Exchange rates determinants: an overview

Forex market is the largest financial market in terms of size. This is so irrespective of the fact that
it is fully over the counter market. By far the largest market for currencies is the interbank market,
which trades spot and forward contracts. The market can be termed as efficient with enough
breadth, depth and resilience.

The basic theories underlying the exchange rates –

1. Law of One Price: In competitive markets free of transportation costs barriers to trade,
identical products sold in different countries must sell at the same price
when the prices are expressed in terms of their same currency.

Purchasing power parity: As inflation forces prices higher in one country but not another
country, the exchange rate will change to reflect the change in relative
purchasing power of the two currencies.

2. Interest rate effects: If capital is allowed to flow freely, the exchange rates stabilize at a point
where equality of interest is established.

The Fisher Effect: the nominal interest rate (r) in a country is determined by the real interest rate
R and the inflation rate i as follows:

(1 + r) = (1 + R)(1 + i)

International Fisher Effect: the spot rate should change in an equal amount but in the opposite
direction to the difference in interest rates between two countries.

S1 - S2
----------- x 100 = i2 – i1
S2

Where: S1 = spot rate using indirect quotes at beginning of the period;

S2 = spot rate using indirect quotes at the end of the period;
i = respective nominal interest rates for country 1 and 2.

Though the above principles attempt to explain the movement of exchange rates, the
assumptions behind these two theories [free flow of capital] are seldom seen and thus these
theories can’t be applied directly.

The dual forces of demand and supply determine exchange rates. Various factors affect these,
which in turn affect the exchange rates:

The business environment: Positive indications (in terms of govt.policy, competetive

advantages, market size etc) increase the demand of the currency, as more and more entities
want to invest there. This investment is for two basic motives –purely business motive, and for
risk diversification purposes. Foreign direct investment is for taking advantage of the comparative
advantages and the economies of scale. Portfolio investment is mainly done for risk
diversification purposes.

Stock market: The major stock indices also have a correlation with the currency rates. The Dow
is the most influential index on the dollar. Since the mid-1990s, the index has shown a strong
positive correlation with the dollar as foreign investors purchased US equities. Three major forces
affect the indices: 1) Corporate earnings, forecast and actual; 2) Interest rate expectations and 3)
Global considerations. Consequently, these factors channel their way through the local currency.
Political Factors: All exchange rates are susceptible to political instability and anticipations
about the new ruling party. A threat to coalition governments in France, India, Germany or Italy
will certainly affect the exchange rate. For eg. Political or financial instability in Russia is also a
red flag for EUR/USD, because of the substantial amount of Germany investment directed to
Russia.

Economic Data: Economic data items like labor report (payrolls, unemployment rate and
average hourly earnings), CPI, PPI, GDP, international trade, productivity, industrial production,
consumer confidence etc. also affect the exchange rate fluctuations.

Confidence in a currency is the greatest determinant of the exchange rates. Decisions are made
keeping in mind the future developments that may affect the currency. And any adverse
sentiments have a contagion effect.

The observers have generally concluded that devaluations should be avoided at all costs, since
the panics have almost all followed currency devaluations. Some are of the view that is it not the
devaluation, but rather the defense of the exchange rate preceding the crisis that opens the door
to financial panic. The devaluation, which follows the depletion of reserves usually, alerts the
market to the exhaustion of reserves, a state of affairs, which is not fully apparent to many market
participants before the devaluation takes place. Holders begin to convert their money into foreign
exchange in expectation of devaluation, and suppose that the central bank defends the exchange
rate, by buying high-powered money and selling dollars. Thus, a panic can unfold simply by the
belief of creditors that it will indeed occur. In the past four years, mainly three types of events
have triggered such panics:

1) The sudden discovery that reserves is less than previously believed

2) Unexpected devaluation (often in part for its role in signaling the depletion of reserves); and,

3) Contagion from neighboring countries, in a situation of perceived vulnerability (low reserves,

high short-term debt, overvalued currency).

Government influence: A country's government may reduce the growth in the money supply,
raising interest rates, and encouraging demand for its currency. Or a government may simply buy
or sell forex to maintain stability or to support either exporters or importers.

Productivity of an economy: An increase in productivity of an economy tends to impact

exchange rates. It affects are more prominent if the increase is in the traded sector. A recent
study by the federal reserve bank of New York shows that over a 30 yrs. Period [1970-1999]
productivity changes and the dollar /euro real exchange rates have moved in tandem.

AN ILLUSTRATION

The study
Report of the Commission of Inquiry into the Rapid Depreciation of the Exchange Rate of the
Rand and Related Matters

Brief history
1. The exchange rate often fluctuated quite a lot over the short term, but followed a more rational
path over the long term.

2. That against the background of over the twenty-one month period from the beginning of 2000
to 11 September 2001 the rand maintained an almost consistent and fairly well-defined declining
trend against the US dollar.
Possible reasons attributed &recommendations:

1. The internal purchasing power of a currency and its exchange rate tend to move together over
time. Historically, South Africa has had a faster than average inflation rate and rand has had a
declining trend against, for example, US dollar.

2. A currency with above average inflation and that tends to depreciate will tend to have higher
than average inflation rates. The more than average interest rates in South Africa made rand
more attractive and valuable.

2. Due to steady depreciation of the rand during 2000 and the first half of 2001 most market
participants came to the view that the currency was weak and it is likely that they took decisions
to help protect themselves against the contagion effect A perfectly legitimate large transaction
by one of the major market players might have led to the emergence of a herd mentality resulting
in the run on the rand. The steady decline was a result of economic, political, policy and
confidence factors and other factors that build over months.

3. After mid October 2001 by a lower level of market liquidity following the Reserve Bank’s
announcement that foreign exchange control rulings were to be policed more rigorously. [impact
of policies]

4. The South African exchange rate is determined by forces of demand and supply. The system
of a managed float is by its nature unstable. Volatile movements in the exchange rate can be
expected from time to time.

5. In the second half of 2001 various adverse external and domestic developments led to a
deterioration in the South African balance of payments and therefore to a decline in the supply of
foreign exchange. [the sept.11 incident]

6. It was the view of the Reserve Bank that the best defence of a currency is prudent macro-
economic policies accompanied by structural and micro-economic reforms, where appropriate.

7. There were a number of variables at play at the same time and certainly in our attempts to try
and understand what was going on, we have been unable to say what caused it was A and not B.
It was a complex set of issues not least of which is the confidence that South Africans have in
their own country and their own economy and so it has been difficult for us to say that there was
one. There were lots of things happening at the same time.

http://www.slu.edu/centers/iib/faculty/zhao/chapt10.doc

http://www.indiainfoline.com/comp/gltr/061200a.html

http://www.mgforex.com/resource/default.asp?loc=Tech

C:\My Documents\forex\Interim Report of the Commission of Inquiry_rand.htm

Economic times-24/7/02

CREDITOR PANICS: CAUSES AND REMEDIES By Jeffrey D. Sachs Harvard Institute for
International Development