THE REAL WORLD RELEVANCE OF THE EXCHANGE RATE REGIME
Up to now, this blog has largely focused on exchange rate regime theory. This post deals with how the choice of exchange rate regime actually affects currency market practitioners in practice. As the exchange rate regimes of both developed and emerging markets are still evolving, it is difficult to find definitive answers. That said, based on what we have already looked at we can draw some useful conclusions. For a start, “fixed” currency pegs are not necessarily fixed forever — if you get caught long a currency that has just devalued it can kill your balance sheet or portfolio. For instance, on February 19, 1982, the Mexican peso lost some 29% of its value. Some 15 years later, on July 2, 1997, the Thai baht lost 10% of its value in a single day. How do we avoid the kind of portfolio or balance sheet losses such disastrous events imply? Currency market practitioners within fixed or pegged exchange rate regimes need to consider the following points:
Does the currency peg contribute to economic stability or instability? Currency pegs can provide monetary credibility by using the exchange rate to force inflation lower, but they can also attract substantial and potentially destabilizing capital flows.
To what extent is a country open to global capital flows? If a country allows high capital mobility, a currency peg may not be appropriate unless it abandons monetary independence and adopts the hardest of pegs, such as a currency board. Capital flows are less easily anticipated than trade flows, but much more quickly reversed.
Is the currency pegged at the correct level? This has been an important question not just for emerging but also for developed economies, notably with the ERM. Currency market practitioners should use the lessons learned in previous posts to judge whether the currency peg level is appropriate. Corporations with subsidiaries in the countries concerned are well placed to do this given local pricing and demand knowledge.
Are there clear patterns of distress ahead of a peg’s collapse? Currency market practitioners can use the CEMC model as a test of market conditions.
What do you do if a currency peg collapse appears imminent? The trick of course is to try to anticipate this before the rest of the financial market does. Remember the lessons of the Asian crisis, where the preceding depreciations of the yen and yuan helped make Asian currencies uncompetitive. Remember also that PPP and REER may not be useful over the short term, but they are useful over a long-term horizon in suggesting currency over- or undervaluation. Also, don’t ignore common sense! Did it make sense in 1998 for Russia, a country which was going cap in hand to the IMF for more money, to have some of the most expensive residential property in the world in Moscow? Every boom is characterized by incidents and anecdotes, which after the bubble bursts seem acts not of folly but of sheer lunacy. Look for signs of these.
Currency risk may not be the only consideration. Within the emerging markets in particular, there may be other important considerations as well, such as convertibility and liquidity risk. Is a currency convertible on the capital account? Also, emerging market currencies are by nature much less liquid than those of developed economies. While USD200–300 billion may go through the Euro–dollar exchange rate every day (spot, forward, swaps and options), only USD10 billion goes through the South African rand, the second most liquid emerging market currency in the world behind the Singapore dollar. Finally, there is also political risk, which is a more important consideration in emerging markets.
Hedge when the market doesn’t want to (and neither do you!). When market conditions are benign is clearly when liquidity is best and pricing potentially most favourable. This is also the best time to hedge currency risk, particularly if one is potentially concerned about the sustainability of the currency regime. However, precisely because market conditions are benign this is not the time when markets are looking to hedge currency risk. The temptation to stay with the pack (or rather the flock!) should be strenuously avoided. If valuation considerations suggest a currency peg may be overvalued, hedging should be seriously considered. It is a question of cost vs. risk rather than risk vs. reward. For the cost of an option of around 1–2%, you hedge yourself against the potential risk of a devaluation of around 30–40%. Granted, options are not available in some markets, but in all markets there are benign and also malign market conditions and seasoned currency market practitioners should be able to tell the difference and take the opportunity when it is at hand.
When the market wants to hedge currency risk it is too late! There is no use complaining about adverse pricing and liquidity developments when the market is scrambling to hedge currency risk. By that time, forwards have screamed higher and option risk reversals have blown out. Take the opportunity of favourable pricing and market conditions when it presents itself, based on valuation considerations.
Most of the ideas presented in the bullet points above focus largely on pegged or fixed exchange rate regimes. A different set of considerations may be required when looking at freely floating exchange rates:
Freely floating exchange rates imply high capital mobility. The two tend to go together. The combination should mean in theory that capital flow reversals are transmitted through the exchange rate more efficiently and with less volatility.
Freely floating exchange rates can however still see major bouts of volatility. While they tend to be rarer these days, particularly if there are no major economic imbalances involved, freely floating exchange rates can also see significant bouts of volatility. This is not just the case within the emerging but also within the developed markets. A case in point is the collapse in the dollar–yen exchange rate in the autumn of 1998 from around 135 to 114 in the space of 36 hours. Speculative trends always reverse and when they reverse they tend to do so violently.
As pegged exchange rates may be temporary, so freely floating rates are no panacea.
Freely floating exchange rates also exact costs and involve risks on the part of the currency market practitioner in seeking to manage currency risk.
Tags: Business, Currency, Exchange rate
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