5. CURRENCY FUNDAMENTALS

Transcription

1 5. CURRENCY FUNDAMENTALS Review... 1 Checklist... 3 Figures Files for Homework Exercise... 1 Fundamentals Worksheet... 2 Homework 5 - U.K. Currency Fundamentals Instructions country_data_rates-trade-gnp_w_currfun-graphs_bpNjy_2017.xlsx/UD- POUND spreadsheet snapshot of pound and factor sign changes... 2 UK Fundamentals Worksheet... 3 Figures Financial... 4 Output... 5 Output and Government... 6 Prices... 7 Balance of Payments... 8 Homework 5 - Japan Currency Fundamentals Instructions country_data_rates-trade-gnp_w_currfun-graphs_bpNjy_2017.xlsx/UD- YEN spreadsheet snapshot of pound and factor sign changes... 2 Japan Fundamentals Worksheet... 3 Figures Financial... 4 Output... 5 Output and Government... 6 Prices... 7 Balance of Payments... 8 J. Bodurtha, 1989, 1992, 2010, 2012 All Rights Reserved

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3 CURRENCY FUNDAMENTALS REVIEW This analysis builds primarily on the output and rate fundamentals description and checklist. The factors affecting currency prices are divided into six classes: financial, prices, output, government, long-term, and balance of payments. As discussed, interest rates are also predominantly affected by the levels of first five of the elements of these classes, and, in turn, rates affect currencies. However, the absolute level of the factors is not what predominantly determines currency values. As exchange rates affect relative prices across countries, it is the level of these factors relative to the factors in another country that matters. Therefore, fundamental factor differentials across countries affect currency values. As a benchmark, we will consider country's currency values relative to the U.S. dollar. Consequently, all differentials are calculated as the U.S. quantity minus the foriegn quantity. A brief write-up on how these factors appear to be related to currency prices is presented next, and a summary checklist exercise on factorcurrency interaction follows. All of these relationships are hypothesized. Our task is to identify which of the hypothesized relationships are actually manifest in the currency histories with the hope that these relationships will help with international business situation identification and planning. FINANCIAL Short-term rate differential increases in excess of expected inflation differentials and/or expected currency appreciation lower foreign currency values. In this case, a higher differential real rate is said to prevail. The reversed effect occurs with lower short-term real rate differentials. Over the last twenty years, another risk-related phenomenon has occurred in which a flight to quality to low-risk dollar investments follows some financial shock. In these exceptional cases, lower foreign currency values are associated with short-term rate differential decreases. Bond yield differential increases (like differential rate increase) in excess of expected inflation differentials and currency appreciation over investors' holding periods lower foreign currency values. The impact of long-term inflationary expectations and government borrowing needs seem to be of predominant importance. With a flight to quality, lower foreign currency values are associated with bond yield differential decreases. Stock return differentials, which are future cashflow outlook-based, generally lead to depreciating foreign currency values. When the increase is due to falling relative discount rates, a rising foreign currency is the likely result, at least in the short-term. Significantly higher expected inflation is, usually, associated with stock market declines. Therefore, lower U.S.-foreign stock return differentials can be indicative of greater U.S. inflation potential and rising foreign currency values. The same is true for greater perceived risk in the U.S. than abroad (more relative U.S. risk yields higher foreign currency values). PRICES Inflation differential increases lead to higher foreign currency values. The dollar buys fewer traded goods, and relative U.S. investment real returns are lower. Oil and other import commodity price increases lead to higher inflation. The effect will be greatest on large oil-commodity importers. These countries face lower currency values. Higher export commodity prices improve the trade account, and result in higher currency values, at least in the short-term. Wage increases provide a cost-push basis for inflation, as well as increase imports. Higher wage differentials yield higher foreign currency values. Money growth differential increases raise foreign currency values. The causes are increased inflation, lower real rates, and high income that leads to more imports. Only when money growth is controlled and the real rate differential rises will a higher money growth differential lead to a rising dollar. Currency Fundamentals 1

4 OUTPUT CURRENCY FUNDAMENTALS REVIEW Consumption, investment and GNP/GDP growth differential increases lead to higher rate differentials and higher relative U.S. imports. These effects result in lower and higher foreign currency values, respectively. The net impact of growth will depend on which factor predominates. Due to the elasticity of capital flows across developed countries, the rate impact appears to be predominant. Trade deficits are due to relatively low exports and high imports. Higher relative U.S. deficits result in higher foreign currency values. Increased employment differentials are associated with higher relative U.S. growth and inflation. The net foreign currency value implication will be deterimined by the net outcome of the positive trade account and inflation effects and the negative real rate effects. GOVERNMENT Deficits lead to greater borrowing, real rates, income and inflation. Higher relative U.S. income and inflation raise imports to raise foreign currency values. Higher real rate differentials lead to lower foreign curency values, and will usually be the predominant factor across most developed countries. Loose monetary policy leads to higher foreign currency values, due to rate and inflationary implications. Exchange rate policy, as reflected in central bank reserve changes, affects how currencies will move when fundamentals change. Fixed rates are sustainable in the face of transitory changes, and when exchange rate mechanism members coordinate policies. Currency price jumps occur when a realignment is necessary. Floating exchange rates permit greater flexibility in managing long-term changes, and in many ways provide less fiscal and monetary policy discipline. Other regulations are very important, e.g. trade and international capital flow restrictions. A politically consistant anti-inflation and stable growth policy leads to a rising currency. (Because many countries won't fulfill this objective.) Better U.S. policies lead to declining foreign currency values. LONG-TERM Productivity and technology improvements lead to higher growth and competiveness. With greater relative U.S. improvement, lower foreign currency values result. Infrastructure declines, relatively, hurt U.S. competitiveness, and raise foreign currency values. Labor/demographics/population affect growth, the yield curve and competitiveness in a relatively complicated manner. Changing short- and medium term expectations for these phenomenon can have a more immediate and dramatic effect. BALANCE OF PAYMENTS Current account deficits indicate an overvalued currency (unless the basic balance is not in deficit). Higher differential deficits are associated with higher foreign currency values. Export prices minus import prices are inversely related to the terms of trade. Over the short-term, increases in relative export prices and decreases in relative import prices lead to a falling foreign currency values, due to the improving trade account and inflation outlooks. Over the longer-term, competitiveness will decline, and these effects should reverse. Increased net U.S. foreign investment demand lowers foreign currency values. Large foreign reserve changes have historically indicated foreign exchange market intervention by central banks. Whether intervention is successful or not remains an open question. The reserve valuation effect of exchange rate changes must also be considered, e.g. Fed does not intervene, but foreign currencies rise and U.S. foreign currency reserves rise. Currency Fundamentals 2

5 U.S. - foreign Foreign Currency Differentials Sources Dollar Value Impact FINANCIAL S/T Rates + if > than expected currency depreciation (or diff. inflation) With a flight-to quality, diferential is down Bond yields + if > than expected currency depreciation (or diff. inflation) Long-term inflation expectation is most important With a flight-to quality, diferential is down. Stock Market + Positive relative growth-cashflow outlook + Relative discount rate decline + - Differential inflation increase + - Differential risk increase + PRICES Inflation + More U.S. imports, relatively, and lower diff. real returns + Oil-commodity + Inflation pressure (unless commodity exporter) prices (not diff.) Wages + Relative cost-push inflation pressure and U.S. trade worsens + Money Supply + Higher diff. inflation, lower diff. real rates, and + higher relative U.S. income-imports OUTPUT Consumption, + Higher relative U.S. rates and capital in-flows investment and Worsening U.S. relative trade performance + GDP/GNP Growth Trade + More relative exports than imports Employment + Higher relative growth and inflation (see above) + Higher differential real rates GOVERNMENT and LONG-TERM Deficit (PSBR) + More relative U.S. borrowing and higher diff. real rates (Uncontrolled leads to higher differential inflation.) + Money Policy + See PRICES above, and Foreign reserves below + FX policy (see Foreign reserves below), other regulations and politics yield mixed effects Population/demographic and productivity changes, and infrastructure improvements. BALANCE OF PAYMENTS Current account deficits + Insufficient current demand for dollars + Export/Import prices + S/T improving trade and lower inflation L/T declining global competitiveness + Foreign investment demand + Net U.S. capital inflows Foreign reserves + With successful intervention (sterilized) stable or + Bucking trend ("leaning against the wind) Currency Fundamentals Exercise-3

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