MF Global

Purchasing Power Parity (PPP)

The PPP theory states that exchange rates are determined by the relative prices of similar baskets of goods. Changes in inflation rates are expected to be offset by equal but opposite changes in the exchange rate. Take the classic example of hamburgers. If the burger costs $2.00 in the US and £1.00 in the UK, then according to PPP, the £-$ exchange rate must be 2 dollars per one British pound. If the prevailing market exchange rate is $1.7 per British pound, then the pound is said to be undervalued and the dollar overvalued. The theory then postulates that the two currencies will eventually move towards the 2:1 relation.

PPP’s major weakness is that it assumes goods are easily tradeable, with no costs to trade such as tariffs, quotas or taxes. Another weakness is that it applies only for goods and ignores services, where room for differences in value is significant.

Interest Rate Parity

IRP states that an appreciation (depreciation) of one currency against another currency must be neutralised by a change in the interest rate differential. If US interest rates exceed Japanese interest rates then the US dollar should depreciate against the Japanese yen by an amount that prevents riskless arbitrage. The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium.

Balance of Payments Model

This model holds that a foreign exchange rate must be at its equilibrium level—the rate that produces a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation’ goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilising the trade balance and the currency towards equilibrium.

Like PPP, the balance of payments model focuses largely on tradeable goods and services, while ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Such flows go into the capital account item of the balance of payments, thus, balancing the deficit in the current account. The increase in capital flows has given rise to the Asset Market Model.

Asset Market Model

The explosion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as growth, inflation and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services. The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with asset markets, particularly equities.

The Dollar & US Asset markets-1999

In summer of 1999, many pundits argued for the fall of the dollar against the euro on the grounds of the expanding US current account deficit, and an overvalued Wall Street. That was based on the rationale that non-US investors would begin withdrawing their funds from US stocks and bonds into more economically sound markets thus, weighing significantly on the dollar. Yet, such fears have lingered since the early 1980s when the US current account soared to a record high 3.5% of GDP.

Just like in the 1980s, foreign investors’ appetite in US assets have remained largely unhinged. Unlike in the 1980s, the 1990s witnessed the disappearance of the budget deficit. Growth in foreign holdings of US Treasuries may have slowed, but it remained more than offset by a prodigious inflow into US stocks. In the case of a burst in the US bubble, the most probable alternative for non-US investors would likely be safer US treasuries, rather than Eurozone or UK stocks, which are likely to be just as battered during such an event. This had already taken place during the crises of November 1998, and the equity scare of December 1996 prompted by Fed Chairman Greenspan’s “irrational exuberance” speech. In the former case, net foreign treasury buying almost tripled to $44 bln, while in the latter case it soared more than 10 times, reaching $25 bln.

Throughout the past two decades, the balance of payments approach in assessing the dollar’s behaviour has given way to the asset market approach. An improvement in Eurozone economic fundamentals will certainly help the young currency recover some lost ground, but it will take more than simple fundamentals to sustain such a recovery. There remains the issue of ECB credibility; which has so far had an inverse relation with the frequency of verbal support for the euro. Looming risks of government stability in the Eurozone big 3 (Germany, France and Italy) and the sensitive issue of expanding membership in the European Monetary Union are also seen as potential obstacles to the single currency.