too much and the speculativeflow capitulated (as reflected by the sudden and dramatic spike higher in the Polish zlotybasket chart in June–July 2001, reflecting a collapse in the zloty’s value).This cycle or pattern is not just reflective of one single example, but instead of a broaderrelationship between speculative flows and economic fundamentals within freely floating exchange rates. To some extent, this reflects the reaction of the current account to changes innational income, as shown in the external balance and balance of payments models, however,the advantage of this is that it specifically focuses on how speculative flows, which make upthe majority of overall currency market flows, affect economic fundamentals. As a result, anappropriate title for this model would appear to be the “speculative cycle of exchange rates”,which we can break down into four key phases:
r Phase I – Fundamental market participants deem a currency good (poor) value and startbuying (selling) it on a sustained basis, thus creating a currency trend.
r Phase II – The longer the trend continues, the more speculative it becomes in nature, as moreand more speculative market participants (i.e. no underlying asset in the transaction) buy(sell) the currency trend.r Phase III – However, as the trend of currency appreciation (depreciation) continues it createsincreasing economic deterioration (improvement), encouraging an increasing number offundamental market participants to sell (buy) their positions.
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r Phase IV – For a time, speculative inflows (outflows) more than offset those fundamentalsoutflows (inflows), but eventually in the face of increasing economic deterioration (improvement) they capitulate and the currency collapses (rallies).Economists may note that this model is not that dissimilar in essence from the belief thatspeculative excess will be corrected by fundamentals, back towards an equilibrium level. Thecrucial difference however is that the relationship between speculation and fundamentals isnot one-way but two-way. What the two ideas have in common however is that they believe ina cycle. The cycle of foreign exchange activity may or may not be the same as the economiccycle, depending on a number of factors such as positional risk and investor asset allocation.In addition, there is no telling how long it will last. It could take weeks, months or even years.However, it is a discernible pattern, reflecting the key dynamics of the currency market andfocusing specifically on speculative flows. In addition, it can be used as a framework for theanalysis and prediction of exchange rates over the short to medium term.2.1.3 Risk Appetite Indicators and Exchange RatesWithin such a cycle, there is obviously a substantial amount of intraday and intraweek volatility,reflecting swings in market sentiment. Traditionally, economists have either ignored such shortterm periods or suggested they could not be predicted. While flow and technical analysis havedone much to dispel such a view, recent work on the relationship between “risk appetite” and asset prices has made a real breakthrough in terms of being able to predict those short-term swingsin sentiment and in turn how they affect currency and asset prices. Risk appetite or market sentiment are not easily definable concepts given that what these are focusing on is the investor’s willingness or otherwise to invest – which is not always based on logic! Despite such difficulties, theprivate sector has over the past few years been hard at work creating “risk appetite indicators”to measure overall conditions for risk tolerance across currency and asset markets. Within theinvestment banks, JP Morgan created its “LCPI Index” Bank of America has its “Global HazardIndicator” and Salomon Smith Barney its “Instability Index”. For the purpose of an example,we will focus on the Instability Index. The index was originally created to track levels of riskappetite or conversely “instability” for fixed income investors. However, because it uses crossmarket indicators for this purpose, we can also use it for managing and trading currency risk.Risk appetite has become an increasingly important concept, not just because of the needto create more accurate models for forecasting short-term currency moves, but also becausethe last few years have shown a marked pick-up in cross-asset market volatility. Indeed, onecan go as far as to suggest that as the globalization of capital flows has proceeded, so volatilityhas increased. Risk appetite is essentially a capital flow event and its relationship is directlyproportional to the size of capital flows involved. For this very reason, just as capital flows acrossborders have grown exponentially, so the degree to which capital flows affect currency marketshas grown proportionately. A crisis in one country is no longer isolated but is transmittedinstantly around the global financial system. Investors who face losses in that one market mayseek to take profit on other positions in order to offset those losses, thus creating a dominoeffect in hitherto unrelated markets.Extreme bouts of cross-market volatility such as were seen in the wake of the ERM, Mexicanand Russian currency crises prompted interest in creating risk appetite indicators which, if notpredicting actual crises themselves, would at least be able to predict significant moves in terms
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of general investor risk tolerance. For this purpose, categories or levels of risk tolerance also hadto be created. The three generally accepted categories within most such risk appetite modelsfor this purpose are:
r Risk-seekingr Risk-neutralr Risk-aversionAs the focus of the Instability Index is on market volatility and “instability” for the purposeof alerting investors to such bouts of unwanted volatility, these categories can be modifiedslightly for the purpose of focusing on such instability:
r Stabler Neutralr UnstableWhen market conditions are perceived as stable according to the market indicators used by theindex, they are of necessity optimum for investors to be in risk-seeking mode. Equally, whenmarket conditions are unstable, this is synonymous with investor risk-aversion or avoidance.The focus for such an analytical tool has been the investor community. However, currencyspeculators and corporations can also use a risk appetite or instability indicator with which totrade or manage their currency risk.Using the context of the 1997–1998 crisis period, the Instability Index seeks to measurerisk appetite using leverage, credit spreads and cross-market (equity, fixed income and foreignexchange) options’ volatilities as its three benchmarks. The period of June 1997–September1998 accelerated the focus in trying to measure risk appetite as first the Asian countriesexperienced currency crises one after another and then Russia devalued and defaulted in August1998. Conceptually, everyone knew what it meant to be risk-averse, but measuring it wasanother matter, let alone trying to use that measurement to predict future phases of risk appetite.While investment banks needed analytical tools to track the overall risk appetite of clients acrossmarkets, particularly in times of stress, academics and policymakers also needed such a toolfor the purpose of measuring just how orderly or disorderly market conditions were in orderto help guide future policy responses. The Instability Index, which was formalized in 1999, isjust such a guide and includes three main components:
r De-leveraging – There are two parts to this. The first looks at the relationship in the currencymarket between the US dollar (as an equity-linked, higher yielding asset) and the likes ofthe Swiss franc (as a traditional safe-haven currency) and Japanese yen (as a low interestrate, funding currency). During times of market stress, the US dollar tends to lose groundagainst these as “leverage” or risk is cut. The second component looks at US and Europeanbank equities as a measure of market “leverage”.r Credit spreads – In the US dollar credit markets, this tracks the spreads between BBB ratedindustrial credits, emerging market Brady bonds and swaps to Treasuries, while it also tracksEuro swap spreads to Bunds. The overall reading gives a very good indicator of investorrisk-tolerance.r Implied volatilities – Across the three asset classes of equities, debt and currencies, trackingthree-month implied volatilities gives a good idea as to demand levels for option-relatedprotection structures from investors. Option implied volatility tends to rise more sharplyduring asset market slumps than when asset prices are rising.
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The advantage with the readings within this index is that they are relatively easily availableand updated daily. Thus, using these three components to represent the degree of “stability”or “instability” in the market, we can have a daily indicator of risk appetite, which can in turnbe used as a forecasting tool for currency markets.The parameters of these readings were set in large part by the global market crisis thathappened in the autumn of 1998. During that time, the Instability Index hit an all-time highof 95.6 on October 8, 1998. This crisis also lifted the index onto a higher plateau. Beforethe crisis, the index averaged 16.1 from January 1997 through July 1998. Since January 1999through mid-2001, the index averaged around 45, spending much of the time between levelsof 30 to 60. Since January 1997, the index has only spent 2.5% of the time above levels of60–65. At such levels, we would expect to see extreme volatility and price action and that isindeed what happened. If we analyse the history of the index from July 1998–October 2001 (seeFigure 2.2), we can clearly discern a corridor when market conditions have been in risk-neutralmode that is when they were neither stable nor unstable. Indeed, a majority of the observationsappear to have occurred in a corridor of between 40 and 50 according to this chart. By creatinga corridor for a risk-neutral stance, we can in turn create specific index parameters for both“risk-seeking/stable” and “risk-aversion/unstable” market conditions. Thus:
r Risk-seeking/stable: <40r Neutral: 40–50r Risk-aversion/unstable: >50In turn, if we compare this index with a number of exchange rates, we find an importantand specific correlation. During “risk-seeking/stable” market conditions, investors tend to buy1009080706050LAST; 38.9
403020100Jul-98
Dec-98
May-99
Figure 2.2 SSB Instability IndexSource: Citigroup.
Oct-99
Mar-00
Aug-00
Jan-01
Jun-01
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Table 2.1 Currency decision template using a risk appetite/instability indicator
Asset managers
Currency speculators
Risk-seeking/stable(<40) Neutral (40–50)
Risk-aversion/unstable (>50)
r Raise currency
r Reduce currency
r Eliminate currency
exposure to highcarry currencies
exposure to highcarry currencies
exposure to high carrycurrencies
r Buy high carry
r Close positions
r Short high carry currencies
currencies
r Short low carry safe
r Buy low carry safe haven
haven currenciesCorporations
r Hedge high carrycurrency strategically
currencies
r Only hedge highcarry currencyexposure tactically
r Only hedge high carrycurrency exposuretactically
credit product as opposed to Treasuries, equities as opposed to money market funds and inthe currency world high carry emerging market currencies as opposed to low carry “safehavens” such as the Swiss franc or Japanese yen. When risk appetite conditions shift from riskseeking/stable (below 40) in the index to neutral (40–50), many of these high carry currenciessuch as the Polish zloty, Hungarian forint, Slovak koruna, Mexican peso and Brazilian realtend to lose ground as investors become slightly more cautious, paring back their exposure.Frequently, the yen or the Swiss franc are used as funding currencies with which to buythese high yielders, hence as risk appetite is reduced so they tend to recover some ground aslong high carry/short funding currency positions are reduced. Finally, when market conditionsdeteriorate to the extent the index moves into “risk-aversion/unstable” territory (above 50),high carry currencies are cut across the board, to the increasing benefit of safe havens such asthe Swiss franc and the Japanese yen.The relationship between risk appetite and specific currency performance has been provenstatistically within academic research using correlation analysis. From this, we can come upwith a rough template for currency trading, hedging and investing decisions using the index(Table 2.1). Note that this is not meant to be an exact list of recommendations. As with anymodel, there will be exceptions. Rather, it is meant as a template against which specific currencyexposures should be measured on a case-by-case basis.There is actual fundamental grounding for using a risk appetite indicator for currency hedging, trading or investing. Since the end of the Cold War, there has been much greater emphasison tightening fiscal and monetary policies in order to bring inflation down. As a result, realinterest rates have been rising. In the developed markets, capital flows over the medium tolong term to those currencies with high real rates. The discipline associated with membershipof the EU and the Euro has exacerbated this process, and the same should happen in Centraland Eastern Europe ahead of accession to the EU. As a result of such global macroeconomicforces, the trend has been to hold high carry currencies in all conditions – risk-seeking/stableand neutral – apart from risk-aversion/unstable.The link between risk appetite or instability and currencies comes through capital flows andtherefore through the balance of payments. Countries with high current account deficits aredependent on capital flows and therefore dependent on high levels of risk appetite. Conversely,countries with current account surpluses are not dependent on capital flows or risk appetite.
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Therefore, during periods of risk-seeking, it should be no surprise that currencies whosecountries have current account deficits tend to outperform. Equally, during periods of riskaversion or avoidance, currencies whose countries have current account surpluses tend tooutperform by default as capital flows are reduced or even reversed.In the developed economies, currencies such as the US dollar, UK pound sterling, Australiandollar and New Zealand dollar are seen as risk-dependent currencies because of their currentaccount deficits. Conversely, currencies such as the Swiss franc and the Japanese yen are notdependent on risk appetite because they have current account surpluses and therefore are seenas “safe havens” in times of risk-aversion. This is not an exact science, because there areexceptions such as the Canadian dollar, which tends to prosper during periods of risk-seekingdespite the fact that Canada has historically run current account surpluses. Generally, however,within the developed economies the relationship between risk appetite and the current accounttends to hold.The principles that we have described here work for the developed market currencies. Theyalso work very well within emerging market currencies, albeit with some caveats. Emerging market economies and currencies have some specific characteristics which need to beconsidered when using a risk appetite or instability indicator:
r Most emerging market economies have current account deficits – Because of high capital
inflows, most emerging market economies run trade and current account deficits. As a result,most are risk-dependent, though one would assume this anyway.r Emerging market economies tend to have structurally high levels of inflation – Due toeconomic inefficiencies and higher growth levels, emerging market economies have tendedto be characterized by higher inflation levels.r Emerging market interest rates are more volatile – Capital inflows to the emergingmarkets are frequently substantially larger than the ability to absorb them without consequentmajor financial and economic imbalances. Such inflows artificially depress market interestrates until such time as economic imbalances become unsustainable, at which point thecurrency collapses and interest rates rise sharply. Thus, such inflows can cause substantialinterest rate volatility.r Political, liquidity and convertibility risk add to emerging market volatility – Politicsis no longer seen as a primary risk consideration within the developed markets, but it still iswithin the emerging markets however, given higher levels of political instability. Emergingmarkets are also considerably less liquid and some are not convertible on the capital account,both of which affect market pricing.These caveats notwithstanding, asset managers, leveraged investors or corporations can usea risk appetite instability indicator as a benchmark for managing or trading emerging marketas well as developed market currency risk. High carry currencies such as the Polish zloty,Hungarian forint, Brazilian real and Mexican peso tend to outperform when market risk appetite conditions are in risk-seeking/stable mode, while equally under-performing when marketconditions are in risk-aversion/unstable mode. Similarly, low carry emerging market currenciessuch as the Singapore dollar and the Czech koruna tend to underperform during periods ofrisk-seeking/stable market conditions and outperform during periods of risk-aversion/unstablemarket conditions.Neither the speculative cycle of exchange rates nor the risk appetite indicator is meantto represent exact science in terms of predicting exchange rates. They do however have theadvantage of focusing on capital account rather than trade flows, in line with the elimination
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of barriers to free movement of capital. In addition, they are specifically useful for focusingon short-term exchange rate moves, an area where the traditional exchange rate models falldown. Finally, the results can be used specifically rather than just generally and tailored to theindividual currency risk needs of asset managers, leveraged investors and corporations.
2.2 CURRENCY ECONOMICSSo far in this chapter, the focus has been on trying to create new exchange rate models based oncapital flows to try to improve forecasting accuracy. As necessary as this is, it does not meanwe abandon the traditional exchange rate models. Classical economic theory has provided thefoundations for exchange rate analysis. The purpose of establishing a framework known ascurrency economics is to be able to combine the new with the exchange rate models and useboth in a more targeted and focused way. Any major differences between this framework ofcurrency economics and classical economics are more methodological than ideological. Thetraditional exchange rate models, focusing as they do on such factors as trade, productivity,prices, money supply and the current account balance, help provide the long-term exchangerate view. Capital flow-based models are considerably more helpful and accurate in terms ofpredicting short-term exchange rate moves.However, these two types of exchange rate model should not necessarily be viewed as polaropposites. The very purpose of establishing a specific framework known as currency economicsis to create an integrated approach to exchange rate analysis, which is capable of answeringthe riddles of short-, medium- and long-term exchange rate moves. The two sides do have somecommon ground, and it should be no surprise that this common ground is to be found in thebalance of payments model – given that it focuses both on trade and capital flows. Within this,there are three specific analytical tools that should be of use to currency market practitionersin bridging the gap between short- and long-term exchange rate analysis:
r The standard accounting identity for economic adjustmentr The J-curver The REER2.2.1 The Standard Accounting Identity for Economic AdjustmentWe looked at this briefly in Chapter 1, but to recap it is expressed as:S−I =Y −E = X−Mwhere:S = SavingsI = InvestmentY = IncomeE = ExpenditureX = ExportsM = ImportsThis can actually be expanded by breaking down “savings” into public and private savingssuch that:(Sp + Sg ) − I = X − M
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where:Sp = Private savingsSg = Government savingsHere, government “dis-saving” reflects having a budget deficit. Thus, from this, we can seeimmediately that there is a possible link between a budget deficit and a trade deficit. If acountry’s budget deficit continues to rise, this is reflected on the left-hand side of the equationby an increasingly negative value for Sg . Unless this is offset by a rise in private savings or a fallin investment, this will eventually mean that the left-hand side of the equation turns negative.Of necessity in this circumstance, the right-hand side of the equation must also be negative,which in turn means that the country has a trade deficit. Thus, a budget deficit can lead to atrade or a current account deficit. The link is not necessarily automatic. However, it shouldbe assumed that widening budget deficits, if sustained over time, lead to widening trade andcurrent account deficits. If we extend this, we see that at some stage widening current accountdeficits will become unsustainable, requiring a real exchange rate depreciation. Thus, wideningbudget deficits may eventually require real (and thus nominal) exchange rate depreciation.Economists are not generally thought of as prone to high emotion. Yet, one has to say thatthe accounting identity is like a work of great art, hiding great intricacy and complexity behindthe veneer of apparent simplicity. From this accounting identity, we can see how economiesadjust to changes in fundamental conditions and therefore how exchange rates should adjustto those conditions. Again, this is probably best shown through an example.Example 1For the purpose of this exercise of showing how the accounting identity can work in practice,imagine a purely theoretical example whereby you are the corporate Treasurer of a SouthAfrican mining company. For argument’s sake, the company mines and exports precious metalsto Europe, the US and Asia. Of course, those precious metals are for the most part priced inUS dollars. However, the company is based in South Africa, thus its export revenues are inUS dollars and its cost base is in South African rand. This may be an oversimplification butlet’s assume for the sake of this example that it is the case. In terms of currency risk, theTreasurer’s main decision is whether to hedge forward receivables or alternatively allow themto be translated at designated intervals depending on exchange rate developments. In thisspecific example, it has to be pointed out that South African exporters have a regulated limitof a period of 180 days with which to repatriate export receivables.If we look back at the first half of 2001, South Africa was recording tremendous tradesurpluses, which is to say that the balance of exports to imports was robustly positive to thetune of over 20 billion rand in that period. Using our accounting identity, this can be expressedby:(Sp + Sg) − I = +ZAR20.5 billionJust as the right-hand side of the equation is strongly positive, so the same must be the case forthe left-hand side. Thus, the inescapable conclusion from this is that the sum of (Sp + Sg ) mustof necessity be considerably higher than I . At the same time, South Africawas actually runninga budget deficit of around 2% of GDP. This represents government dis-saving, meaning thatSg is actually negative. Thus, we can in turn extrapolate from this that either South Africa’sprivate savings (Sp ) had become extraordinarily high or investment (I ) was either low or
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negative. Those familiar with the South African economy know that low private savings hasbeen a perennial structural weakness of that economy. Thus, the first suggestion is extremelyunlikely. If we accept this, then in turn we must conclude from the accounting identity that lowor negative domestic investment (I ) in South Africa was the reason why the left-hand side ofthe equation was also strongly positive.While precious metal exports have declined as a percentage of total South African exportsin recent years, they still make up a considerable proportion at around 15%. Thus, the risingoverall trade surplus may also reflect rising precious metal exports. Our corporate Treasurer,seeing mounting export receipts in US dollars, may presume that the sheer weight of the risingtrade surplus may cause the rand to appreciate. If he or she does so, they may in turn decideto sell US dollars forward for rand to lock in at favourable levels and avoid having to hedgeforward later at slightly less favourable levels. However, this may not in fact be the rightdecision to take. If we look again at the accounting identity in this specific example, we seea picture of low or negative domestic investment in the economy. Domestic investment in aneconomy is not the same concept as inward portfolio or capital investment. However, we mayassume that if domestic investment is low or negative, inward investment is also likely to below or negative. A currency market practitioner thinks not just in terms of trade or capitalflows, but rather in terms of total flows going through the market; the common ground betweenthe new capital flow-based and the traditional trade flow-based exchange rate models. Thus, inthis example capital flows may be low or negative, potentially offsetting the positive impact onthe rand of trade flows. As a result, the corporate Treasurer should think twice before hedgingby selling US dollars for rand until such time as they have to since any trade-related benefit tothe rand may be offset by investment-related losses.In practice, the dollar–rand exchange rate traded in a relatively tight range through the firsthalf of 2001, apparently confirming that net positive trade flows were offset by net negativeinvestment outflows. Subsequently, of course, South Africa’s trade balance swung from asubstantial surplus to an even more substantial deficit due to the combination of strong domestic demand, boosted by loose monetary policy, and weak external demand. With domesticinvestment rising but inward investment still weak, those net negative trade flows becamethe dominating factor in subsequent rand weakness. From August 2001 through to the end ofthe year, the rand fell from around 8 to the US dollar to a low of 13.85. Ill-informed peoplehave said it was due to speculation. The truth is somewhat less sinister, which is that it wasdue to fundamental factors at work that were evident within the standard accounting identityfor economic adjustment.This is an example of how a corporation can use the accounting identity to analyse theircurrency exposures. For good measure, we should try the same exercise for an investor.Example 2An institutional investor may also be concerned with currency risk, albeit from a slightlydifferent perspective. Instead of mining precious metals out of the ground, our investor may bebuying a portfolio of international equity and fixed income securities. Whether our investor likesit or not, the very act of international investment automatically assumes not only currency riskbut also a specific currency view. What do I mean by this? If an investor in the UK decides to buya 10-year US Treasury note, in order to do that they have to buy US dollars. In market parlance,they are whether they like it or not “long dollars, short sterling”. If during the time in whichthey hold the investment, sterling falls against the dollar, this is a very favourable development,
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which should help enhance the total return of the investment. Why? Because when the US dollarproceeds are translated back into sterling, a fall in sterling against the dollar means that thedollar is worth more sterling. The ensuing currency profit should thus boost the total return.Say, however, that sterling actually appreciates significantly against the US dollar. In thiscase, any profit earned on the original investment in the US Treasury note may be reduced oreven eliminated when the proceeds are translated back into sterling. The rise in sterling wouldmean that the US dollar proceeds would now be worth less sterling when translated. Seasonedinternational investors are of course well aware of such considerations, but however basicthe example it is worth restating. Currency risk is not always a consideration of internationalinvestors, but it should be if they are concerned with the total return of their portfolio.Returning to our accounting identity, let’s consider an example, in this case the US in thesecond half of 2001. In social and human terms, the tragic events of September 11, 2001 causedtremendous grief and sorrow. They also had substantial economic impact, though that of coursewas not the immediate consideration. Using the accounting identity for economic adjustment,let’s try and get a better idea of what was happening in the US at that time. Recapping theidentity:S−I = X−MA UK investor looking at the US economy during the first half of 2001 saw that the UScontinued to run significant trade deficits. In other words, the right-hand side of the equationwas substantially negative (to the tune of around USD160 billion). Equally, our investor wouldbe able to assume that the left-hand side of the equation was also negative. At the time, theUS was still running budget surpluses, so the combination of (Sp + Sg) was positive, meaningthat the culprit for the trade deficit was booming investment. This also reflected boominginward investment, more than offsetting the massive trade deficit. As a result, the US dollarrose substantially during the first half of 2001.From July 2001 however things changed. Market participants began to question the abilityof the Federal Reserve under Chairman Alan Greenspan to engineer the economic recoverymiracle that everyone had been hoping for. Declining domestic demand in the US meantdeclining import demand. In terms of the accounting identity, this meant that M was decliningrelative to X , in turn reducing the trade deficit. This is indeed what we saw during the secondhalf of the year, even before September 11. The US trade deficit shrunk from over USD30 billiona month to around 25 billion, a decline of over 16%. On the left-hand side of the accountingidentity, as M fell relative to X on the right-hand side, so I declined relative to S. Lowerdomestic investment would surely be reflective of lower inward investment. Again, this isexactly what happened in practice. Domestic corporate investment was already falling sharply.In line with that, inward investment fell sharply. The improvement in the trade deficit was nota sign of economic improvement, but rather a reflection of a fall in import demand. As onemight expect, the other side of the equation shows a fall in investment growth.Such information could potentially be very useful for our investor. The immediate assumption is that a reduced trade deficit should be good for a currency, but this is not necessarily so.Indeed, in this case the fall in the trade deficit was due to a fall in import and domestic demand.It was a sign of economic weakness. Moreover, lower domestic investment also meant lowerinward investment. In practice, this meant that inward investment fell below the level of thetrade deficit. As a result, the dollar fell across the board. Sterling rose against the US dollar. Ifour investor had analysed the situation using the accounting identity, they may have been able
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to hedge that exposure to a rise in sterling against the US dollar, thus avoiding a currency lossto the portfolio’s total return.The purpose of both of these examples has been to show how currency market practitioners can use a key tool of currency economics, the standard accounting identity of economicadjustment, to manage their currency risk.2.2.2 The J-CurveThis is a particularly useful concept because it deals with that frustrating delay between thechange in the exchange rate and the adjustment to the economy. Equally, it deals with bothtrade and capital flows. Suppose international investors have been buying the equity and fixedincome securities of an emerging market economy such as Korea. For some reason, thoseinvestors “lose confidence” in the Korean economic story and as a result the Korean won.What does that mean? In practice it means that international investors all try to sell at the sametime. However, if investors all try and sell at the same time, chances are their orders will notbe filled. The Korean won will fall like a stone, but on very little actual volume.Classic economic theory suggests that a fall in the nominal exchange rate should lead to areduction in the current account deficit by making imports more expensive and exports cheaper.However, this assumes that the transmission mechanism from the exchange rate to export andimport prices is immediate. We know however that this is not the case. Corporations tend totake a wait-and-see attitude in times of market distress, delaying major price changes untilfinancial and economic conditions become clearer. In economist jargon, as we saw in themonetary approach to exchange rates, prices are “sticky”. Thus, in our example the Koreanwon may fall without any immediate benefit to the trade and current account balances. This isnot completely a hypothetical example because this is exactly what we saw during the Asiancurrency crisis of 1997–98. Then, a crisis in Thailand focused investor concerns on much ofthe rest of Asia, triggering a general loss of confidence in Asian assets and currencies. Asiancurrencies collapsed but on far