A short lesson in exchange rate determination

In fact, among all the variables economists try to understand, the external value of the currency is arguably the most difficult to explain.

The most important long-run fundamental exchange rate drivers are inflation differentials and differences in productivity growth. Countries with a persistently higher rate of inflation will lose competitiveness, something which is more or less the story of the peripherals before European Monetary Union (EMU) entry and until 2009.Similarly, a higher rate of labour productivity growth pushes down unit labour costs, increasing competitiveness and allowing for a nominal appreciation.

In the long run, real exchange rates will always adjust so as to keep the net international investment position sustainable. If persistently high inflation threatens to cause perennial deficits, the real exchange rate will eventually have to depreciate, yet if perennial surpluses seem to be emerging, a real appreciation will be needed. The upshot is that the current account ‘rules the roost’ when it comes to exchange rate determination. An appreciation could be a sign of strength as it implies either monetary policy has been successful in keeping inflation down, or that productivity growth has been healthy.

President Hollande disagrees, and his view is perhaps understandable; the reason exchange rates are usually “out of line with fundamentals” is precisely because they are almost completely determined by what happens on the capital account of the balance of payments. Trade flows are insignificant compared to gross capital flows and in a world with high capital mobility the latter is very difficult to predict. The main reason is that especially short-term capital flows appear driven more by “psychological elements” than hard economic facts.

Not all (euro) appreciations are made the same…

So, how “bad” is the recent euro appreciation? Is it sufficient to materially worsen the growth outlook, cause the risks to inflation to shift to the downside and elicit a monetary policy response? In short: “No, not yet”.

As always, it pays to look at the facts. The effective exchange rate has appreciated 7% from a trough in late July, putting it roughly at the average level seen since 1999, though still 5% below the level seen in early 2011 and 10-15% below the level seen in early 2010. From a one- to two-year perspective it has still depreciated – an important observation because some decisions taken in the real economy depend on long term movements.

Nevertheless, shorter-term movements are also important; with all else being equal; appreciation will mean either less exports or lower profit margins, which may have negative repercussions for labour and investment demand.

’All else’ is, however, usually not equal. Much depends on the speed and magnitude of appreciation as well as the strength of demand in export markets. Between early 2006 and early 2008 the Euro area was easily able to stomach a more or less gradual 10-15% appreciation because the global economy was booming.

Another determinant of damage done by an appreciation is the composition of the export base.

If a country specialises in highly sophisticated capital goods that are not easily available elsewhere – such as Germany – demand for its exports will be relatively price insensitive.

In France and Italy however, the produce is readily available elsewhere, and appreciation will hurt sooner. It is no coincidence that every French President has, at some point during his term in office, clamoured for exchange rate depreciation.

…as the behaviour in other parts of the financial markets matters as well

The reason for the appreciation is also important: Appreciation because of increased investor confidence in the region is less harmful than one caused by exogenous shocks. The appreciation seen between July 2012 (Draghi’s famous speech) and December 2012 was actually part of a vote of confidence in the euro area. With the Outright Monetary Transactions (OMT) acting as a liquidity backstop for sovereigns, the tail risks of a break up reduced significantly. This caused capital to flow back towards the euro area, causing not just an exchange rate appreciation but also an improvement in domestic financial conditions. To a large extent, the appreciation since December last year has been driven by the expectation that other central banks, such as the Bank of Japan (BoJ), will ease more aggressively than the European Central Bank (ECB). Financial conditions have tightened as a result, but remain considerably looser than in July 2012 – a reason we do not expect any immediate action.

The OMT has certainly improved financial stability and the ECB is likely to be patient and wait to see the extent of these improvements will be to the real sphere of the economy. However, we believe it is likely to happen eventually, and feel that it would in fact be a positive change. The effect on exchange from rates the BoJ could ‘force’ an easier global monetary policy stance – something much needed in the DM space because of the large output gap and fiscal austerity, as well as in the EM space where the rebalancing away from export led to domestic led growth is much needed.