest parity condition will be modified as follows:
it = itf + (E(St+1) - St)/St + RPt
where now RP represents the risk premium on domestic assets; this risk premium could, for example, represent the risk of default on domestic assets. If such premium is positive, the return on the domestic asset should be in equilibrium above the expected return on the foreign assets because agents consider the domestic assets more risky than the foreign one: the difference between the return on the domestic assets and the expected return on the foreign asset is exactly given by the risk premium:
it -[itf + (E(St+1) - St)/St] = RPt
Solving the expression above for the current spot rate, we can rewrite the risk-adjusted interest parity condition as:
St = [E(St+1)] / [ it - itf + 1 - RPt]
This expression shows us all the factors that determine the current spot exchange rate and that can lead to a change in its value.
First, an increase at time t of the expectation that at time t+1 the currency will be more depreciated leads to a depreciation of the current (time t) spot exchange rate St. In fact, starting from an initial equilibrium, an increase in E(St+1) leads (for a given initial value of St) to an increase in the expected return on the foreign asset [itf + (E(St+1) - St)/St]; then, agents will try to get rid of the domestic asset, sell domestic currency and buy foreign currency in order to buy the foreign asset. This capital outflows out of the domestic economy will lead to a depreciation of the current spot exchange rate St; such depreciation will reduce the expected return on the foreign asset and restore the interest parity.
Second, an increase at time t of the the foreign interest rate (itf) leads to a depreciation of the current (time t) spot exchange rate. In fact, starting from an initial equilibrium, an increase in (itf) leads (for a given initial value of St) to an increase in the expected return on the foreign asset [itf + (E(St+1) - St)/St]; then, agents will try to get rid of the domestic asset, sell domestic currency and buy foreign currency in order to buy the foreign asset. This capital outflows out of the domestic economy will lead to a depreciation of the current spot exchange rate St; such depreciation will reduce the expected return on the foreign asset and restore the interest parity.
Third, an increase at time t of the the risk premium on domestic assets (RPt) leads to a depreciation of the current (time t) spot exchange rate. In fact, starting from an initial equilibrium, an increase in (RPt) leads (for a given initial value of St and it) to a reduction in the risk-adjusted return on the domestic assets represented by (it-RPt); then, agents will try to get rid of the domestic asset, sell domestic currency and buy foreign currency in order to buy the foreign asset. This capital outflows out of the domestic economy will lead to a depreciation of the current spot exchange rate St; such depreciation will reduce the expected return on the foreign asset and restore the parity between the risk-adjusted return on the domestic assets and the expected return on the foreign asset.
Fourth, an increase at time t of the the domestic interest rate (it) leads to an appreciation of the current (time t) spot exchange rate. In fact, starting from an initial equilibrium, an increase in (it) leads (for a given initial value of St) to an increase in the return on the domestic asset; then, agents will try to get rid of the foreign asset, sell foreign currency and buy domestic currency in order to buy the domestic asset. This capital inflow into the domestic economy will lead to an appreciation of the current spot exchange rate St; such appreciation will increase the expected return on the foreign asset [itf + (E(St+1) - St)/St] and restore the interest parity.
The above example show that various factors (an increase in the future expected exchange rate, an increase in the foreign interest rate and an increase in the risk premium on the domestic assets) will all lead to a depreciation of of the domestic currency because they lead to an increase in the expected return on foreign assets or to a fall in the risk-adjusted return on domestic assets. All these factors, especially the expectation of future depreciation and the increase in the risk premium on domestic assets, seem to have played an important role in the rapid depreciation of the Asian currencies in 1997. How could the Asian governments have prevented these sharp depreciations of their currencies and maintained their exchange rate pegged to the US dollar? The answer is simple: if exogenous shocks such an increase in the future expected exchange rate, an increase in the foreign interest rate and an increase in the risk premium on the domestic assets lead to capital outflows and a pressure on the domestic currency to devalue, the equation above suggest that the only way to prevent such devaluation is to sharply increase the domestic interest rate to a level that restores the risk-adjusted interest parity condition.
However, such a policy of high interest rates is problematic since it
might prevent a devaluation but it is also certain to lead to a domestic
recession if the domestic interest rate remains high for long enough. In
fact, the monetary tightening and credit squeeze that follows a sharp increase
in domestic interest rates usually lead to a fall in domestic demand for
investment and consumption purposes. This fall in aggregate demand is then
followed by a fall in production and a recession. Therefore, defending
a fixed exchange rate parity when the market is pushing for a currency
depreciation may turn out to be very costly in output terms. This is exactly
what happened to Argentina in 1995 where, following the devaluation of
the Mexican Peso in December 1994, speculative capital outflows forced
the government to increase dramatically short-term interest rates to defend
its currency board (a rigid fixed exchange rate system with a 1 to 1 parity
of the Argentinean Peso with the US Dollar). Argentina was then able to
avoid a devaluation of its currency but paid a big price with a severe
recession in 1995. A similar situation in currently occurring in Hong Kong
where a sharp increase in domestic interest rates has so far (January 1998)
prevented a depreciation of the Hong Kong Dollar while most of the other
regional currencies have been forced to devalue their currencies. Such
high interest rates are, however, leading to a serious slowdown in the
level of economic activity in Hong Kong and might well lead to a recession
We will discuss in more detail the causes of currency crises in Chapter 8 of the Lecture Notes. Read that chapter now if you want an early introduction to currency crises.
|Cash Flows from Operating Activities||9,458|
|Cash Flows from Financial Activities|
|Cash flow from current transactions|
|Current account balance
(including official foreign reserves)
|Cash flow from financial (capital) transactions|
= Change in Official Foreign Reserves