Transcript Currency Analysis with Fundamentals

Currency Analysis with
Fundamentals
Fundamental Analysis involves the use
of data to assess the strength/weakness
of a currency
Economic Data
Financial Data
Demographic Data
GDP
Employment
Prices
Interest Rates
Asset Prices
Population Growth
Asset Prices
International Data
International Data
Trade Balance
FDI
Official Reserve Position
Trade Balance
FDI
Official Reserve Position
Trade Balances

The trade balance approach focuses on
a country’s current account.
Exports = demand for a country’s currency
 Imports = supply of a country’s currency


Trade deficit (surplus) countries should
experience currency depreciations
Example: Bolivia (Bolivian Peso)
35
30
25
20
Exports (% GDP)
Imports (%GDP)
15
10
5
0
1998
1999
2000
2001
Example: Bolivia (Bolivian Peso)
The J-Curve
Recall that currency demand/supply is based
on foreign exchange expenditures
 If elasticities are low, then rising prices can
actually increase expenditures
 Elasticities tend to increase over longer
time horizons
 Necessities (in particular, energy) have
lower elasticities than luxuries

Balance of Payments
The trade balance approach assumes that
currency flows are due to purchases of
goods/services alone.
 The Capital & Financial Accounts keep track
of net inflow of cash due to financial
transactions (CA + KFA = 0)



Private Capital inflow: Purchases of domestic
assets
Official Reserve Transactions: Acquisition of official
reserve assets (between central banks)
Example: Israel (Shekel)
50
45
40
35
30
25
20
15
10
5
0
Exports (% of
GDP)
Imports (% of
GDP)
1998
1999
2000
2001
Example: Israel (Shekel)
Example: Israel (Shekel)
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
Foreign Direct
Investment
(Billions of $)
1998
1999
2000
2001
Balance of Payments
Approach
Adding the Capital account complicates the
analysis:
 Remember, if a country is financing its trade
deficit by selling its assets. These assets are
claims to future payments



How big is “too big”
A country’s ability to repay its debts lies in in its
ability to run future trade surpluses (or have a
VERY cheap currency)
Example
Variable
El Salvador
Hungary
GDP Growth
1.82
3.8
Capital Formation 15.97
(% GDP)
Illiteracy
20.1
27.13
Debt Service
6.35
37.5
Industry Value
Added (% GDP)
29.4
33.7
.66
Monetary Approach (Flexible
Prices)

The classical approach assumes that all
prices are flexible and that all markets
clear.
Money markets take the lead
 Bond markets play a passive role.

Capital Markets


Classical theory
assumes completely
integrated capital
markets
At the prevailing world
interest rates, the trade
balance is determined
by
S – I – (G-T)
20
16
12
8
4
0
0
100 200 300 400 500
Monetary Policy & Capital
Markets

Money is ”Neutral” in classical theory.
Therefore, Federal Reserve policy only
influences the price level
Classical Money Demand

It is assumed that households choose to hold a
fraction of their nominal income in the form of cash
(or a checking account)
Classical Money Demand

It is assumed that households choose to hold a
fraction of their nominal income in the form of cash
(or a checking account)
Money Demand = k* PY
Classical Money Demand

It is assumed that households choose to hold a
fraction of their nominal income in the form of cash
(or a checking account)
Money Demand = k* PY
For example, suppose that National Income is $8T.
If the average household chooses to hold 10% of
their income in the form of cash, what is
aggregate money demand?
Classical Money Demand

It is assumed that households choose to hold a
fraction of their nominal income in the form of cash
(or a checking account)
Money Demand = k* PY
For example, suppose that National Income is $8T.
If the average household chooses to hold 10% of
their income in the form of cash, what is
aggregate money demand?
Money Demand = (.1)($8T) = $800B
Money Market Equilibrium

The aggregate price level will adjust so that money
supply equal money demand
Money Market Equilibrium

The aggregate price level will adjust so that money
supply equal money demand
M = Money Demand = k*PY
Money Market Equilibrium

The aggregate price level will adjust so that money
supply equal money demand
M = Money Demand = k*PY

Solving the above expression for price gives us
P = M/(kY)
Money Demand and the
Quantity Theory of Money

An alternative way of expressing the
previous expression is
MV = PY
Where ‘V’ is the velocity of money (V = 1/k)

This is known as quantity theory of
money
Implications of the Quantity
Theory

In the long run, velocity is relatively constant.
Therefore, a country’s inflation rate is equal to
Inflation = Money Growth – Output Growth
Purchasing Power Parity

Purchasing power parity (PPP) suggests that currencies should
have the same purchasing power everywhere.
P = eP*

A more useful form of PPP is
%Change in e = Inflation – Inflation*

For example, if the US inflation rate (annual) is 4% while the
annual European inflation rate is 2%, the the dollar should
depreciate by 2% over the year.
Currency Fundamentals

Begin with PPP
%Change in e = Inflation – Inflation*
Currency Fundamentals

Begin with PPP
%Change in e = Inflation – Inflation*

The Quantity theory gives us
Inflation = Money Growth – Output Growth
Currency Fundamentals

Begin with PPP
%Change in e = Inflation – Inflation*

The Quantity theory gives us
Inflation = Money Growth – Output Growth

Therefore, we have
%change e = (Money Growth – Money Growth*)
+ ( Output Growth* - Output Growth)
Interest rate Parity

Recall, integrated capital markets imply equal
real rates of return across countries
r = r*
Interest rate Parity

Recall, integrated capital markets imply equal
real rates of return across countries
r = r*

Purchasing Power Parity gives us
e = Inflation – Inflation*
Interest rate Parity

Recall, integrated capital markets imply equal real
rates of return across countries
r = r*

Purchasing Power Parity gives us
e = Inflation – Inflation*

Combining the two yields
i – i* = %change in e
Assets should pay the same nominal return
across countries
Example: Norway (Krone)
18
16
14
12
10
8
6
4
2
0
-2
Inflation (US)
Inflation (Norway)
1998
1999
2000
2001
2002
Example: Norway (Krone)
4
3.5
3
2.5
GDP Growth (US)
2
GDP Growth
(Norway)
1.5
1
0.5
0
1998
1999
2000
2001
2002
Example: Norway (Krone)
The Importance of Relative
Prices

The fundamentals do quite well in explaining general
trends, but are not so good at shorter term
fluctuations
Exchange Rates & the
Fundamentals (JPY/USD)
300
250
200
Actual
PPP
150
100
50
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
0
Exchange Rates & the
Fundamentals (GBP/USD)
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
Actual
PPP
The Importance of Relative
Prices


The fundamentals do quite well in explaining general
trends, but are not so good at shorter term
fluctuations
While impediments to trade (tariffs, transportation
costs can be blamed for the failure of PPP) –
movement in the real exchange rate
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Nominal/Real Exchange Rates
300
250
200
150
Yen/$
100
50
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Nominal/Real Exchange Rates
300
250
200
150
Yen/$
Real
100
50
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
Nominal/Real Exchange Rates
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
GBP/$
Real
The Importance of Relative
Prices



The fundamentals do quite well in explaining general
trends, but are not so good at shorter term
fluctuations
While impediments to trade (tariffs, transportation
costs can be blamed for the failure of PPP) –
movement in the real exchange rate
A more like solution is a real/appreciation caused by
some relative price shift


Terms of Trade
Non-Traded Goods
Non Traded Goods

Suppose that two countries have identical price
indices
P = .5(Goods) + .5(Services)
Non Traded Goods

Suppose that two countries have identical price
indices
P = .5(Goods) + .5(Services)
 Suppose the domestic price of services increases
Non Traded Goods

Suppose that two countries have identical price
indices
P = .5(Goods) + .5(Services)
 Suppose the domestic price of services increases
 The domestic price level rises by 10%
 No change in the nominal exchange rate is
required
 A real appreciation of 10% occurs
Non Traded Goods

In the previous example, a 20% rise in the price of a
non-traded good created a 10% real appreciation
 No change in nominal exchange rate
 10% rise in domestic price level
Non Traded Goods


In the previous example, a 20% rise in the price of a
non-traded good created a 10% real appreciation
 No change in nominal exchange rate
 10% rise in domestic price level
This real appreciation could happen a number of
different ways. For example
 5% nominal appreciation
 5% domestic price level increase
Terms of Trade

Suppose that we have the US and Venezuela.



P = .2(oil) + .8(manufactured goods)
P* = .4(oil) + .6(manufactured goods)
Now, suppose oil prices rise by 10%.
Terms of Trade

Suppose that we have the US and Venezuela.



P = .2(oil) + .8(manufactured goods)
P* = .4(oil) + .6(manufactured goods)
Now, suppose oil prices rise by 10%.




The exchange rate is unchanged
P Rises by 2%
P* rises by 4%
A real depreciation of the dollar occurs
Terms of Trade

The previous example gave us:





The exchange rate is unchanged
P Rises by 2%
P* rises by 4%
A 2% real depreciation of the dollar occurs
However, any combination that adds up to a
2% real depreciation is possible. For example

A 2% nominal depreciation with no price changes.
Terms of Trade
It is generally assumed that a country’s
exports will make up a larger share of
its price index than imports.
 Therefore, in the previous example, the
US is an importer of oil, and an exporter
of manufactured goods.

Terms of Trade
The Terms of Trade is defined as the
relative price of exports in terms of
imports
 In the previous example, the Terms of
Trade for the US worsened causing a
real depreciation of the $.

Oil Prices
Year
1972
1973
1974
1978
1979
1980
1985
1986
Price ($/Brl.)
$10.65
$11.58
$18.76
$18.66
$24.19
$37.85
$32.69
$16.61
Real $ Exchange Rate
Nominal $ Exchange Rate
Case Study: Mexico (Peso)
Variable
1998
1999
2000
2001
2002
GDP Growth
5.03
3.62
6.56
-.17
.74
Capital
Formation
24.32
23.45
23.47
20.52
NA
Exports
30.69
30.79
31.03
27.34
NA
Imports
32.83
32.4
32.97
29.68
NA
Inflation
15.37
15.25
12.19
6.32
4.78
FDI (B)
11.9
12.5
14.2
24.7
NA
Terms of
Trade
100.4
102.32
107.39
NA
NA
Case Study: Mexico (Peso)
Case Study: India (Rupee)
Variable
1998
1999
2000
2001
2002
GDP Growth
5.9
7.13
3.95
5.45
4.4
Capital
Formation
21.38
23.66
22.51
22.43
NA
Exports
11.22
11.76
13.79
13.26
15.18
Imports
12.91
13.72
14.55
13.95
16.1
Inflation
7.88
3.85
4.52
3.47
4
FDI (B)
2.63
2.17
2.42
3.40
NA
Terms of
Trade
108.74
97.3
92.9
NA
NA
Case Study: India (Rupee)
Case Study: Singapore
(Dollar)
Variable
1998
1999
2000
2001
2002
GDP Growth
-.86
6.42
9.41
-2.47
2.25
Capital
Formation
32.38
32.44
32.38
24.43
20.62
Exports
NA
NA
NA
NA
NA
Imports
NA
NA
NA
NA
NA
Inflation
-2.38
-5.45
4.5
-1.23
.16
FDI (B)
6.38
11.8
5.4
8.6
NA
Terms of
Trade
96.96
96.03
93.29
NA
NA
Case Study: Singapore
(Dollar)