Jul 5

The Fundamental Rally – practice

Economy currency, FInance, microeconomy Comments Off

Fundamental rally was indeed the driving force for Asian currency strength in the second quarter of 1999. As the Asian economies showed increasing signs of recovery, so capital inflows resumed, more than offsetting renewed deterioration in their trade and current account balances. Asian currencies maintained their strength also for much of the third quarter before concerns over Y2K and specific microeconomic concerns in Korea and Thailand over Daewoo and Krung Thai Bank caused a retracement. In addition to these specific concerns, at the global level the US Federal Reserve changed the rules of the game. At its June 30 meeting of the Federal Open Market Committee, the US central bank raised interest rates for the first time since its March 25, 1997 meeting. The Fed hiked the Fed funds’ target rate by 25 basis points to 5.00% from 4.75%, however it was not so much the degree of the move as what that move itself signified — the end of monetary easing.
Candidly, the problem with any economic model is that it does not, indeed cannot, take account of what we call “event risk”. That is to say, it cannot by definition allow for events which occur unexpectedly and which can and often do cause temporary or even extended reversals in market sentiment. The CEMC model is no different in this. Its aim is to provide a framework for anticipating how emerging market currencies might perform, based on the phase in which they find themselves, all other factors being equal. Of course, in reality all factors are frequently not equal and event risk can play a part in distorting price action. A model aimed at targeting the various phases of emerging market currency crises cannot include external factors such as a change in Fed policy. That said, such external factors or event risk notwithstanding, CEMC is still a robust model in providing a predictive framework for emerging market pegged currencies.
This was not aimed at pegged currencies deliberately, but rather as a result of trying to provide an explanation for the Asian crisis and in turn link it to other emerging market currency crises — which also happened to involve currency pegs. The policy of pegging their currencies to the US dollar had provided substantial stability for the likes of Mexico, Asia, Brazil, Russia or Turkey. This had attracted significant capital inflows. In all cases however, those capital inflows caused real exchange rate appreciation and led to trade balance deterioration. The degree of that real exchange rate appreciation was much more significant in a fixed or pegged exchange rate regime. Equally, pegged currencies that experienced the greatest degree of real exchange rate appreciation also had the greatest degree of trade and current account deterioration. The one major exception was China, which in 1994–1995 experienced a real depreciation, thus cushioning the current account balance (a significant surplus) from the after- effects of the Asian crisis in 1997–1998. By early 1997, it was clear there were overvaluation concerns over several Asian currencies and that such overvaluation had been a major factor in current account deterioration. There were two possible macroeconomic responses. Either domestic prices collapsed to reduce the lost trade competitiveness as reflected by current account deterioration or the currency experienced a real depreciation to offset the previous appreciation. In the end, the currency took most of the burden of adjustment, and in spectacular fashion.
The lesson from this is that the type of exchange rate regime has a major influence on the real exchange rate performance and thus in turn on the trade balance. Indeed, the type of exchange rate regime coupled with an event — such as the US dollar’s real exchange rate appreciation — led to a series of events. While the degree of eventual market reaction (the Asian currency crisis) could not have been and generally was not predicted, the series of events itself was predictable. For this very reason, we can deduce two things:
The Asian currency crisis happened because of fundamental imbalances created by the exchange rate regime.
A model can be created to reflect this series of events for the purpose of looking at other emerging and developed market currencies.
Thus, CEMC was created and can be used to watch the progress of the likes of Turkey, Argentina and Venezuela going forward.
Floating exchange rate regimes behave differently as the transmission mechanism from the exchange rate regime through the real exchange rate to the trade balance is also different. As an example, let’s look again at the Polish zloty during 2001. During the flrst half of 2001, the zloty was one of the top performing currencies in the world against both the Euro and the dollar, supported by heavy capital inflows. Then, in early July 2001, it collapsed. What happened? In April 2000, the National Bank of Poland had made one of its smartest decisions, scrapping the zloty’s crawl and peg regime and making the currency fully floating. Since the zloty was a floating currency how could it collapse? Economic theory suggests a floating currency will reflect economic deterioration gradually, thus militating against the worst effects of that deterioration. Economic theory suggests that economic deterioration through a widening current account deflcit should lead to gradual real exchange rate depreciation in order to restore equilibrium. Yet, there is nothing gradual about a freely floating currency losing almost 10% of its value in a couple of days, as happened with the Polish zloty. Similarly, in the autumn of 1998 as noted earlier, the dollar–yen exchange rate collapsed from 135 to 114 in less than two days. So, what happened?
To answer this question, we have to refer back to the speculative cycle of exchange rates we first looked at in previous posts, which focuses specifically on speculative flow to explain moves and trends in freely floating exchange rates. To recap, the central idea behind this is that the longer an exchange rate trend develops, the inherently more speculative in nature it becomes. Eventually, speculative buying (selling) is overwhelmed by fundamental selling (buying) and the exchange rate trend reverses. Sometimes, this reversal is sudden and dramatic, as in the cases of the Polish zloty and the Japanese yen. Somewhat helpfully, ahead of that reversal, option volatility tends to start rising, which currency market practitioners should view as awarning of the reversal to come. This is indeed what happened with the zloty and the yen. We looked at this phenomenon briefly in a previous post. Here, in the context of a post devoted speciflcally to exchange rate models, we do so in considerably more detail. While this can be applied to developed market currencies, there are specific considerations with these such as “safe haven” and “reserve currency” status, which distort all models. This particular model is particularly effective with freely floating emerging market currencies, given how capital inflows influence nominal and real interest rates. In the case of the CEMC model, we used the example of Thailand to demonstrate it in practice. With the freely floating exchange rate model, specializing in emerging markets, we use the example of Poland.