Tuesday, November 20, 2007

How the "Masters of the Universe" think about Exchange Rates!

In a recent excellent, if perhaps deliciously short, report issued by the most profitable bank this year entitled "The Foreign Exchange Market" -- one of the sub-reports attempts to forecast the exchange rates for the coming year. What struck me about it is -- other than the predictions they make (I have my issues with that... see below) -- is the elegance of the underlying method. The way do is as follows:
  1. Changes in Terms of Trade (= price of exports divided by price of imports) is a function of changing commodity prices (energy, industrial metals, agriculture, live stock).
  2. Extract sensitivity estimates (the coefficients in a regression) to predict terms of trade.
  3. Changes in Real Exchange Rates ( = price of one unit foreign currency in domestic currency * ratio of foreign and domestic price levels) is a function of two key parameters.
    • Terms of Trade
    • Relative productivity levels -- measured by, say, per-capita output per hour etc.,
  4. Perform regressions on #3, using #2 to arrive at new estimates for real-exchange rates.
  5. Convert real exchange rates into nominal exchange rates.
Amongst key predictions are USD-CAD = 1.10; USD-INR = 50.1. i.e., their model supposedly predicts that the the Canadian dollar is expected to depreciate from the present levels, and so is the USD expected to appreciate against the Indian Rupee. Since, they do not explicitly mention all the concerned control variables in the exchange rate attribution -- it is difficult to really validate their claims, even intuitively.

My own guess is that there are three key parameters that affect the short term exchange rate fluctuations:
  1. Global capital flows -- that chase the second-order effects anticipated changes in terms of trade.
  2. Changes in US deficits (budgetary and trade) -- this is particularly accentuated by the coming US electoral-cycle.
  3. Idiosyncratic events -- particularly emerging market macroeconomic instabilities.
So, I suspect their analysis are largely driven by "true" long term economic factors, while the intermediate fluctuations are more complicated beasts -- and therein lies, as Shakespeare writes, the rub.

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