Exchange Rate Policies

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Revision of Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) Indices*The indices of Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) are used as indicators of external competitiveness. NEER is the weighted average of bilateral nominal exchange rates of the home currency in terms of foreign currencies. Conceptually, the REER, defined as a weighted average of nominal exchange rates adjusted for relative price differential between the domestic and foreign countries, relates to the purchasing power parity (PPP) hypothesis.The Reserve Bank of India (RBI) has been constructing five-country and thirty six-country indices of NEER and REER as part of its communication policy and to aid researchers and analysts. Theses indices are published in the Bank’s monthly Bulletin. Three major developments as set out in the following paragraphs have necessitated a review of the existing indices.First, introduction of the Euro (notes and coins) with effect from January 1, 2002 necessitated the need to replace the existing national currencies of the Euro zone by the common currency for the members, which formed part of RBI’s 5-country and 36-country REER/NEER indices. The European Commission (Eurostat) introduced a harmonised index of consumer prices (HICP) for the member countries, which entailed individual consumer price indices to be replaced by HICP in the construction of the REER. Second, there has been a significant shift in India’s trade relations across countries/regions, mainly towards developing and emerging economies during the last decade, requiring a change in the currency basket and the weights assigned to India’s trading partners included in the REER. Third, the base year of the Wholesale Price Index of India (WPI), was changed to 1993-94, necessitating a change in the base year for 36-country REER and NEER indices.Against the above backdrop, the Reserve Bank has now decided to replace its existing 5-country indices with new six-currency indices of NEER/REER. The thirty six-country indices have also been revised and replaced with new 36-currency indices of NEER/REER. In this regard, the RBI Press Release dated November 4, 2005 had set out the broad outline of the revision of the REER/NEER indices. As indicated in the Press Release, this is a detailed article elaborating upon the methodology adopted in the construction of the new series and the conceptual issues involved such as the coverage, the base year, prices and weights that are chosen and the rationale there-in. The time series data on the new 6-currency and 36-currency indices along with their broad trends have also been examined.I. THE METHODOLOGYThe NEER is the weighted geometric average of the bilateral nominal exchange rates of the home currency in terms of foreign currencies. Specifically,The REER is the weighted average of NEER adjusted by the ratio of domestic price to foreign prices. Specifically, Where e : Exchange rate of Indian rupee against a numeraire, i.e., the IMF’s Special Drawing Rights (SDRs) in indexed form,* Prepared jointly in the Division of International Finance, Department of Economic Analysis and Policy and the Department of External Investments and Operations, Reserve Bank of India. As set out in the methodology, the REER has four parameters/variables pertaining to country/currency coverage (n), relative prices (P/Pi), Exchange Rate Policies Exchange Rate Policies By: OpenStaxCollege Exchange rate policies come in a range of different forms listed in [link]: let the foreign exchange market determine the exchange rate; let the market set the value of the exchange rate most of the time, but have the central bank sometimes intervene to prevent fluctuations that seem too large; have the central bank guarantee a specific exchange rate; or share a currency with other countries Let’s discuss each type of exchange rate policy and its tradeoffs A Spectrum of Exchange Rate Policies A nation may adopt one of a variety of exchange rate regimes, from floating rates in which the foreign exchange market determines the rates to pegged rates where governments intervene to manage the value of the exchange rate, to a common currency where the nation adopts the currency of another country or group of countries Floating Exchange Rates A policy which allows the foreign exchange market to set exchange rates is referred to as a floating exchange rate The U.S dollar is a floating exchange rate, as are the currencies of about 40% of the countries in the world economy The major concern with this policy is that exchange rates can move a great deal in a short time Consider the U.S exchange rate expressed in terms of another fairly stable currency, the Japanese yen, as shown in [link] On January 1, 2002, the exchange rate was 133 yen/dollar On January 1, 2005, it was 103 yen/dollar On June 1, 2007, it was 122 yen/ dollar, and on January 1, 2009, it was 90 yen/dollar As investor sentiment swings back and forth, driving exchange rates up and down, exporters, importers, and banks involved in international lending are all affected At worst, large movements in exchange rates 1/11 Exchange Rate Policies can drive companies into bankruptcy or trigger a nationwide banking collapse But even in the moderate case of the yen/dollar exchange rate, these movements of roughly 30 percent back and forth impose stress on both economies as firms must alter their export and import plans to take the new exchange rates into account Especially in smaller countries where international trade is a relatively large share of GDP, exchange rate movements can rattle their economies U.S Dollar Exchange Rate in Japanese Yen Even relatively stable exchange rates can vary a fair amount The exchange rate for the U.S dollar, measured in Japanese yen, fell about 30% from the start of 2002 to the start of 2005, rose back by mid-2007, and then dropped again by early 2009 (Source: http://research.stlouisfed.org/fred2/series/EXJPUS) However, movements of floating exchange rates have advantages, too After all, prices of goods and services rise and fall throughout a market economy, as demand and supply shift If an economy experiences strong inflows or outflows of international financial capital, or has relatively high inflation, or if it experiences strong productivity growth so that purchasing power changes relative to other economies, then it makes economic sense for the exchange rate to shift as well Floating exchange rate advocates often argue that if government policies were more predictable and stable, then inflation rates and interest rates would be more predictable and stable Exchange rates would bounce around less, too The great economist Milton Friedman (1912–2006), for example, wrote a defense of floating exchange rates in 1962 in his book Capitalism and Freedom: “Being in favor of floating exchange rates does not mean being in favor of unstable exchange rates When we support a free price system [for goods and services] at home, this does not imply that we favor a system in which prices fluctuate wildly up and down 2/11 Exchange Rate Policies What we want is a system in which prices are free to fluctuate but in which the forces determining them are sufficiently stable so that in fact prices move within moderate ranges This is equally true in a system of floating exchange rates The ultimate objective is a world in which exchange rates, while free to vary, are, in fact, highly stable because basic economic policies and conditions are stable.” Advocates of floating exchange rates admit that, yes, exchange rates may sometimes fluctuate They point out, however, that if a central bank focuses on preventing either high inflation or deep recession, with low and reasonably steady interest rates, then exchange rates will have less reason to vary Using Soft Pegs and Hard Pegs When a government intervenes in the foreign exchange market so that the exchange rate of its currency is different from what the market would have produced, it is said to have established a “peg” for its currency A soft peg is the name for an exchange rate policy where the government usually allows the exchange rate to be set by the market, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene in the market With a hard peg exchange rate policy, the ... Unit Exchange rates Before you read Discussion 1. If you keep a banknote in your pocket, you know that it will almost certainly be worth less after a few months. If you deposit it in a bank, of course, it will be worth a little more. Why? 2. If you change your bank notes into another currency, you will receive a certain amount of notes and coins, but this amount can change every day, or more than once a dat. Why? Reading 1 Exchange rates The Bretton Woods agreement of 1944 established fixed exchange rates, defined in terms of gold and the US dollar, i.e. their parities with the US dollar were fixed. In this period, a US dollar was a promissory note issued by the United States Treasury. If anybody requested it, the Treasury had to exchange the note for 1/35 th of an ounce of gold. Under this system, overvalued or undervalued currencies could only be adjusted with the agreement of the International Monetary Fund. Such adjustments are called devaluations and revaluations. The Bretton Woods system of gold convertibility and pegging against the dollar was abandoned in 1971, because following inflation, the Federal Reserve did not have enough gold to guarantee the American currency. Gold convertibility was replaced by a system of floating exchange rates. ( Today, the US dollar- the unofficial world currency- is merely a piece of paper on which is written ‘In God We Trust.’ God, not gold!) A freely (or clean) floating exchange rate is determined purely by supply and demand. Theoretically, in the absence of speculation, exchange rates should reflect purchasing power parity- the cost of a given selection of goods and services in different countries. Proponents of floating exchange rates, such as Milton Friedman, argued that currencies would automatically establish stable exchange rates which would reflect economic realities more precisely than calculations by central bank officials. Yet they underestimated the impact of speculation, and the fact that companies and investors frequently follow short-term money market trends even if these are contrary to their own long-term interests. In the late 1970s and early 1980s, the American, British and other governments deregulated their financial systems, and abolished all exchange controls. Residents in these countries are now able to exchange any amount of their currency for any other convertible currency. This has led to the current situation in which 95% of the world’s currency transactions are unrelated to transactions in goods but are purely speculative. Enormous amounts of money move round the world, chasing high interest rates or capital gains, as investors- including rich individuals, companies and pension funds- seek to maximize the value of their assets. In London alone, in the late 1990s, over $300 billion worth of currency was traded on an average day- the equivalent of about 30%of the value of the goods Britain produces each year. Banks, of course, make a profit from the spread between a currency’s buying and selling prices. Few governments, however, leave exchange rates wholly at the mercy of market forces. Most of them attempt to influence the level of their currency when necessary. Managed (or dirty) floating exchange rate are more common than freely floating ones. For example, in the 1980s, most Western European government joint the EMS ( European Monetary System) which established parities between member currencies. There was also an Exchange Rate Mechanism (ERM): if the rate diverged by more than plus or minus 2¼ per cent from the central parity, central banks had to intervene in exchange market, buying and selling in order to increase or decrease the value of their currency. Yet international speculators can be more powerful than governments. For example, on a single day in September 1992 the Bank of England lost five Exchange rate exposure Exchange rate exposure Kathryn M.E. Dominguez a,b,c, * , Linda L. Tesar b,c,1 a Ford School of Public Policy, University of Michigan, United States b NBER, United States c Department of Economics, University of Michigan, Lorch Hall, 611 Tappan Street, Ann Arbor, MI 48109-1220, United States Received 23 November 2001; received in revised form 1 October 2004; accepted 21 January 2005 Abstract In this paper we examine the relationship between exchange rate movements and firm value. We estimate the exchange rate exposure of publicly listed firms in a sample of eight (non-US) industrialized and emerging markets. We find that exchange rate movements do matter for a significant fraction of firms, though which firms are affected and the direction of exposure depends on the specific exchange rate and varies over time, suggesting that firms dynamically adjust their behavior in response to exchange rate risk. Exposure is correlated with firm size, multinational status, foreign sales, international assets, and competitiveness and trade at the industry level. D 2005 Elsevier B.V. All rights reserved. Keywords: Firm- and industry-level exposure; Exchange rate risk; Pass-through JEL classification: F23; F31; G15 1. Introduction It is widely believed that changes in exchange rates have important implications for financial decision-making and for the profitability of firms. One of the central 0022-1996/$ - see front matter D 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.jinteco.2005.01.002 * Corresponding author. Gerald R. Ford School of Public Policy, University of Michigan, Lorch Hall, 611 Tappan Street, Ann Arbor, MI 48109-1220, United States. Tel.: +1 734 764 9498; fax: +1 734 763 9181. E-mail addresses: kathrynd@umich.edu (K.M.E. Dominguez), ltesar@umich.edu (L.L. Tesar). 1 Tel.: +1 734 763 2254; fax: +1 734 764 2769. Journal of International Economics 68 (2006) 188 – 218 www.elsevier.com/locate/econbase motivations for the creation of the euro was to eliminate exchange rate risk to enable European firms to operate free from the uncertainties of changes in relative prices resulting from exchange rate movements. At the macro level, there is evidence that the creation of such currency unions results in a dramatic increase in bilateral trade (Frankel and Rose, 2002). But do changes in exchange rates have measurable effects on firms? The existing literature on the relationship between international stock prices (at the industry or firm level) and exchange rates finds only weak evidence of systematic exchange rate exposure (see Doidge et al., 2003; Griffin and Stulz, 2001 for two recent studies). This is particularly true in studies of US firm share values and exchange rates. 2 The first objective of this paper is to document the extent of exchange rate exposure in a sample of eight (non-US) industrialized and developing countries over a relatively long time span (1980–1999) and over a broad sample of firms. We follow the literature in defining exchange rate exposure as a statistically significant (ex post) relationship between excess returns at the firm- or industry-level and foreign exchange returns. A key result from our analysis is the finding that exchange rate exposure matters for non-US firms. We find that for five of the eight countries in our sample over 20% of firms are exposed to weekly exchange rate movements and exposure at the industry level is generally much higher, with over 40% of industries exposed in Germany, Japan, the Netherlands and the UK. 3 We find that there is considerable heterogeneity in the extent of exposure across our sample of countries as well as large variation Discussion Papers No. 340, February 2003 Statistics Norway, Research Department Hilde C. Bjørnland and Håvard Hungnes The importance of interest rates for forecasting the exchange rate Abstract: This study compares the forecasting performance of a structural exchange rate model that combines the purchasing power parity condition with the interest rate differential in the long run, with some alternative models. The analysis is applied to the Norwegian exchange rate. The long run equilibrium relationship is embedded in a parsimonious representation for the exchange rate. The structural exchange rate representation is stable over the sample and outperforms a random walk in an out-of- sample forecasting exercise at one to four horizons. Ignoring the interest rate differential in the long run, however, the structural model no longer outperforms a random walk. Keywords: Equilibrium real exchange rate, cointegration VAR, out-of-sample forecasting JEL classification: C22, C32, C53, F31 Acknowledgement: The authors wish to thank Å. Cappelen, P. R. Johansen and T. Skjerpen for very useful comments and discussions. The usual disclaimers apply. Address: Hilde C. Bjørnland, University of Oslo and Statistics Norway. E-mail: h.c.bjornland@econ.uio.no. Håvard Hungnes, Statistics Norway, Research Department. E-mail: havard.hungnes@ssb.no Discussion Papers comprise research papers intended for international journals or books. As a preprint a Discussion Paper can be longer and more elaborate than a standard journal article by in- cluding intermediate calculation and background material etc. Abstracts with downloadable PDF files of Discussion Papers are available on the Internet: http://www.ssb.no For printed Discussion Papers contact: Statistics Norway Sales- and subscription service N-2225 Kongsvinger Telephone: +47 62 88 55 00 Telefax: +47 62 88 55 95 E-mail: Salg-abonnement@ssb.no 3 1. Introduction The well cited finding by Meese and Rogoff (1983), that a comprehensive range of exchange rate models were unable to outperform a random walk, has motivated numerous studies to examine the role of economic fundamentals in explaining exchange rate behaviour. Later on, however, MacDonald and Taylor (1994), Chrystal and MacDonald (1995), Kim and Mo (1995) and Reinton and Ongena (1999) among others, have found that a series of monetary models can beat a random walk in forecasting performance, at least at the long horizons, using a metric like the root mean square errors (RMSE) for evaluation. However, although the monetary models have proved somewhat successful in explaining exchange rate behaviour, they have also encountered many problems. In particular, many of the cointegrating relationships have taken on incorrect signs when compared to theoretical models (McNown and Wallace (1994)). One of the basic building blocks of the monetary models is the purchasing power parity (PPP). However, empirical evidence from the post Bretton Woods fixed exchange rate system, have found little to support the PPP condition (see e.g. Rogoff (1996) for a survey) 1 and forecasts based on the PPP condition alone, have provided mixed results (see for instance Fritsche and Wallace (1997) among others). The PPP condition has its roots in the goods market. Another central parity condition for the exchange rate that plays a crucial role in capital market models is uncovered interest parity ... Summary In a floating exchange rate policy, a country’s exchange rate is determined in the foreign exchange market In a soft peg exchange rate policy, a country’s exchange rate is usually determined... exchange rates policies face tradeoffs A hard peg exchange rate policy will reduce exchange rate fluctuations, but means that a country must focus its monetary policy on the exchange rate, not... allows the exchange rate to change with inflation and rates of return, but also raises a risk that exchange rates may sometimes make large and abrupt movements The spectrum of exchange rate policies