Emerging Financial Markets 4: Macroeconomic Inconsistencies

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Emerging Financial Markets 4 Macroeconomic
Inconsistencies
Prof. J.P. Mei
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Exchange Rate Determination I

• Purchasing Power Parity The Law of One price for
  the same good all over the world (Absolute PPP)
• Assumption Free and frictionless trade (no
  transaction cost, taxes, and uncertainty)
• PPP is often violated in reality but tend to
  correct itself when large deviations occur.
• The Construction of the Big Mac Index (which
  currency is over-valued?)

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Exchange Rate Determination I

• Purchasing Power Parity with Inflation (Relative
  PPP)
• s ID - IF s (S1 - S0 )/ S0, S/F (1)
• 1. Relative PPP is based on Absolute PPP.
• 2. High inflation economy should have
  depreciating currency.
• This explains Why the Hong Kong dollar is
  vulnerable (Plot US and HK inflation)
• 50 of the deviation from Relative PPP gets
  corrected within 5 years.

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Inflation Differential among US, Thailand, and
Hong Kong
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Exchange Rate Determination II

• Domestic Fisher Relation rD r E(ID)
• Law of One Price International Fisher Relation
• rD - rF E(ID) -E(IF) , or E(s) rD - rF (2)
• 1. Interest rate differential is determined by
  difference in inflation expectation. High
  inflation economy should have higher rates.
• 2. Expected exchange rate change is determined
  by Interest rate differential. High interest
  country should expect to see a weaker currency in
  the future.

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Exchange Rate Determination III

• Interest Rate Parity (Arbitrage condition)
• F S0 (1rD )/(1 rF ) or f rD - rF
  (3)
• 1. Forward rate is determined by the spot rate
  and interest differentials.
• 2. Serious violation of IRP would lead to
  arbitrage profit
• 3. If F SF (synthetic forward), sell forward,
  buy SF (borrow , sell spot, lend FX)
• 4. If F
• 5. Thai governments money losing machine
  Forward market operation to keep the forward rate
  high.

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Interest Rate Differentials
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Notes on Exchange Rate Determination

• RER tend toward PPP in the very long run.
• Short run deviation from PPP are large and
  volatile (Indonesia and Thailand).
• Deviation from PPP suggests segmentation in
  international goods markets. There is a large
  buffer within which nominal exchange rate can
  move without producing immediate response in
  relative domestic prices. (i.e., Big Mac price
  can remain low in Indonesia for quite a while.)

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What went wrong in Thailand

• Poor Export to Short-term Debt Coverage Ratio
• Loss of Competitive Strength and Foolish Property
  Market Speculation Relatively Small Reserves
• Large foreign currency debt led corporation to
  dramatically increase their demand of foreign
  currencies.
• Operational Errors
• Lack of Political Will to Defend the Currency
• Inconsistency in Implementing the Defense
• Reckless Forward Market Operation