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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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Transitioning from least developed country status: Are countries better off?

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The Least Developed Countries (LDCs) are an internationally defined group of highly vulnerable and structurally constrained economies with extreme levels of poverty. Since the category was created in 1971, on the basis of selected vulnerability indicators, only five countries have graduated and the number of LDCs has doubled.  One would intuitively have thought that graduation from LDC status would be something that all LDCs would want to achieve since it seems to suggest that transitioning countries are likely to benefit from increased economic growth, improved human development and reduced susceptibility to natural disasters and trade shocks.

However, when countries graduate they lose international support measures (ISMs) provided by the international community. There is no established institutional mechanism for the phasing out of LDC country-specific benefits. As a result, entities such as the World Bank and the International Monetary Fund may not always be able to support a country’s smooth transition process.

Currently, 14 out of 53 members of the Commonwealth are classified as LDCs and the number is likely to reduce as Bangladesh, Solomon Islands and Vanuatu transition from LDC status by 2021. The three criteria used to assess LDC transition are: Economic Vulnerability Index (EVI), Human Assets Index (HAI) and Gross National Income per capita (GNI).  Many of the forthcoming LDC graduates will transition based only on their GNI.  This GNI level is normally set at US $ 1,230 but if the GNI reaches twice this level at US $ 2,460 a country can graduate.

So what’s the issue?  A recent Commonwealth – Trade Hot Topic publication confirms that most countries graduate only on the basis of their GNI, some of which have not attained significant improvements in human development (HAI) and even more of which fall below the graduation threshold for economic development due to persistent vulnerabilities (EVI).  This latter aspect raises the question as to whether transitioning countries will, actually, be better off after they graduate.

Given the loss of ISMs and the persistent economic vulnerabilities of many LDCs, it is no surprise that some countries are actually seeking to delay graduation, Kiribati and Tuvalu being two such Commonwealth countries despite easily surpassing twice the GNI threshold for graduation.

How is it possible that a country can achieve economic growth but not have appreciable improvements in resilience to economic vulnerability?  Based on a statistical analysis discussed in the Trade Hot Topic paper, a regression model, based on all forty-seven LDCs, was produced.  The model revealed that there was no statistically significant relationship between economic vulnerability and gross national income per capita.  The analysis was repeated just for Commonwealth countries and similar results were obtained.

Most importantly, analysis revealed that there was a positive relationship between GNI and EVI. In other words, increases in wealth (using GNI as a proxy) is likely to result in an increase in economic vulnerability.  This latter result is counterintuitive since one would expect more wealth to result in less economic vulnerability.

So what’s the take away?

The statistical results do not necessarily imply that improving the factors affecting economic vulnerability cannot result in improvements to economic prosperity.  It does suggest, however, that either insufficient efforts have gone into effecting such improvements or that there are natural limits to the extent to which such improvements can be effected.

One thing is clear, the multilateral lending agencies should revisit the removal of measures supporting climate change or other vulnerabilities for LDCs on graduation, since the empirical evidence suggests that countries could fall back into LDC status or stagnate and be unable to achieve sustainable development. Whilst transitioning from LDC status should be desirable, it should not be an end in itself. Rather than to transition and remain extremely vulnerable, countries should be resistant to such change or continue to receive more targeted support until vulnerabilities are reduced to more acceptable levels.

What are your thoughts?

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U.S. policy and the Turkish Economic Crisis: Lessons for Pakistan

M Waqas Jan

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Over the last week, the Turkish Lira has been dominating headlines the world over as the currency continues to plunge against the US dollar. Currently at the dead center of a series of verbal ripostes between Presidents Donald Trump and Recep Tayyip Erdogan, the rapidly depreciating Lira has taken center stage amidst deteriorating US-Turkey relations that are wreaking havoc across international financial markets. Considering Pakistan’s current economic predicament, the events unfolding in Turkey offer important lessons to the dangers of unsustainable and unrealistic economic policies, within a dramatically changing international scenario. This holds particular importance for Pak-US relations within the context of the impending IMF bailout.

In his most recent statements, Mr. Erdogan has attributed his economy’s dire state of affairs as an ‘Economic War’ being waged against it by the United States. President Trump too has made it evident that the latest rounds of US sanctions that have been placed on Turkey are directly linked to its dissatisfaction with Ankara for detaining American Pastor Andrew Brunson. Mr Bruson along with dozens of others has been charged with terrorism and espionage for his purported links to the 2016 attempted coup against President Erdogan and his government.  There is thus a modicum of truth to Mr. Erdogan’s claims that the US sanctions are in fact, being used as leverage against the weakening Lira and the Turkish economy as part of a broader US policy.

However, to say that the latest US sanctions alone are the sole cause of Turkey’s economic woes is a gross understatement. The Lira has for some time remained the worst performing currency in the world; losing half of its value in a year, and dropping by another 20% in just the last week. Just to put the scale of this loss in to perspective, the embattled currency was trading at about 2 Liras to the dollar in mid-2014. The day before yesterday, it was trading at about 7 Liras to the dollar.

While the Pakistani Rupee has also depreciated quite considerably over the last few months, its recent drop (-17% against the dollar over the past 12 months) pales in comparison to the sustained and exponential downfall of the Lira. Yet, both the Turkish and Pakistani economies are at a point where they are experiencing an alarming dearth of foreign exchange reserves that have in turn dramatically increased their international debt obligations.

The ongoing financial crises in both Turkey and Pakistan are similar to the extent that both countries have pursued unsustainable economic policies for the last few years. These have been centered on increased borrowing on the back of overvalued currencies. While this approach had allowed both governments to finance a series of government investments in various projects, the long term implications of this accumulating debt has now caught up with them dramatically. As a result, both countries may soon desperately require IMF assistance; assistance, that in recent times, has become even more overtly conditional on meeting certain US foreign policy requirements.

In the case of Pakistan, these objectives may coincide with recent US pressures to ‘do more’ regarding the Haqqani network; or a deeper examination of the scale and viability of the China- Pakistan Economic Corridor. With regards to the latter, US Secretary of State Mike Pompeo has clearly stated that American Dollars, in the form of IMF funds, to Pakistan should not be used to bailout Chinese investors. The rationale being that a cash-strapped Pakistan is more likely to adversely affect Chinese interests as opposed to US interests in the region at the present. The politics behind the ongoing US-China trade war add even further relevance to this argument.

In the case of Turkey however, which is a major NATO ally, an important emerging market, and a deeply integrated part of the European financial system, there is a lot more at stake in terms of US interests. Turkey’s main lenders comprise largely of Spanish, French and Italian banks whose exposure to the Lira has caused a drastic knock on effect on the Euro. The ensuing uncertainty and volatility that has arisen is likely to prove detrimental to the US’s allies in the EU as well as in key emerging markets across South America, Africa and Asia. This marks the latest example of the US’s departure from maintaining and ensuring the health of the global financial system, as a leading economic power.

Yet, what’s even more unsettling is the fact that while the US is wholly cognizant of these wide-ranging impacts, it remains unfazed in pursuing its unilateral objectives. This is perhaps most evident in the diminishing sanctity of the NATO alliance as a direct outcome of these actions.  After the US, Turkey is the second biggest contributor of troops within the NATO framework. As relations between both members continue to deteriorate, Turkey has been more inclined to gravitate towards expanding Russian influence. In effect, contributing to the very anti-thesis of the NATO alliance. The recent dialogues between Presidents Erdogan and Putin, in the wake of US sanctions point markedly towards this dramatic shift.

Based on the above, it has become increasingly evident that US actions have come to stand in direct contrast to the Post-Cold War status quo, which it had itself help set up and maintain over the last three decades. It is rather, the US’s unilateral interests that have now taken increasing precedence over its commitments and leadership of major multilateral frameworks such as the NATO, and the Bretton Woods institutions. This approach while allowing greater flexibility to the US has however come at the cost of ceding space to a fast rising China and an increasingly assertive Russia. The acceleration of both Pak-China and Russo-Turkish cooperation present poignant examples of these developments.

However, while it remains unclear as to how much international influence US policy-makers are willing to cede to the likes of China and Russia over the long-term, their actions have made it clear that US policy and the pursuit of its unilateral objectives would no longer be made hostage to the Geo-Politics of key regions. These include key states at the cross-roads of the world’s potential flash-points such as Turkey and Pakistan.

Therefore, both Turkey and Pakistan would be well advised to factor in these reasons behind the US’s disinterest in their economic and financial predicaments. Especially since both Russia and China are still quite a way from being able to completely supplant the US’s financial and military influence across the world; perhaps a greater modicum of self-sufficiency and sustainability is in order to weather through these shifting dynamics.

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Social Mobility and Stronger Private Sector Role are Keys to Growth in the Arab World

MD Staff

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In spite of unprecedented improvements in technological readiness, the Arab World continues to struggle to innovate and create broad-based opportunities for its youth. Government-led investment alone will not suffice to channel the energies of society toward more private sector initiative, better education and ultimately more productive jobs and increased social mobility. The Arab World Competitiveness Report 2018 published by the World Economic Forum and the World Bank Group outlines recommendations for the Arab countries to prepare for a new economic context.

The gap between the competitiveness of the Gulf Cooperation Council (GCC) and of the other economies of the region, especially the ones affected by conflict and violence, has further increased over the last decade. However, similarities exist as the drop in oil prices of the past few years has forced even the most affluent countries in the region to question their existing social and economic models. Across the entire region, education is currently not rewarded with better opportunities to the point where the more educated the Arab youth is, the more likely they are to remain unemployed. Financial resources, while available through banks, are rarely distributed out of a small circle of large and established companies; and a complex legal system limits access to resources locked in place and distorts private initiative.

At the same time, a number of countries in the region are trying out new solutions to previously existing barriers to competitiveness.

  • In ten years, Morocco has nearly halved its average import tariff from 18.9 to 10.5 percent, facilitated trade and investment and benefited from sustained growth.
  • The United Arab Emirates has increased equity investment in technology firms from 100 million to 1.7 billion USD in just two years.
  • Bahrain is piloting a new flexi-permit for foreign workers to go beyond the usual sponsorship system that has segmented and created inefficiencies in the labour market of most GCC countries.
  • Saudi Arabia has committed to significant changes to its economy and society as part of its Vision 2030 reform plan, and Algeria has tripled internet access among its population in just five years.

“We hope that the 2018 Arab World Competitiveness Report will stimulate discussions resulting in government reforms that could unlock the entrepreneurial potential of the region and its youth,” said Philippe Le Houérou, IFC’s CEO. “We must accelerate progress toward an innovation-driven economic model that creates productive jobs and widespread opportunities.”

“The world is adapting to unprecedented technological changes, shifts in income distribution and the need for more sustainable pathways to economic growth, “added Mirek Dusek, Deputy Head of Geopolitical and Regional Affairs at the World Economic Forum. “Diversification and entrepreneurship are important in generating opportunities for the Arab youth and preparing their countries for the Fourth Industrial Revolution.”

With a few exceptions, such as Jordan, Tunisia and Lebanon, most Arab countries have much less diversified economies than countries in other regions with a similar level of income. For all of them, the way toward less oil-dependent economies is through robust macroeconomic policies that facilitate investment and trade, promotion of exports, improvements in education and initiatives to increase innovation and technological adoption among firms.

Entrepreneurship and broad-based private sector initiative must be a key ingredient to any diversification recipe.

The Arab Competitiveness Report 2018 also features country profiles, available here: Algeria, Bahrain, Egypt, Jordan, Kuwait, Lebanon, Morocco, Oman, Qatar, Saudi Arabia, Tunisia, United Arab Emirates.

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