Exchange Rate Policy 3: Equilibrium exchange rates

How does one tell whether an exchange rate is over- or under-valued? Driver and Westway (2004)* lists 11 different methodologies on how to do this. If you recall from my first exchange rate policy post, structural models have the potential for making this determination. The insight into using these types of models is that exchange rates are affected by many factors, not just one or two, i.e. currencies should move in relation to the underlying fundamentals of an economy. If this sounds familiar, it’s because this is a common refrain of Tan Sri Zeti when talking about the level of the MYR. By implication, the fundamental equilibrium view rejects the concept of purchasing power parity or PPP, or alternatively that the PPP changes across time (depending on which model you use).

*Rebecca L Driver & Peter F Westaway, "Concepts of equilibrium exchange rates", Working Paper no. 248, Bank of England (2004). Link is here - warning! PDF link.

Which fundamentals are important to which currency can be radically different – a lot of the time spent in specifying these models is determining which variables actually matter. For instance, for countries like Malaysia with strong natural resources, commodity prices are an obvious starting point, although there are many more factors to take into account. A non-exhaustive list of fundamentals would include:

1. Government consumption, which is presumed to fall more on non-tradables. Higher government consumption in that case should in theory (through the Balassa-Samuelson Hypothesis) cause an appreciation of the exchange rate;

2. Relative real interest rates, where higher rates cause appreciation;

3. Openness to trade, where higher openness allows for greater tradable goods arbitration. This will equate to a depreciation of the exchange rate;

4. Net foreign assets, which measures capital stocks. A typical approach is to take changes in stocks as the variable i.e. a flow approach using changes to the current account, or the international investment position. The impact depends on the policy stance and structure of the economy – where economic growth is slower, a higher net foreign asset position implies greater income flows which result in an appreciation. However, empirical evidence suggests in high growth periods or for fast growing developing economies, capital inflows can appreciate the currency despite decreasing the net foreign asset position;

5. The terms of trade, which measures the price of exports in terms of imports. The result on the exchange rate here depends on the relative strength of income and substitution effects, although the empirical evidence suggests the former. This implies an appreciation of the exchange rate;

6. Relative productivity, both internal (between the non-tradable and tradable sectors) and external (in tradables). Higher international productivity in the tradable sector suggests a depreciation, while higher productivity in the tradable sector relative to the non-tradable sector implies an appreciation;

7. Demographic structure, such as the dependency ratio.

I have seen a lot of variations and proxy alternates in the variables used, some due to specific country effects and others due to data limitations. Some of the variables, such as trade openness, are subjective. Government consumption sometimes is not significant, but the government deficit might if borrowing is primarily external.

The different modeling approaches also yield different estimates of the equilibrium value of the exchange rate. There is in fact no single, correct way to go about this. The consensus is to always apply two or three different modeling approaches, which should give a good ballpark figure as to how far a currency is off its “true” equilibrium value. If on the other hand all the models are pointing in one direction, then that is something our fictional central banker has to take seriously. In terms of actual use, I would take the following three models as the most prevalent:

1. Macroeconomic Balance model (MBM) – measures the difference between projected medium term current account balance with an estimated equilibrium current account balance.

2. External sustainability model (ESM) – a variant of the MBM model, but measures the difference between actual current account balances with the balance that would stabilise the net foreign asset position at some benchmark.

3. The Reduced Form Structural Model – equates the medium term equilibrium exchange rate as a direct function of medium term fundamentals. The term "reduced form" indicates that variables that don't impact the exchange rate are dropped from the specification i.e. these aren't "full" structural economic models.

These are the models in general use by the IMF* in assessing currency misalignments, and where possible all three are calculated to get a balanced view of a currency’s equilibrium position. I’m not about to lay out in any length of how the models are calculated – even within the broad categories above, you can use different statistical approaches in the estimation, and results may vary according to the sample period chosen as well as the presence of any structural breaks.

* Press statement here, PDF document here

Neither is data gathering a trivial exercise. If you take the 15 currencies I’m using in my short term broad MYR index, that means you have to have the required data for all the variables for all the currencies involved, and in the correct frequencies for the full sample period selected. Secondly, some of the theoretical concepts don’t translate well to real world data – such as for example trade openness – which requires using some form of proxy. Third, some data is just not collected, or available for limited periods or not accurately measurable, such as net foreign assets. There’s thus a lot of room for specification error and measurement error.

Even with those caveats, there’s still no alternative to making the attempt at measuring currency misalignments. Any currency that is not following a full free float with open capital account regime can get into serious misalignment problems, with potentially expensive adjustments required to regain equilibrium either through currency adjustments, real economy adjustments or both. The worse case of course, is when these adjustments are imposed by the market, as we saw in 1997-98.

This naturally takes us to the choice of exchange rate regime, which will be covered by the next post.