Exchange Rate Determinants, Carry Trade, and Central Bank Influence

FX Carry Trade

Uncovered interest rate parity states that a currency with a high interest rate should depreciate relative to a currency with a lower interest rate, so that an investor would earn the same return investing in either currency. For example, suppose that short term interest rates are 3% in the U.K. and 1% in the United States. Uncovered interest rate parity implies that the GBP should depreciate by 2% relative to the USD over the coming year.

However, uncovered interest rate parity is not bound by arbitrage. If the GBP depreciates by less than 2% (or even appreciates), an investor who has invested in the higher yielding GBP using funds borrowed in USD will earn excess profits. In an FX carry trade, an investor invests in a higher yielding currency using funds borrowed in a lower yielding currency.

The lower yielding currency is called the funding currency.

Risks of the Carry Trade

As discussed earlier, the carry trade is profitable only if uncovered interest rate parity does not hold over the investment horizon. The risk is that the funding currency may appreciate significantly against the currency of the investment, which would reduce a trader’s profit, or even lead to a loss. Furthermore, the return distribution of the carry trade is not normal; it is characterized by negative skewness and excess kurtosis (i.e., fat tails), meaning that the probability of a large loss is higher than the probability implied under a normal distribution.

We call this high probability of a large loss the crash risk of the carry trade.

Crash risk stems from the carry trade’s leveraged nature: an investor borrows a low yielding (funding) currency and then invests in a high yielding currency. As more investors follow and adopt the same strategy, the demand for high yielding currency actually pushes its value up. However, with this herding behavior comes the risk that all investors may attempt to exit the trade at the same time.

(This is especially true if investors use stop loss orders in their carry trades.) During turbulent times, as investors exit their positions (i.e., a flight to safety), the high yielding currency can experience a steep decline in value, generating large losses for traders pursuing FX carry trades.

Balance of Payments

Balance of payments (BOP) accounting is a method used to keep track of transactions between a country and its international trading partners. It includes government transactions, consumer transactions, and business transactions. The BOP accounts reflect all payments and liabilities to foreigners as well as all payments and obligations received from foreigners.

The current account measures the exchange of goods, the exchange of services, the exchange of investment income, and unilateral transfers (gifts to and from other nations). The current account balance summarizes whether we are selling more goods and services to the rest of the world than we are buying from them (a current account surplus) or buying more from the rest of the world than we are selling to them (a current account deficit).

The financial account (also known as the capital account) measures the flow of funds for debt and equity investment into and out of the country.

When a country experiences a current account deficit, it must generate a surplus in its capital account (or see its currency depreciate). Capital flows tend to be the dominant factor influencing exchange rates in the short term, as capital flows tend to be larger and more rapidly changing than goods flows.

Influence of BOP on Exchange Rates

Current Account Influences

Current account deficits lead to a depreciation of domestic currency via a variety of mechanisms:

• Flow supply/demand mechanism. Current account deficits in a country increase the supply of that currency in the markets (as exporters to that country convert their revenues into their own local currency). This puts downward pressure on the exchange value of that currency.

  The decrease in the value of the currency may restore the current account deficit to a balance, depending on the following factors:

• The initial deficit. The larger the initial deficit, the larger the depreciation of domestic currency needed to restore current account balance.
• The influence of exchange rates on domestic import and export prices. As a country’s currency depreciates, the cost of imported goods increases. However, some of the increase in cost may not be passed on to consumers.
• Price elasticity of demand of the traded goods. If the most important imports are relatively price inelastic, the quantity imported will not change.
• Portfolio balance mechanism. Countries with current account surpluses usually have capital account deficits, which typically take the form of investments in countries with current account deficits. As a result of these flows of capital, investor countries may find their portfolios’ composition being dominated by few investee currencies.

  When investor countries decide to rebalance their investment portfolios, it can have a significant negative impact on the value of those investee country currencies.

• Debt sustainability mechanism. A country running a current account deficit may be running a capital account surplus by borrowing from abroad. When the level of debt gets too high relative to GDP, investors may question the sustainability of this level of debt, leading to a rapid depreciation of the borrower’s currency.

Capital Account Influences

Capital account flows are one of the major determinants of exchange rates. As capital flows into a country, demand for that country’s currency increases, resulting in appreciation. Differences in real rates of return tend to be a major determinant of the flow of capital: higher relative real rates of return attract foreign capital.

Capital flows into a country may be needed to overcome a shortage of internal savings to fund investments needed for economic growth. However, capital flows in excess of needed investment capital pose several problems. This is especially problematic for emerging markets.

Excessive capital inflows into emerging markets create problems for those countries such as:

• Excessive real appreciation of the domestic currency.
• Financial asset and/or real estate bubbles.
• Increases in external debt by businesses or government.
• Excessive consumption in the domestic market fueled by credit.

Emerging market governments often counteract excessive capital inflows by imposing capital controls or by direct intervention in the foreign exchange markets. We will discuss this further in a subsequent LOS.

Mundell Fleming Model

Developed in early 1960s, the Mundell Fleming model evaluates the short term impact of monetary and fiscal policies on interest rates, and consequently on exchange rates. The model assumes that there is sufficient slack in the economy to handle changes in aggregate demand, and that inflation is not a concern. Accordingly, changes in inflation rates due to changes in monetary or fiscal policy are not explicitly modeled by the Mundell Fleming model.

We will look at the implications of this model for flexible exchange rate regimes as well as for fixed exchange rate regimes.

Flexible Exchange Rate Regimes

In a flexible (floating) exchange rate system, rates are determined by supply and demand in the foreign exchange markets. We will examine the influence of monetary and fiscal policies when international capital flows are relatively unrestricted (high mobility of capital) versus when capital flows are relatively restricted (low mobility of capital), both under a flexible exchange rate system.

High Capital Mobility

Expansionary monetary policy and expansionary fiscal policy are likely to have opposite effects on exchange rates. Expansionary monetary policy will reduce the real interest rate and, consequently, reduce the inflow of capital investment in physical and financial assets. This decrease in financial inflows (deterioration of the financial account) reduces the demand for the domestic currency, resulting in depreciation of the domestic currency.

Restrictive monetary policy should have the opposite effect, increasing real interest rates and leading to an appreciation in the value of the domestic currency.

Expansionary fiscal policy (an increased deficit from lower taxes or higher government spending) will increase government borrowing and, consequently, real interest rates. An increase in real interest rates will attract foreign investment, improve the financial account, and consequently, increase the demand for the domestic currency.

Low Capital Mobility

Our discussion so far has assumed free flow of capital, which is a valid assumption with respect to developed markets. In emerging markets, however, capital flows may be restricted. In that case, the impact of trade imbalance on exchange rates (goods flow effect) is greater than the impact of interest rates (financial flows effect).

In such a case, expansionary fiscal or monetary policy leads to increases in net imports, leading to depreciation of the domestic currency. Similarly, restrictive monetary or fiscal policy leads to an appreciation of domestic currency. Figure 5.2 summarizes the influence of fiscal and monetary policy on the value of the domestic currency.

Figure 5.2: Monetary and Fiscal Policy vs. the Value of the Domestic Currency

Fixed Exchange Rate Regimes

Under a fixed exchange rate regime, the government fixes the rate of exchange of its currency relative to one of the major currencies.

An expansionary (restrictive) monetary policy would lead to depreciation (appreciation) of the domestic currency as stated previously. Under a fixed rate regime, the government would then have to purchase (sell) its own currency in the foreign exchange market. This action essentially reverses the expansionary (restrictive) stance.

This explains why, in a world with mobility of capital, governments cannot both manage exchange rates as well as pursue independent monetary policy. If the government wants to manage monetary policy, it must either let exchange rates float freely or restrict capital movements to keep them stable.

Monetary Approach to Exchange Rate Determination

Monetary models only take into account the effect of monetary policy on exchange rates (fiscal policy effects are not considered). With the Mundell Fleming model, we assume that inflation (price levels) plays no role in exchange rate determination. Under monetary models, we assume that output is fixed, so that monetary policy primarily affects inflation, which in turn affects exchange rates.

There are two main approaches to monetary models:

1. Pure monetary model. Under a pure monetary model, the PPP holds at any point in time and output is held constant. An expansionary (restrictive) monetary policy leads to an increase (decrease) in prices and a decrease (increase) in the value of the domestic currency.

Therefore an x% increase in the money supply leads to an x% increase in price levels and then to an x% depreciation of domestic currency. The pure monetary approach does not take into account expectations about future monetary expansion or contraction.

2. Dornbusch overshooting model. This model assumes that prices are sticky (inflexible) in the short term and, hence, do not immediately reflect changes in monetary policy (in other words, PPP does not hold in the short term). The model concludes that exchange rates will overshoot the long run PPP value in the short term.

In the case of an expansionary monetary policy, prices increase, but over time. Expansionary monetary policy leads to a decrease in interest rates, and a larger than PPP implied depreciation of the domestic currency due to capital outflows. In the long term, exchange rates gradually increase toward their PPP implied values.

• Similarly, a restrictive monetary policy leads to excessive appreciation of the domestic currency in the short term, and then a slow depreciation toward the long term PPP value.

Portfolio Balance Approach to Exchange Rate Determination

The portfolio balance approach focuses only on the effects of fiscal policy (and not monetary policy). While the Mundell Fleming model focuses on the short term implications of fiscal policy, the portfolio balance approach takes a long term view and evaluates the effects of a sustained fiscal deficit or surplus on currency values.

When the government runs a fiscal deficit, it borrows money from investors. Under the portfolio balance approach, investors evaluate the debt based on expected risk and return. A sovereign debt investor would earn a return based on both the debt’s yield and its currency return.

(When we invest in a foreign currency denominated security, our realized return will be comprised of the return earned on that security in its local currency, as well as a return from the performance of that foreign currency versus our domestic currency.) When a government pursues a long term stance of expansionary fiscal policy, an investor should evaluate the implications of such a policy on expected risk and return (typically the yield should increase due to a higher risk premium). If investors perceive that the yield and/or currency return is sufficient, they will continue to purchase the bonds. However, continued increases in fiscal deficits are unsustainable and investors may refuse to fund the deficits, leading to currency depreciation.

Combining the Mundell Fleming and portfolio balance approaches, we find that in the short term, with free capital flows, an expansionary fiscal policy leads to domestic currency appreciation (via high interest rates). In the long term, the government has to reverse course (through tighter fiscal policy) leading to depreciation of the domestic currency. If the government does not reverse course, it will have to monetize its debt (i.e., print money, monetary expansion), which would also lead to depreciation of the domestic currency.

A combination of “push” and “pull” factors determine the flow of capital into a country. Pull factors are favorable developments that make a country an attractive destination for foreign capital. These include relative price stability, a flexible exchange rate regime, improved fiscal position, privatization of state owned enterprises etc. Push factors are largely driven by mobile international capital seeking high returns from a diversified portfolio.

As stated earlier, capital flows can lead to excessive appreciation of a currency. This can lead to several problems including loss of competitiveness of exports in the global markets, asset price bubbles, and excessive consumption fueled by credit creation. Excessive capital inflows to a country can also lead to a currency crisis when such capital is eventually withdrawn from the country.

To reduce these problems, policymakers may intervene by imposing capital controls or by direct intervention in the foreign exchange market by the central bank.

Objectives

The objectives of capital controls or central bank intervention in FX markets are to:

• Ensure that the domestic currency does not appreciate excessively.
• Allow the pursuit of independent monetary policies without being hindered by their impact on currency values. For example, an emerging market central bank seeking to reduce inflation may pursue a restrictive monetary policy, increasing interest rates. However, these higher rates may attract large inflows of foreign capital, pushing up the value of the domestic currency.
• Reduce the aggregate volume of inflow of foreign capital.

Effectiveness

For developed market countries, the volume of trading in a country’s currency is usually very large relative to the foreign exchange reserves of its central bank. Evidence has shown that for developed markets, central banks are relatively ineffective at intervening in the foreign exchange markets due to lack of sufficient resources. Evidence in the case of emerging markets is less clear: central banks of emerging market countries may be able to accumulate sufficient foreign exchange reserves (relative to trading volume) to affect the supply and demand of their currencies in the foreign exchange markets.

History has shown that market participants have failed to predict crises and typically are surprised by them. When market sentiment changes significantly, crises may occur even for countries with sound economic fundamentals.

The following conditions have been identified as warning signs in the period leading up to a currency crisis:

• Terms of trade (i.e., ratio of exports to imports) deteriorate.
• Fixed or partially fixed exchange rates (versus floating exchange rates).
• Official foreign exchange reserves dramatically decline.
• Currency value that has risen above its historical mean.
• Inflation increases.
• Liberalized capital markets, that allow for the free flow of capital.
• Money supply relative to bank reserves increases.
• Banking crises (may also be coincident).