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Economy

The Foreign Exchange Rate Determination Issue and its Empirical Deviations

Enrique Muñoz-Salido

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The discussion about the theories that determine the foreign exchange rate is a recurrent issue in the economic literature. Theoretical and empirical approaches achieved to outline a shaky framework in the past decades.

The mainstream of modern economic literature holds that relative prices of countries determine the behavior of their foreign exchange rate. The most well-known theoretical approach to this explanation is the Purchasing Power Parity (PPP) theory, which asserts that the purchasing power of countries is the same when measure in the same currency.

The reason for the PPP model to hold is the presence of the international arbitrage, which makes prices equal between countries and corrects their purchasing power disparities. This is possible due to when the price of a good is cheaper in the domestic country than in the foreign country, foreign importers and domestic exporters will buy the good in the domestic country in order to sell it in the foreign country to obtain the profit derived from the both countries price imbalance. As a result of this situation, the price of the domestic good would increase while the price of the foreign good would decrease making one price equals to the other. This would lead to assert that when PPP holds, the purchasing power of those countries is the same (constant) over time.

Canada/U.S. Foreign Exchange Rate vs. PPP

exchangerate

*Percentage change relative to the base year 2010

Source (Muñoz-Salido, 2016)

As it can be seen in this graph of the Canada/U.S. foreign exchange rate and the PPP theory, there are consistent patterns regarding to the theoretical relationship of those variables. In general, it can be observed that whenever the value of Canadian dollar falls (so it implies an appreciation of the U.S. dollar against the Canadian dollar) against the value of the U.S. dollar, then always the Canada’s price level falls relative to that in the U.S., and , conversely, whenever there is a depreciation of the U.S. dollar against the Canadian dollar (so there is an increase in the value of the Canadian dollar relative to that in the U.S. dollar) then there is an increase in the Canadian price level relative to that in the U.S., which is strongly consistent with the PPP theory.

The only periods when this pattern is distorted is from 1974 to 1977 and from 2007 to 2013. This is not consistent with the PPP theory and it can be associated with not having the proper conditions for the PPP to hold, concretely. Following Coughlin’s & Koedijk’s (1990) statements, it can be explained by economic shocks, in this case the energy crisis at earlier 1970s which ended in the later 1970s and by the financial crisis which covered the aforementioned period.

Bearing in mind our results in this sample dataset, Stockman (1978) suggests that while a great part of changes in the exchange rate can be explained by inflation rates, there is many substantial changes in the exchange rate that remain unexplained. Stockman tries to justify part of this deviation by the role of the information about the future (id est. an increase in the expected rate of domestic inflation). He asserts that this information role makes a reduction on the demand for domestic money and connotes all nominal prices, including the price of foreign exchange, to rise. Nevertheless, he stresses that this alone cannot account for deviations from PPP unless exchange rates are associated with fluctuations in the ratio of domestic and foreign price levels. Stockman’s (1978) also addresses part of this deviation issue by associating its cause with other policies such a tariffs, quotas and controls on foreign exchange transactions which may affect the exchange rate indirectly by directly affecting the terms of trade.

In light of this ever-present deviation of empirical findings from the theory, Musa (1984) fiercely criticise the stickiness of prices. He addresses the short-run deviations to the slow price adjustment due to they are fixed in the short-run and they don’t adjust immediately to its equilibrium value. Stockman (1978) adds that this fact could be the main cause for the exchange rate to depreciate in the short-run, due to in the long-run good prices have already had time to adjust to a market equilibrium. Nevertheless, De Grauve et al. (1985) associate part of empirical deviations from PPP with the influence of the size of the stochastic disturbances in the money market by setting the assumption that the larger the size of the monetary and inflationary disturbances, the larger the variability of the real exchange rate. They also notice that this relation is not linear connoting an increase in the variability of the real exchange rate when monetary and inflationary disturbance occurs but levelling off after this immediate increase due to the force of goods arbitrage. They also set the international arbitrage as a grader factor when this disturbance arises.

In addition, Coughlin & Koedijk (1990) attribute part of this deviation to the fact that floating exchange rates are relatively new over time, so that the exchange rate determination is trying to be addressed by the convergence of two different type of exchange rate that have different behaviour. Under this assumption, they stress the fact that the relative price ratio of the real exchange rate fluctuates more in the floating-rate period than in the fixed exchange rate period. Also, they hold that another possibility that may explain this deviation is the effect of random shocks of various origins which disturb the real exchange rate theoretical behaviour, such as oil price shocks. As stated above, our results in the graph of Canada/U.S. foreign exchange rate and PPP theory coincide in dates with two economic shocks when the PPP theoretical pattern is distorted from 1974 to 1977 and from 2007 to 2013. Following Coughlin’s and Koedijk’s statements, this fact can be explained by the energy and the financial crisis influence in the aforementioned period.

Taylor & Taylor (2004) try to address this deviation issue by introducing trade costs and real shocks to the model with the aim to correct the deviations of the real from the foreign exchange rate. They hold that in order to improve the better understanding of the volatility of the real exchange rate, it can be combined the PPP theory with transactions costs and nonlinearity (due to, for example, the long-lasting effects made by price rigidities as stated above by Musa and Stockman) to obtain a more consistent empirical results that allow for the theory to properly hold.

Another requirement for the PPP model to hold is that the real version of the exchange rate achieved provided by PPP must show mean-reversion, so the behaviour of the real exchange rate is stable as it returns to a long-run level despite its fluctuations. When this assumption is violated, it entails that there are trends, random walks or cycles that may explain the causality of the foreign exchange rate instead the PPP model. In other words, this doesn’t allow for the foreign exchange rate to be explained or predicted by the PPP. De Gauve et al. (1985) propose an improvement to the stationarity of the series by applying an alternative statistical technique that makes it possible to decompose a time series into cycles of different frequencies, the spectral analysis. The results on this analysis would show how much of the total change is due to an observed cycle (a low-frequency cycle that repeats itself some times) and how much to seasonal movement (a high-frequency cycle that repeats itself predominantly). As a result, it is obtained a regression information on the extent to which the total variability of series is due to cycles of different frequencies.

In light that the theory assumes the trade to be constant, it can be asserted that in some periods of economic weakness the perfect arbitrage cannot play the same role for correcting purchasing power imbalances than when the economic system is not disturbed. Also, there could be potential factors for the international arbitrage to change over time such as the presence of the internet-based trade since 2000s or the development of new technologies, which can accelerate and change the international trade patterns.

In short, some of these hypothetical deviation statements can lie as a suitable explanation for slight deviations of empirical results from the theoretical framework of PPP theory of the literature in the past decades.

A conclusion to be drawn from this analysis is that PPP theory tends to hold with peculiarities. In the light of this evidence, Dornsbusch (1985) asserts that “There can be no objection to the strong or absolute version of PPP as a theoretical statement. Objections arise, however, when it is interpreted as an empirical proposition”. It can be asserted that the more the model simplifies the reality through theoretical assumptions the more the reality can be distorted. By logical thinking, it can be considered that the more this model is corrected for such an inaccuracy the more the deviation can be reverted.

In short, the vicissitudes with which the PPP holds in the literature over time can be considered as a challenging avenue for future research and as a suggestion for developing in depth the assumptions in which theoretical economic models are based.

Enrique is an MSc Candidate in Social Anthropology at Regent’s Park College, University of Oxford. His research interests lie at the intersection of human behaviour and social interactions and his top analytical skills comprise macro and micro data analysis and statistical methods. Prior to joining Oxford, Enrique completed his MSc in Economics (distinction) at the University of Brighton, UK, where he was a Santander Scholar, and his undergraduate degree at the Autonomous University of Barcelona, Spain.

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What an ‘Impossibility Clause’ can make possible

Mehrnoosh Aryanpour

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Since the implementation of the JCPOA in January of 2016, and throughout the current period of accelerating investment by foreign enterprises in Iran, many participants have taken for granted that in the event of a “Snapback” or the reimposition of UN, U.S. and EU sanctions under the provisions of the JCPOA, foreigners must perforce exit all investments in Iran and Iran’s major industries would be relegated to the shadows as an unlawful destination for foreign capital.

The operative assumption has been that any such reimposition of sanctions under a Snapback scenario would make it “impossible” for such foreign participants to maintain, lawfully, their investments in the various projects within Iran, investment they have made a huge effort to structure and uphold in the still-new era of significantly relaxed sanctions.  In fact, the very idea of the impossibility of maintaining significant investments in Iran under such sanctions has become something of a fixation. To the dismay of Iranian partners in various ventures, their foreign partners tend to focus on securing their own interests, rights, and recompense under a Snapback. An efficient exit strategy is often sought.

In reality, those who are here on the ground in Iran know that, regardless of the whims of the American President or the vicissitudes of foreign capital flows, the continued development and renovation of Iran’s domestic economy, both in terms of absolute production, as well as in terms of sophistication, efficiency, and integration, will continue apace, and therefore, the wiser among the stewards of foreign investment in Iran understand that it is as much a question of ensuring business continuity for their Iranian-Foreign joint venture projects despite changing international sanctions regimes, which have been imposed by the West against Iran for decades.

As a result, the most basic and fundamental considerations for any prospective foreign project participant and its Iranian partner become:

1. How the foreign participant can, through appropriately drafted “Impossibility Clause(s)”, remain invested in the Iranian venture for as long as possible under the threat of renewed or reimposed sanctions, and without incurring unacceptable risk.

2. How the foreign participant can contractually envision the broadest range of adverse sanctions scenarios through a single and efficient impossibility mechanism.

3. How the foreign participant can provide for a gradual approach to any putative withdrawal procedure, as opposed to the simplistic solution of outright termination upon Snapback after a period of suspension.

4. How the foreign participant can, in the event of the extinguishment of impossibility, subsequent relaxation or obtained exemption of sanctions, reasonably provide for the right, or at least the option, for itself to reenter an investment project which it may have exited because of Snapback.

The legal thought process underpinning successful solutions which industry practitioners may be likely to embrace is beyond the scope of this article, but the conceptual summary can be a useful guide for all of us as we come to grips with what can be made possible by “Impossibility Clauses”.

1. Remaining invested, minimizing risk: Of course, it is true that for many projects, a direct investment by the foreign participant though its stake in an Iranian joint venture entity may be the most straightforward means of effecting the transfer of capital that allows the foreign party to have a stake in a project.  It also allows for the simplest mechanism by which a foreign party may apply for and successfully obtain an investment license in accordance with the Foreign Investment Promotion and Protection Act.

Nonetheless, such a direct investment may, particularly in the case of European entities which also do business in U.S. jurisdictions or in jurisdictions which have significant links with the U.S. financial system, provide little or no cushion under even the most benign reimposition of any form of secondary sanctions.  This is because the direct investment leaves the foreign party little room to maneuver by way of restructuring or otherwise allocating its participatory interest in the project as sanctions change.

For this reason, a more effective solution could include the formation of a foreign special purpose vehicle to act for the project entity.  In the case of a joint venture, an SPV incorporated in a jurisdiction less likely to be adversely affected by reimposition of sanctions would allow for a more flexible platform to facilitate intelligent solutions such as exit and re-entry options, trustee or agency relationships, and contingent sale-repurchase strategies to prepare for the worst outcome of a sanctions scenario which may force a foreign party to exit Iranian investment.

2.Knowing unknowns, counting uncountables: Even now, with the most recently issued ultimatum by the American President declaring that the end of the JCPOA as we know it is nigh (to be either amended or abrogated, if Mr. Trump is to be believed), there exists a wide variety of circumstances involving the reimposition of sanctions, ranging from those that would make the maintenance of an interest in a project by a foreign party merely inconvenient to those which would make maintaining such an interest lawfully untenable.   These may range from largely toothless, otherwise symbolic targeted secondary sanctions which apply only to the entities of specific countries, as we have continued to see since Trump’s October 2017 decertification, or those which may apply only to certain economic sectors or types of goods or projects, to those which render further financial flows in support of such a project functionally impracticable.  Most challenging of all would be the failure of the UN to continue to waive the imposition of sanctions against Iran.

Thus, a single mechanism to classify sanctions in some way as materially adverse changes and evaluate consequences seems a more pragmatic solution than contemplating what may constitute an “impossibility” event, and including it under grounds for termination.

Under a scenario in which the foreign party has made appropriate structuring preparations as suggested, the determining exit remedies depends on compliance with mandatory applicable laws of the project vehicle’s jurisdiction.  To put it another way, the most straightforward test of whether the foreign party may have to adjust, or exit from its participation, comes down to whether it can fulfill project obligations while abiding by all applicable regulations that may apply to it.  Beyond such a litmus test, imagining or prognosticating about the myriad complexities of a possible Snapback scenario may be fruitless and contractually inefficient.

3.Avoiding the black-and-white trap: Of course, a foreign project participant can easily avail itself of the opportunity to stipulate that under any kind of scenario of project impracticability caused by sanctions, certain or envisioned, termination shall be the one and only prescribed remedy.

But this is likely to disadvantage the foreign party in the context of negotiations over comprehensive project terms with its Iranian counterparty, and it may limit the scope of the project work itself and fail to allow for a more complex investment structure which cannot survive the threat of termination overnight due to a “Snapback” of one kind or another.

Aside from termination, and its precursor remedy, suspension, there should also be the possibility to contemplate a variety of concepts including assignment, agency and delegation, in order to benefit from the vagaries of sanctions regulations and their exemptions. In some cases, project obligations which would be in violation of sanctions for some foreign entities may not be so for others.  As has been shown by the agreements between foreign export credit agencies (“ECA”s) such as EKF, BPI and Invitalia, developments at an international level, especially where adequate sovereign support and sufficiently ringfenced banking facilities exist, are being contemplated to facilitate the kind of continuity required for the decades-long projects now underway in Iran.   In addition to these ECAs, other parties such as quasi-sovereign corporations, particularly those from less dollarized jurisdictions, can play a role as fallback transferees of the exiting foreigner’s project interest or shares under Snapback.  Moreover, it should always be noted that under even the most negative circumstances, the potential for a foreign party to obtain a waiver does exist and can be specified for the benefit of all parties.

4.Saving face, weighing options: Although some foreign entities have a checkered past derived from cutting and running under the threat of or the actual imposition of sanctions against Iran, time has shown that many of the same foreign parties which were forced, or chose, to exit their project ventures are the first ones to have returned since the JCPOA. Such is the compelling nature of Iran as a destination for foreign capital.

Iranian parties to a project know both this history itself and its implications. Foreign participants may wish to keep close to the exits, but foreign companies that have been victimized by their own government’s whims regarding sanctions, and the slippage inherent in exiting and reentering, cannot be understated.
For this reason, foreign project partners may choose to consider the solution of exit and entry “options” for themselves under adverse sanction scenarios, and thus it is important for all parties involved to understand what an “option” precisely means, and how to value such an option.

In financial speak, an option is defined as the right but not the obligation to sell (or buy) an asset in a fixed quantity at a fixed price on (or before) a fixed date in time.  In the case in question, the asset is the participatory interest of the foreign party in the Iranian project, and the date is that point in time at when the parties to a project agree that the foreign party must leave due to sanctions (or is able to re-enter due to easing of sanctions).

However, it is not obvious immediately what the fixed price should be for foreign project interest at the time of exit or re-entry, and, most importantly, what may be overlooked is the tremendous value that such an option has.  In finance, the greater the underlying uncertainty about an asset, the more valuable any option on that uncertain asset is. Similarly, the longer the life of an option on an asset, the more valuable that option is.  In the context of long term investments, any option to exit (or re-enter) should be linked with a significant premium (that is, the worth of the option), and the contract parties should ensure that they successfully negotiate an appropriately fair value for the flexibility the options offer. As an illustrative example, the alternative to any exit put option for the foreign party is a fire-sale in the face of illiquid conditions for its share interest under the menace of reimposed international sanctions, or more problematic still, the inability to exit its share interest altogether, which an option is supposed to protect against.

Absent a foreign investor’s legal immunity to the whims of the UN, OFAC, or other authorities, there is no perfect panacea for fool proofing long-term Iranian projects against the kind of uncertainty which the spectre of sanctions create.  But although this threat, to a certain extent, has forestalled the growth in Iran’s industry and economy despite the strengthening of Iran’s relationships with the international community, it is now apparent, moreso than ever before, that foreign parties can be expected to take an increasingly pragmatic approach in efforts to remain engaged with their Iranian projects for as long as possible.  They can effectively do so by allowing for the most flexible and broad classification of sanctions-related termination risks, by specifying a menu of contractually stipulated responses to reimposed sanctions (in conjunction with intelligent and pre-emptive project structuring) and by exchanging due consideration with the Iranian party for the invaluable options which allow them to remain confident that they can, if absolutely necessary, exit the project and someday re-enter, at a fair price.

Thus, it seems that the operative watchword for all foreign investors in Iran is continuity: continuity of the progression towards innovation, development and growth, and continuity of the participation of foreign interests in that process, bolstered by intelligent structuring solutions, both legal and financial, for dealing with the complicated reality of international economic sanctions.  With a measure of foresight, and a functional, flexible contractual framework, all participants in long-term, large-scale project joint ventures can move closer to the ideal of mitigating most, if not all, of the adverse consequences of sanctions regulations on investment decisions and risk management.

First published in our partner Tehran Times

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Creating Quality Jobs Crucial to Boost Productivity, Growth in Indonesia

MD Staff

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Indonesia must create good and quality jobs to help increase the country’s productivity and competitiveness for sustained and inclusive growth, says a new Asian Development Bank (ADB) study.

The study, titled Indonesia: Enhancing Productivity through Quality Jobs, takes an in-depth look at the challenges in creating better jobs and raising the country’s labor productivity, as well as the necessary skills needed for a youthful and increasingly better educated workforce to meet the demands of the digital age. The publication was launched today at an event in Jakarta hosted by ADB and the Coordinating Ministry for Economic Affairs.

“Indonesia has a tremendous potential to capitalize on its youthful workforce by addressing the country’s long-term challenges to job creation and inclusive growth,” said Rudy Salahuddin, Deputy Minister for Creative Economy, Entrepreneurship, and SME Competitiveness, Coordinating Ministry for Economic Affairs.

“Not only does the country need to create a more skilled workforce, but it also needs to adjust to new global patterns of technology and the demand for new skills,” said Bambang Susantono, ADB Vice-President for Knowledge Management and Sustainable Development.

The study provides three key messages on how to create good and quality jobs for Indonesia’s large workforce. First, improved education and skills development are necessary to create enough quality jobs to raise productivity. Second, as urban jobs are expanding faster, supportive public policies for sustainable cities are fundamental in generating quality jobs. Lastly, there should be continued efforts to improve labor market institutions and regulations that promote a wider range of employment options and better income security for workers.

The study identifies policy initiatives focused on creating better jobs in the labor market, raising labor productivity, and facilitating worker adjustment to the challenges of the digital age. These issues are addressed both from the supply side and from the demand side of the labor market. Policymakers should ensure that initiatives aimed at increasing productivity also target the poor, women, older people, and other disadvantaged groups.

Labor market institutions like private businesses, small-scale enterprises, and community groups also play a critical role in helping improve the employability of Indonesians. Combining new work opportunities with new technology, ideas, and organization will raise productivity and contribute to improved living standards.

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Agriculture Is Creating Higher Income Jobs in Half of EU Member States but Others Are Struggling

MD Staff

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Half of EU member states have leveraged the Common Agricultural Policy (CAP) to significantly reduce poverty and drive higher incomes in farming, while other countries are still lagging, according to the latest World Bank study.

The ‘Thinking CAP’ report details how new investments and services in farming, reinforced by the EU’s flagship agriculture policy, can drive down poverty and transform agriculture into a sector which can provide higher paying jobs for those who farm.

Hungary, Slovakia, Estonia, Denmark and the Netherlands are all examples of member states that have successfully modernized their agricultural sectors by providing advisory services, roads, secure property rights and access to education and health services in rural areas. Others, such as Bulgaria, Portugal, Romania, Slovenia and Greece, still have some way to go in reducing poverty and ensuring that agricultural work pays. They can do so by improving the basic conditions for a successful agricultural sector, which would improve the results of the financial investments available under the CAP. Other remaining member states fall in between these two categories – achieving a successful transformation or lagging behind.

“Agriculture and poverty in half of the member states of the EU no longer go hand-in-hand. It’s clear that the income gap between agriculture and other sectors is narrowing and in some countries, such as the Netherlands, agricultural work can pay more than jobs in other sectors,” says Arup Banerji, Regional Director for the European Union Countries at the World Bank. “Today, about half of EU member states recognize that farming can boost shared prosperity, while the other half still has some work to do to provide the basic conditions to bring about necessary structural changes.”

The World Bank report shows that the EU CAP is associated with improving employment conditions in farming. Decoupled payments – annual payments based on how much land a farmer uses – and the co-financing of on-farm investments do show clear links with improvements in agriculture. For instance, in the newer member states agricultural labor productivity growth increases from 3.1 percent to 4.7 percent per year with a 10 percent increase in this type of CAP spending. However, there are certain categories of subsidy – known as coupled payments, which reward farmers for producing a particular crop or livestock— for which the report could find no such association. In the past, these coupled payments also led to extreme overproduction and price distortion on global markets.

“Some countries are running before they can walk by issuing payments to farmers who don’t have the necessary infrastructure to effectively bring their products to market or to make the best use of their investment,” said Rogier van den Brink, Lead Economist at the World Bank. “However, the processes the CAP has put in place are impressive. The CAP casts a very wide net and reaches farmers in every far-flung corner of the EU. Because of this, improvements in the CAP along the lines of the recommendations outlined in our report will further strengthen its role as a powerful instrument of structural transformation.”

Going forward, the report says the monitoring of CAP funds should focus on delivering tangible results rather than confusing bureaucratic processes. This would also encourage the co-financing of private investment into CAP-supported projects which are in the public interest such as environmentally sound practices, organic farming and animal welfare.

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