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.

USD vs Other Major Trading Currencies

In the picture above, I have plotted three weighted indices against the US$. (The weights and their calculations are given here.)

• Major Currencies: The indices in pink are a weighted average of Euro, CAD, YEN, GBP, CHF, AUD, SKK.
• Other Important Trading Partners: The indices in yellow are a weighted average of China, Mexico, Korea, Taiwan, HK, Malaysia, Singapore, BRL, Thai, India, Philippines, Israel, Indonesia, Russia, Saudi Arabia, Chile, Argentina, Colombia, Venezuela.
• Broad: The indices in blue are the entire basket of the two.

These countries have been selected as those that have more than ½ % in 2003 in either exports or imports. The first group (pink) is those currencies that are traded extensively outside their domicile. The second group isn’t traded extensively outside their own markets.

What is most amazing in these numbers is the presence of clear volatility regimes in place. The daily standard deviation of these indices are given here:

Dates	Broad Index	Major Currencies	OITP
2nd Jan ’07 to 16th Mar ‘07	0.357%	0.612%	0.230%
19th Mar ’07 to 19th Jun ‘07	0.766%	0.933%	0.646%
20th Jun’07 to 19th Oct ‘07	1.261%	1.853%	0.792%

Some conclusions:

1. The credit-induced crises of confidence have led to increased volatility in the FX markets.
2. The broad reaction has been – flight to safety. i.e., with respect to the Major currencies, the USD has been a “risky” holding. However with respect to the OITP, the USD depreciation has been lesser than expected – partly because the USD continues to be seen, on average, as a “safe” currency.
3. The OITP depreciation masks wide variation – where Venezuela has done substantially differently than India against USD.
4. Coupled with G7 consensus that Asian currencies should be “allowed” to get stronger – the OITP will be where the most diverse kind of action will be.

What does this portend for the future? My guess is that till the US economy picks up – the dollar slide against the Majors will continue. This is further aided by the Treasury’s policy of letting the dollar slide. The coming revaluation of the yuan will make this a really interesting group to think about. Need to think about this a bit more.