currency analysis with fundamentals. fundamental analysis involves the use of data to assess the...

Currency Analysis with Currency Analysis with FundamentalsFundamentals

Fundamental Analysis involves the use of data to assess the strength/weakness of a currency

Economic Data

GDP Employment Prices

Financial Data

Interest Rates Asset Prices

Demographic Data

Population Growth Asset Prices

International Data

Trade Balance FDI Official Reserve Position

International Data

Trade Balance FDI Official Reserve Position

Trade BalancesTrade Balances

The trade balance approach focuses on The trade balance approach focuses on a country’s current account.a country’s current account. Exports = demand for a country’s Exports = demand for a country’s

currencycurrency Imports = supply of a country’s currencyImports = supply of a country’s currency

Trade deficit (surplus) countries should Trade deficit (surplus) countries should experience currency depreciationsexperience currency depreciations

Example: Bolivia (Bolivian Example: Bolivia (Bolivian Peso)Peso)

0

5

10

15

20

25

30

35

1998 1999 2000 2001

Exports (% GDP)Imports (% GDP)

Example: Bolivia (Bolivian Example: Bolivia (Bolivian Peso)Peso)

The J-CurveThe J-Curve

Recall that currency demand/supply is Recall that currency demand/supply is based on foreign exchange based on foreign exchange expendituresexpenditures

If elasticities are low, then rising prices If elasticities are low, then rising prices can actually increase expenditurescan actually increase expenditures Elasticities tend to increase over Elasticities tend to increase over

longer time horizonslonger time horizons Necessities (in particular, energy) Necessities (in particular, energy)

have lower elasticities than luxurieshave lower elasticities than luxuries

Balance of PaymentsBalance of Payments

The trade balance approach assumes The trade balance approach assumes that currency flows are due to that currency flows are due to purchases of goods/services alone.purchases of goods/services alone.

The Capital & Financial Accounts keep The Capital & Financial Accounts keep track of net inflow of cash due to track of net inflow of cash due to financial transactions (CA + KFA = 0)financial transactions (CA + KFA = 0) Private Capital inflow: Purchases of Private Capital inflow: Purchases of

domestic assetsdomestic assets Official Reserve Transactions: Acquisition of Official Reserve Transactions: Acquisition of

official reserve assets (between central official reserve assets (between central banks)banks)

Example: Israel (Shekel)Example: Israel (Shekel)

05

101520253035404550

1998 1999 2000 2001

Exports (% ofGDP)Imports (% ofGDP)

Example: Israel (Shekel)Example: Israel (Shekel)

Example: Israel (Shekel)Example: Israel (Shekel)

00.5

11.5

22.5

33.5

44.5

5

1998 1999 2000 2001

Foreign DirectInvestment(Billions of $)

Balance of Payments Balance of Payments ApproachApproach

Adding the Capital account complicates Adding the Capital account complicates the analysis:the analysis:

Remember, if a country is financing its Remember, if a country is financing its trade deficit by selling its assets. These trade deficit by selling its assets. These assets are claims to future paymentsassets are claims to future payments How big is “too big”How big is “too big” A country’s ability to repay its debts lies in A country’s ability to repay its debts lies in

in its ability to run future trade surpluses (or in its ability to run future trade surpluses (or have a VERY cheap currency)have a VERY cheap currency)

ExampleExample

VariableVariable El SalvadorEl Salvador HungaryHungary

GDP GrowthGDP Growth 1.821.82 3.83.8

Capital Capital Formation (% Formation (% GDP)GDP)

15.9715.97 27.1327.13

IlliteracyIlliteracy 20.120.1 .66.66

Debt ServiceDebt Service 6.356.35 37.537.5

Industry Value Industry Value Added (% GDP)Added (% GDP)

29.429.4 33.733.7

Monetary Approach (Flexible Monetary Approach (Flexible Prices)Prices)

The classical approach assumes The classical approach assumes that all prices are flexible and that that all prices are flexible and that all markets clear. all markets clear. Money markets take the leadMoney markets take the lead Bond markets play a passive role.Bond markets play a passive role.

Capital MarketsCapital Markets

Classical theory Classical theory assumes completely assumes completely integrated capital integrated capital marketsmarkets

At the prevailing At the prevailing world interest rates, world interest rates, the trade balance is the trade balance is determined by determined by

S – I – (G-T) S – I – (G-T) 0

4

8

12

16

20

0 100 200 300 400 500

Monetary Policy & Capital Monetary Policy & Capital MarketsMarkets

Money is ”Neutral” in classical Money is ”Neutral” in classical theory. Therefore, Federal Reserve theory. Therefore, Federal Reserve policy only influences the price policy only influences the price levellevel

Classical Money DemandClassical Money Demand

It is assumed that households choose to hold a It is assumed that households choose to hold a fraction of their nominal income in the form of fraction of their nominal income in the form of cash (or a checking account)cash (or a checking account)

Classical Money DemandClassical Money Demand

It is assumed that households choose to hold a It is assumed that households choose to hold a fraction of their nominal income in the form of fraction of their nominal income in the form of cash (or a checking account)cash (or a checking account)

Money Demand = k* PYMoney Demand = k* PY

Classical Money DemandClassical Money Demand It is assumed that households choose to hold a It is assumed that households choose to hold a

fraction of their nominal income in the form of fraction of their nominal income in the form of cash (or a checking account)cash (or a checking account)

Money Demand = k* PYMoney Demand = k* PY

For example, suppose that National Income For example, suppose that National Income is $8T. If the average household chooses to is $8T. If the average household chooses to hold 10% of their income in the form of hold 10% of their income in the form of cash, what is aggregate money demand?cash, what is aggregate money demand?

Classical Money DemandClassical Money Demand It is assumed that households choose to hold a It is assumed that households choose to hold a

fraction of their nominal income in the form of fraction of their nominal income in the form of cash (or a checking account)cash (or a checking account)

Money Demand = k* PYMoney Demand = k* PY

For example, suppose that National Income is For example, suppose that National Income is $8T. If the average household chooses to $8T. If the average household chooses to hold 10% of their income in the form of cash, hold 10% of their income in the form of cash, what is aggregate money demand?what is aggregate money demand?

Money Demand = (.1)($8T) = Money Demand = (.1)($8T) = $800B$800B

Money Market EquilibriumMoney Market Equilibrium

The aggregate price level will adjust so that The aggregate price level will adjust so that money supply equal money demandmoney supply equal money demand

Money Market EquilibriumMoney Market Equilibrium

The aggregate price level will adjust so that The aggregate price level will adjust so that money supply equal money demandmoney supply equal money demand

M = Money Demand = k*PYM = Money Demand = k*PY

Money Market EquilibriumMoney Market Equilibrium

The aggregate price level will adjust so that The aggregate price level will adjust so that money supply equal money demandmoney supply equal money demand

M = Money Demand = k*PYM = Money Demand = k*PY

Solving the above expression for price gives usSolving the above expression for price gives us

P = M/(kY)P = M/(kY)

Money Demand and the Money Demand and the Quantity Theory of MoneyQuantity Theory of Money

An alternative way of expressing An alternative way of expressing the previous expression is the previous expression is

MV = PY MV = PY

Where ‘V’ is the velocity of money (V = Where ‘V’ is the velocity of money (V = 1/k)1/k)

This is known as quantity theory of This is known as quantity theory of moneymoney

Implications of the Implications of the Quantity Theory Quantity Theory

In the long run, velocity is relatively constant. In the long run, velocity is relatively constant. Therefore, a country’s inflation rate is equal to Therefore, a country’s inflation rate is equal to

Inflation = Money Growth – Output Inflation = Money Growth – Output GrowthGrowth

Purchasing Power ParityPurchasing Power Parity Purchasing power parity (PPP) suggests that currencies Purchasing power parity (PPP) suggests that currencies

should have the same purchasing power everywhere.should have the same purchasing power everywhere.

P = eP*P = eP*

A more useful form of PPP is A more useful form of PPP is

%Change in e = Inflation – Inflation*%Change in e = Inflation – Inflation*

For example, if the US inflation rate (annual) is 4% while For example, if the US inflation rate (annual) is 4% while the annual European inflation rate is 2%, the the dollar the annual European inflation rate is 2%, the the dollar should depreciate by 2% over the year.should depreciate by 2% over the year.

Currency FundamentalsCurrency Fundamentals

Begin with PPPBegin with PPP%Change in e = Inflation – Inflation*%Change in e = Inflation – Inflation*

Currency FundamentalsCurrency Fundamentals

Begin with PPPBegin with PPP%Change in e = Inflation – Inflation*%Change in e = Inflation – Inflation*

The Quantity theory gives usThe Quantity theory gives us Inflation = Money Growth – Output Inflation = Money Growth – Output GrowthGrowth

Currency FundamentalsCurrency Fundamentals

Begin with PPPBegin with PPP%Change in e = Inflation – Inflation*%Change in e = Inflation – Inflation*

The Quantity theory gives usThe Quantity theory gives usInflation = Money Growth – Output Inflation = Money Growth – Output

GrowthGrowth

Therefore, we haveTherefore, we have %change e = (Money Growth – Money %change e = (Money Growth – Money Growth*)Growth*) + ( Output Growth* - + ( Output Growth* - Output Growth)Output Growth)

Interest rate ParityInterest rate Parity

Recall, integrated capital markets imply Recall, integrated capital markets imply equal real rates of return across equal real rates of return across countriescountries

r = r*r = r*

Interest rate ParityInterest rate Parity

Recall, integrated capital markets imply Recall, integrated capital markets imply equal real rates of return across equal real rates of return across countriescountries

r = r*r = r* Purchasing Power Parity gives usPurchasing Power Parity gives us

e = Inflation – Inflation*e = Inflation – Inflation*

Interest rate ParityInterest rate Parity

Recall, integrated capital markets imply equal Recall, integrated capital markets imply equal real rates of return across countriesreal rates of return across countries

r = r*r = r* Purchasing Power Parity gives usPurchasing Power Parity gives us

e = Inflation – Inflation*e = Inflation – Inflation* Combining the two yieldsCombining the two yields

i – i* = %change in ei – i* = %change in e

Assets should pay the same nominal Assets should pay the same nominal return return across countriesacross countries

Example: Norway (Krone)Example: Norway (Krone)

-202468

1012141618

1998 1999 2000 2001 2002

Inflation (US)Inflation (Norway)

Example: Norway (Krone)Example: Norway (Krone)

0

0.5

1

1.5

2

2.5

3

3.5

4

1998 1999 2000 2001 2002

GDP Growth (US)

GDP Growth(Norway)

Example: Norway (Krone)Example: Norway (Krone)

The Importance of The Importance of Relative PricesRelative Prices

The fundamentals do quite well in explaining The fundamentals do quite well in explaining general trends, but are not so good at shorter general trends, but are not so good at shorter term fluctuationsterm fluctuations

Exchange Rates & the Exchange Rates & the Fundamentals (JPY/USD)Fundamentals (JPY/USD)

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300

Jan-8

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Jan-8

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Jan-8

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Jan-8

6

Jan-8

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Jan-9

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Jan-9

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Jan-9

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Jan-9

8

ActualPPP

Exchange Rates & the Exchange Rates & the Fundamentals (GBP/USD)Fundamentals (GBP/USD)

00.10.20.30.40.50.60.70.80.9

1

Jan-8

0

Jan-8

2

Jan-8

4

Jan-8

6

Jan-8

8

Jan-9

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Jan-9

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ActualPPP

The Importance of The Importance of Relative PricesRelative Prices

The fundamentals do quite well in explaining The fundamentals do quite well in explaining general trends, but are not so good at shorter general trends, but are not so good at shorter term fluctuationsterm fluctuations

While impediments to trade (tariffs, While impediments to trade (tariffs, transportation costs can be blamed for the transportation costs can be blamed for the failure of PPP) – movement in the real failure of PPP) – movement in the real exchange rateexchange rate

Nominal/Real Exchange Nominal/Real Exchange RatesRates

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250

300

Jan-8

5

Jan-8

6

Jan-8

7

Jan-8

8

Jan-8

9

Jan-9

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Jan-9

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Jan-9

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Jan-9

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Jan-9

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Jan-9

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Jan-9

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Jan-9

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Yen/ $

Nominal/Real Exchange Nominal/Real Exchange RatesRates

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100

150

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300

Jan-8

5

Jan-8

6

Jan-8

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Jan-8

8

Jan-8

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Jan-9

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Jan-9

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Yen/ $Real

Nominal/Real Exchange Nominal/Real Exchange RatesRates

00.20.40.60.8

11.21.41.6

Jan-8

0

Jan-8

2

Jan-8

4

Jan-8

6

Jan-8

8

Jan-9

0

Jan-9

2

Jan-9

4

Jan-9

6

Jan-9

8

GBP/ $Real

The Importance of The Importance of Relative PricesRelative Prices

The fundamentals do quite well in explaining The fundamentals do quite well in explaining general trends, but are not so good at shorter general trends, but are not so good at shorter term fluctuationsterm fluctuations

While impediments to trade (tariffs, While impediments to trade (tariffs, transportation costs can be blamed for the transportation costs can be blamed for the failure of PPP) – movement in the real failure of PPP) – movement in the real exchange rateexchange rate

A more like solution is a real/appreciation A more like solution is a real/appreciation caused by some relative price shiftcaused by some relative price shift Terms of TradeTerms of Trade Non-Traded Goods Non-Traded Goods

Non Traded GoodsNon Traded Goods

Suppose that two countries have identical Suppose that two countries have identical price indicesprice indices

P = .5(Goods) + .5(Services)P = .5(Goods) + .5(Services)

Non Traded GoodsNon Traded Goods

Suppose that two countries have identical Suppose that two countries have identical price indicesprice indices

P = .5(Goods) + .5(Services)P = .5(Goods) + .5(Services) Suppose the domestic price of services Suppose the domestic price of services

increasesincreases

Non Traded GoodsNon Traded Goods

Suppose that two countries have identical Suppose that two countries have identical price indicesprice indices

P = .5(Goods) + .5(Services)P = .5(Goods) + .5(Services) Suppose the domestic price of services Suppose the domestic price of services

increasesincreases The domestic price level rises by 10%The domestic price level rises by 10% No change in the nominal exchange rate is No change in the nominal exchange rate is

requiredrequired A A real real appreciation of 10% occursappreciation of 10% occurs

Non Traded GoodsNon Traded Goods

In the previous example, a 20% rise in the In the previous example, a 20% rise in the price of a non-traded good created a 10% real price of a non-traded good created a 10% real appreciation appreciation No change in nominal exchange rateNo change in nominal exchange rate 10% rise in domestic price level10% rise in domestic price level

Non Traded GoodsNon Traded Goods

In the previous example, a 20% rise in the In the previous example, a 20% rise in the price of a non-traded good created a 10% real price of a non-traded good created a 10% real appreciation appreciation No change in nominal exchange rateNo change in nominal exchange rate 10% rise in domestic price level10% rise in domestic price level

This real appreciation could happen a number This real appreciation could happen a number of different ways. For exampleof different ways. For example 5% nominal appreciation5% nominal appreciation 5% domestic price level increase5% domestic price level increase

Terms of TradeTerms of Trade

Suppose that we have the US and Suppose that we have the US and Venezuela.Venezuela. P = .2(oil) + .8(manufactured goods)P = .2(oil) + .8(manufactured goods) P* = .4(oil) + .6(manufactured goods)P* = .4(oil) + .6(manufactured goods)

Now, suppose oil prices rise by 10%.Now, suppose oil prices rise by 10%.

Terms of TradeTerms of Trade

Suppose that we have the US and Suppose that we have the US and Venezuela. Venezuela. P = .2(oil) + .8(manufactured goods)P = .2(oil) + .8(manufactured goods) P* = .4(oil) + .6(manufactured goods)P* = .4(oil) + .6(manufactured goods)

Now, suppose oil prices rise by 10%.Now, suppose oil prices rise by 10%. The exchange rate is unchangedThe exchange rate is unchanged P Rises by 2%P Rises by 2% P* rises by 4%P* rises by 4% A real depreciation of the dollar occursA real depreciation of the dollar occurs

Terms of TradeTerms of Trade

The previous example gave us:The previous example gave us: The exchange rate is unchangedThe exchange rate is unchanged P Rises by 2%P Rises by 2% P* rises by 4%P* rises by 4% A 2% real depreciation of the dollar occursA 2% real depreciation of the dollar occurs

However, any combination that adds up However, any combination that adds up to a 2% real depreciation is possible. to a 2% real depreciation is possible. For exampleFor example A 2% nominal depreciation with no price A 2% nominal depreciation with no price

changes.changes.

Terms of TradeTerms of Trade

It is generally assumed that a It is generally assumed that a country’s exports will make up a country’s exports will make up a larger share of its price index than larger share of its price index than imports. imports.

Therefore, in the previous Therefore, in the previous example, the US is an importer of example, the US is an importer of oil, and an exporter of oil, and an exporter of manufactured goods.manufactured goods.

Terms of TradeTerms of Trade

The Terms of Trade is defined as The Terms of Trade is defined as the relative price of exports in the relative price of exports in terms of imports terms of imports

In the previous example, the In the previous example, the Terms of Trade for the US Terms of Trade for the US worsened causing a real worsened causing a real depreciation of the $.depreciation of the $.

Oil PricesOil Prices

YearYear Price ($/Brl.)Price ($/Brl.)

19721972 $10.65$10.65

19731973 $11.58$11.58

19741974 $18.76$18.76

19781978 $18.66$18.66

19791979 $24.19$24.19

19801980 $37.85$37.85

19851985 $32.69$32.69

19861986 $16.61$16.61

Real $ Exchange RateReal $ Exchange Rate

Nominal $ Exchange RateNominal $ Exchange Rate

Case Study: Mexico (Peso)Case Study: Mexico (Peso)

VariableVariable 19981998 19991999 20002000 20012001 20022002

GDP GrowthGDP Growth 5.035.03 3.623.62 6.566.56 -.17-.17 .74.74

Capital Capital FormationFormation

24.3224.32 23.4523.45 23.4723.47 20.5220.52 NANA

ExportsExports 30.6930.69 30.7930.79 31.0331.03 27.3427.34 NANA

ImportsImports 32.8332.83 32.432.4 32.9732.97 29.6829.68 NANA

InflationInflation 15.3715.37 15.2515.25 12.1912.19 6.326.32 4.784.78

FDI (B)FDI (B) 11.911.9 12.512.5 14.214.2 24.724.7 NANA

Terms of Terms of TradeTrade

100.4100.4 102.32102.32 107.39107.39 NANA NANA

Case Study: Mexico (Peso)Case Study: Mexico (Peso)

Case Study: India (Rupee)Case Study: India (Rupee)

VariableVariable 19981998 19991999 20002000 20012001 20022002GDP GrowthGDP Growth 5.95.9 7.137.13 3.953.95 5.455.45 4.44.4

Capital Capital FormationFormation

21.3821.38 23.6623.66 22.5122.51 22.4322.43 NANA

ExportsExports 11.2211.22 11.7611.76 13.7913.79 13.2613.26 15.1815.18

ImportsImports 12.9112.91 13.7213.72 14.5514.55 13.9513.95 16.116.1

InflationInflation 7.887.88 3.853.85 4.524.52 3.473.47 44

FDI (B)FDI (B) 2.632.63 2.172.17 2.422.42 3.403.40 NANA

Terms of Terms of TradeTrade

108.74108.74 97.397.3 92.992.9 NANA NANA

Case Study: India (Rupee)Case Study: India (Rupee)

Case Study: Singapore Case Study: Singapore (Dollar)(Dollar)

VariableVariable 19981998 19991999 20002000 20012001 20022002GDP GrowthGDP Growth -.86-.86 6.426.42 9.419.41 -2.47-2.47 2.252.25

Capital Capital FormationFormation

32.3832.38 32.4432.44 32.3832.38 24.4324.43 20.6220.62

ExportsExports NANA NANA NANA NANA NANA

ImportsImports NANA NANA NANA NANA NANA

InflationInflation -2.38-2.38 -5.45-5.45 4.54.5 -1.23-1.23 .16.16

FDI (B)FDI (B) 6.386.38 11.811.8 5.45.4 8.68.6 NANA

Terms of Terms of TradeTrade

96.9696.96 96.0396.03 93.2993.29 NANA NANA

Case Study: Singapore Case Study: Singapore (Dollar)(Dollar)