by Chris Chen
The most common analytic to determine a long run foreign exchange rate is purchasing power parity (PPP). However, the system has limitations because historically, deviations from estimated PPP values have been both large and persistent. This suggests there are forces other than relative national inflation rates which have been driving long-term exchange rates.
Thus, economists have considered alternative approaches to assessing long-term value in markets. One popular approach is the Macroeconomic-Balance Approach. This is the theory that the long-run equilibrium exchange rate should equal a country’s savings investment. The Macroeconomic-Balance Approach is what the International Monetary Fund (IMF) uses.
Recently, economists used econometrics, the application of statistical methods to economic data, to identify factors which influence the long-run equilibrium of foreign exchange. They have identified factors such as productivity growth, a country’s terms of trade, and net international investment.
Purchasing Power Parity and its Long Term Investment Strategy
PPP is the concept that a country’s long-run exchange rate equilibrium is determined by the ratio of domestic to foreign prices. In theory, the prices of similar tradable goods and services should be the same in two countries when expressed in either local or foreign currency.
Long-term investors can benefit when a purchasing power parity misalignment seeks to correct itself. (A PPP misalignment occurs when nominal exchange rates fail to move in line with the relative inflation or if the nominal exchange rate rises or falls by large amounts to modestly changing inflation rates.) Many empirical studies have shown that in the long run, exchange rates exhibit a tendency to gravitate toward their purchasing power parity levels. Investors can purchase what they view to be undervalued currencies or sell overvalued currencies in accordance to where they view the purchasing power equilibrium.
PPP deviations can be large and persistent over short and medium-term horizons; therefore, trading with this strategy is risky. In the short and medium horizons, purchasing power deviations may widen instead of narrow. To minimize risk, investors gradually could take long positions in undervalued currencies (or short positions in overvalued currencies) as misalignments start to build. In addition, investors could take modest positions when misalignments are small and if deviations from purchasing power parity grow and persist, take more aggressive positions.
Savings-Investment Balance and its Long Term Investment Strategy
Along with purchasing power parity, another way foreign exchange traders determine the long-run exchange rate is through a concept known as the savings-investment balance. The savings-investment balance is the idea that a country’s net savings and net investments are equal to its current account balance. Thus, the real exchange rate would be at the intersection of the savings-investment and current account balance graphs.
Long-term investors can use the savings-investment balance strategy by first estimating a trade equation and national income model. Then, they compare the intersection of the model with the estimate equilibrium exchange rate to determine whether or not the currency is over- or under-valued. For instance, if the currency is determined to be undervalued, an investor would take a long position.
Factors Which Influence the Long-Run Exchange Rate
Productivity Growth: Many economists cite the rise in U.S. productivity relative to overseas productivity growth as one of the key variables that drove the dollar up during the 1990s. In addition, former Fed Chairman Alan Greenspan stated the dollar’s seven-year uptrend during that time was due to an increase in United States productivity.
Country’s Terms of Trade: A country’s terms of trade can influence the direction that exchange rates take. For instance, in commodity-oriented economies such as Australia, New Zealand, and Canada, there is a strong positive relationship between the commodity-price indices and the aforementioned currencies.
Net International Investment: There are two reasons why a positive long-run relationship exists between a country’s international investment position and its real exchange rate.
First, foreign exchange rates do not adjust and equilibrate to the current-account balance. This is because countries which are in deficient use capital inflows to finance their debt and thus the exchange rate may be different.
Second, there is a positive relationship between the trends in international investment position and trends in exchange rates. As a result, the cumulative trends in account imbalances give rise to shifts in wealth from countries with trade surpluses to countries with trade deficits.