happens in reality because this simple model of productivity(supply) growth and wage (demand) growth does not take account of the very modern conceptof debt. Inadequate demand growth in the form of wages can be artificially propped up tomeet ever-increasing supply growth in the form of productivity through debt or borrowing.Eventually, of course, the gap between supply and demand becomes too wide even for debt to
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bridge. When that happens, supply crashes. At the microeconomic level, faced with a massiveinventory overhang, companies cut costs and the easiest way of doing that is to cut jobs.Demand falls as well. This is how financial crashes happen, whether we are talking aboutJapan in 1990 or the US in 2000. Does this automatically lead to an exchange rate reaction?Not necessarily so. After all, the yen continued to rise for another five years after the “bubbleeconomy” burst. Similarly, the US dollar has continued to rise despite the bursting of the“internet bubble economy” in 2000. Some explanation for this can be given by the fact thatproductivity rates have remained extremely high in the US – as they did in Japan – despite thefinancial and economic distress that has been seen in the last two years. What we learn fromthis however is that productivity growth appears to be in part cyclical in nature, in so far asit does not go on for ever but instead reaches unsustainably high levels which lead ultimatelyto a violent correction. The bursting of a productivity bubble should eventually lead to lowertrend productivity growth for a period of time and higher prices, thus requiring according toPPP an exchange rate depreciation to offset this price disparity under the law of one price. Thisis of course not what we have seen in Japan to date. Instead, debt/GDP has continued to riseinexorably as the real interest rate has consistently exceeded the real GDP growth rate. Therising debt burden, along with the rising real interest rate, has acted not only to keep a lid onprice growth but also to cause actual price deflation. Under PPP, if anything this should lead toyen appreciation, which is of course the last thing Japan needs. Turning to the US, corporateand consumer debt levels are extremely high. For now however, productivity growth remainsextremely high as well, certainly higher than the EU. Both of these factors support the ideathat the US dollar should remain a strong currency near term.In Figure 1.2, we again use the Euro–dollar exchange rate, this time compared with relativeproductivity growth levels. As the figure shows, there is an important relationship between3.501.353.00EUR/USD (LHS)1.25
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Euro-zone 12 [inc. GR]: YoY Productivity Employee at 1996 Pr/Each Rates(SA, Thous, US$)US: YoY Nonfarm Business Sector: Output Per Hour, All Persona (SA, % Chg. Yr. Ago)
Figure 1.2 Euro–dollar exchange rate vs. relative productivity growth levels
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Sources: FERI, BLS
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the two, though admittedly the degree of correlation has declined sharply for periods of time.In this regard, relative productivity growth levels are an important indicator of exchange ratedirection, but apparently not capable of providing a more sophisticated analysis in terms ofeither the timing or degree of the chosen direction.
1.5 THE PORTFOLIO BALANCE APPROACHHaving dealt so far with the relative price of goods, money, interest and current/capital flows,the last model we will look at in this chapter deals with the relative price of assets. This is thePortfolio Balance Approach and it deals specifically with the relationship between the relativeprice of domestic and foreign bonds and the exchange rate. Within this model, it is presumedthat a change in monetary and/or fiscal conditions will in turn lead to changes in the supplyand demand for domestic currency bonds and the demand for foreign currency bonds, whichwill in turn trigger a reaction in the exchange rate between the two currencies.On the monetary side, assume that a cut in interest rates by the central bank causes outflowsfrom domestic interest rate-bearing securities into money/cash, as per the Monetary Approachwe looked at earlier. If one assumes for the sake of this simple model that domestic bondsupply is unchanged, demand for those bonds should be reduced because of the lower interestrate. This effect should cause increased demand for the foreign currency bonds, which in turnshould cause the domestic currency to depreciate against the foreign one. Equally, if one startsfrom the premise that the central bank raises interest rates, this should, according to this simplemodel, cause a domestic currency appreciation.Looking at this question from the fiscal side, assume that a government expands fiscal policyin the face of an economic downturn. In terms of the domestic bond market, this should leadto an increase in domestic bond supply. Holders of existing domestic bonds will only supportsuch an increase if it leads to a higher interest rate to compensate for the increased supply.Thus, increased domestic bond supply should eventually result in increased domestic bonddemand, reduced foreign currency bond demand and an appreciation in the domestic currencyagainst the foreign currency. Similarly, according to this model, decreased bond supply shouldeventually lead to depreciation in the domestic currency due to outflows by investors in favourof foreign bonds.This Portfolio Balance Approach appears overly simplistic and it is. Indeed, it has been avery poor predictor of exchange rates, not least because it does not deal with the real-worldrealities of a fixed income fund manager who has to make asset allocation decisions.ExampleAssume for argument’s sake that our fixed income fund manager invests only in US Treasuries and Japanese government bonds (“JGBs”). The Portfolio Balance Approach assumesmoney/cash is not interest bearing, but this is not in fact true. Thus, the fund manager can alsohave a cash allocation, which he/she can put on a modest deposit rate. The fund manager startsthe year with a 60% allocation in US Treasuries, 35% in JGBs and 5% in cash. If the FederalReserve cuts interest rates, our fund manager does not immediately reduce his/her allocationin Treasuries in favour of JGBs as the model assumes. Much depends on the relative policymixes in the US and Japan and also the prevailing nominal and real interest rate differentialsbetween the two countries. There are far too many uncertainties within this situation for us to
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be able to assume that JGBs would automatically be favoured over US Treasuries due to a USinterest rate cut. If Japanese interest rates are already substantially below those of the US, oneUS interest rate cut might make no difference whatsoever to the asset allocation. Therefore,one cannot assume that the US dollar would fall against the Japanese yen.Looking at this from a fiscal policy perspective, again let’s suppose that the governmentexpands fiscal policy in order to boost a flagging economy. This implies increased bond supply.If we assume that this economy is that of the US, then our fund manager has a dilemma.Increased bond market supply will of necessity push interest rates higher – and bond priceslower. Depending on where the fund manager is positioned along the US Treasury curve, thismay result in painful losses. Thus, if anything the fund manager may in fact initially reducehis/her allocation in US Treasuries. In our example the fund manager can only invest in USTreasuries, JGBs and cash. As this example assumes a change in US fiscal policy but not USmonetary policy, the fund manager may reduce his/her allocation initially in US Treasuries infavour of JGBs. Thus, assuming for the purpose of this example that our fictional fund managerrepresents the entire universe of institutional investors, the exchange rate reaction may at leastinitially be the complete opposite of what the Portfolio Balance Approach suggests.Clearly, where theory and practice meet is not in the short-term reaction but in the long-termtrend. A trend of rising domestic interest rates relative to foreign interest rates will attractrising foreign demand for domestic bonds and therefore in turn cause a domestic currencyappreciation relative to the foreign currency. Equally, rising bond market supply should on atrend basis have the same exchange rate reaction by causing bond yields to rise, thus attractingincreased foreign investor interest. Both of these exchange rate reactions may occur over thelong term. Thus, we can use this approach, as with the Mundell–Fleming model, to explainthe inexorable strength of the US dollar in the 1980–1985 period.Over the short term however, what we may see is in fact the complete opposite exchange ratereaction. Indeed, the very concept of short term is subjective as such “disparities” relative to themodel can go on for years. For instance, between 1996 and 2000 the US dollar rose dramaticallyagainst its major currency counterparts, despite tight fiscal policy and varying degrees of loosemonetary policy. This should, according to both the Portfolio Balance Approach and theMundell–Fleming model, have produced exchange rate depreciation, yet it did not. Indeed, itproduced the complete opposite. Clearly, the model does not take account of such issues asexisting investor positioning and the degree of policy credibility (which may cause investorsto be more eager to buy a bond than simple yields would otherwise imply).Thus, to summarize the Portfolio Balance Approach, use it sparingly in trying to determine orpredict exchange rates and only for long-term trends. Furthermore, use it from the perspectiveof asset allocation. As fiscal policy expands, investors will gradually, after a suitable intervalto allow for the rise in bond yields, increase their asset allocation in the bonds of that country,assuming that those bonds are already within their benchmark index. Thus, as Japanese fiscalpolicy has been expanded in the 1990s, so investors have increased their asset allocation ofJGBs. This may be considered a further reason for the yen’s appreciation from 1990 to mid1995, but not thereafter as it fell back. Note however that such asset allocation shifts are alsocyclical in nature, as they will be increased within a particular bond market to the extentthat monetary and fiscal policies are perceived as credible. When they are no longer seen ascredible, not surprisingly the asset allocation shift goes into reverse. For instance, in 2001 andearly 2002 investors started to perceive Japanese fiscal policy as out of control, causing mostto reduce their JGB weightings and some to remove JGBs entirely from their portfolio.
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1.6 SUMMARYTo conclude, the traditional exchange rate models, which are based on some form of equilibriumvalue, do offer an important and useful long-term guide towards exchange rate prediction.Indeed, without these long-term signposts, currency strategists might be quite lost in seekingto predict exchange rates past one year out. As a result, in terms of their usefulness to specifictypes of currency market practitioner, corporations, strategic “real money” investors or “macro”hedge funds with a multi-month or even multi-year perspective would probably find them mostvaluable as an analytical tool. On the other hand, these traditional exchange rate models areunlikely to be of more than passing interest or use to short-term speculators or interbank dealerswhose time frame is far shorter. Lastly, it is a major theme of this book that currency analysisand strategy should be part of an integrated approach, involving the simultaneous use of severalanalytical disciplines. The apparent weaknesses of traditional exchange rate models, I wouldsuggest, adds to this case that such an integrated currency strategy framework be adopted.It has to be said that to date, when faced with the unsatisfying results that the traditionalexchange rate models have produced as far as predicting exchange rates is concerned, theeconomic community has for the most part either ignored these inconvenient results or declaredthat it is impossible to forecast short-term exchange rate moves as they are determined by theso-called “random walk” theory. Occasionally, there has been a paper, illuminating in bothits honesty as well as its intellectual acumen, which has “fessed up” to both the failure ofthese models as predictive tools and a lack of understanding as to why that may be the case.The majority of the time, however, the reaction to the obvious question has been denial orthe random walk excuse. According to the latter, since traditional exchange rate models donot appear able to predict short-term exchange rate moves, it must follow logically that suchshort-term exchange rate moves cannot in fact be predicted at all and must therefore followa “random walk” path, suggesting an equal probability of appreciating or depreciating overtime. Fortunately, however, recent developments in technical and capital flow analysis haveachieved significantly better results in predicting exchange rates than the random walk wouldimply. Thus, the correct approach to analysing and predicting exchange rates would seem to beto use market-based approaches such as technical and flow analysis for short-term exchangerate moves and the traditional exchange rate models for medium- to long-term predictions.This is certainly not the whole story in trying to create an integrated framework for analysingcurrencies, but it forms a good start in our understanding of how we should approach exchangerates.Building on this, going forward, it seems logical to assume that traditional exchange ratemodels should be modified to suit the modern structure of currency market flows. More specifically, trade flows, which form the premise behind the PPP, Balance of Payments and ExternalBalance Approaches, were once seen as the main driver of currency market overall flow. However, nowadays, they make up only around 1–2% of the USD1.2 trillion in daily volume goingthrough the currency market. Hence, as the overall importance of trade to total market flowhas declined, so to a degree has the relevance of those exchange rate models that rely solely onshifts in trade flow patterns. Meanwhile, just as the pre-eminence of trade flows has declined,so the importance of portfolio flows has grown exponentially as barriers to capital have beenlifted over the past two decades. The Portfolio Balance Approach is clearly an attempt to focuson asset markets and specifically the bond market as a driver of exchange rates, yet this modelremains unsatisfactory as a predictor of exchange rates for the reasons given. In order to try toget to a better answer of exchange rate movement over the short term, we have to define the
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main flow drivers of exchange rates:
r “Speculative” flow (without an underlying attached asset)r Equity flowr Fixed income flowr Direct investment flowr Trade flow
By far, speculative flow is the main driver of exchange rates over the short term. It is notsufficient to suggest that speculative flows follow a “random walk” for the simple reason thatboth technical and flow analysis have discovered consistent patterns in short-term exchangerates which should not exist under random walk theory. Within asset market flow, equity andfixed income flows continue to do battle for pre-eminence. For instance, from 1998 to mid2000, net inflows to the US equity markets were a key driver of dollar strength. Equally, as theUS equity market began to falter, the resulting equity outflows from the US market weighed onthe US dollar. Eventually, however, these flows were more than made up for by fixed incomeinflows to the US fixed income markets as the Federal Reserve continued to cut interest ratesto support the economy. Direct investment is also an increasingly important driver of exchangerates, both in the developed economies and in the emerging markets, as barriers to inwardinvestment have also fallen away. In 2001, the top five performing currencies in the worldagainst the USD were the Mexican peso, Polish zloty, Czech koruna, Hungarian forint andPeruvian sol, all of which benefited from substantial direct investment inflows which had asignificant impact on their exchange rates.The importance of all of these flow types continues to fluctuate in line with market trends.What is clear however, is that until there is a specific exchange rate model which focuses onthe main flow dynamic of the currency market, namely speculative flow, it is unlikely thatexchange rate models in general will be able to improve upon their current accuracy to anysignificant degree. In the next chapter, this is in fact what we will try and do – to build a simpleexchange rate model, which focuses on speculative flow. In addition, we also examine howto use “currency economics”, or the bits of economic theory that are relevant to the currencymarket, in a practical manner for currency forecasting, trading and investing.
2Currency Economics: A More FocusedFrameworkIn the previous chapter, we had a pretty detailed look at traditional exchange rate models.Significant research went into these models and indeed they are valuable in trying to predict long-term exchange trends. Where they fall down is their ability to predict short-termmoves.The reaction of economists to this realization in truth has been mixed. Of late, however,there seems to have been a gradual recognition that a greater focus is needed in applying thegeneral rules of economics to the specific dynamics of the currency market. For want of abetter term, I have called this greater focus “currency economics”. I should say at the outsetthis is not an attempt to create an entirely new field of currency analysis. Rather, it is tocreate a more focused framework, using those existing economic principles that are relevantto the currency market and when necessary adding on other analytical disciplines to providean integrated approach to currency analysis. After all, analysis is the means to an end. Itshould not be viewed as the end in itself. A certain degree of flexibility is needed to modifythe theory to fit better the practice. As John Maynard Keynes himself is reputed to have said,“When things change, we change”. To a trader, this is only common sense. However, to themodern economic community, such flexibility appears frequently elusive. Further, while themore flexible economists have pondered how to make the traditional exchange rate modelsmore accurate in predicting exchange rate moves, other disciplines appear to have got therebefore them. To a considerable degree, technical and flow analysis have succeeded whereclassical economics has yet to. We will look at these in detail in Chapters 3 and 4, but for nowthe point has to be acknowledged that these disciplines have had success precisely becausethey have focused on solving the problem of predicting short-term exchange rate moves.Yet, if exchange rates are only subject to random walk theory over short-term periods, howcan this be so? The answer is obvious and it is this – they are not subject to random walktheory, but instead can over short time periods demonstrate clear and identifiable patterns,patterns that can be used to predict their movements. This is not to say they will be predictedevery time, but it is to say trying to forecast short-term exchange rate moves need not be theequivalent of a blind monkey throwing a dart at a dartboard, as random walk theory mightsuggest.Suggesting that other types of analysis have succeeded to a degree in predicting short-termexchange rate moves does not mean we abandon the attempt to improve economic analysis tomake it better able to do the same thing. To do this however, we have to get past the stage ofrelying solely on the traditional exchange rate models and focus more on the specific dynamicsof the currency market. Only when we understand these can we hope to get measurably betterresults in applying economic analysis to the prediction of short-term exchange rates. Beforethat, we need to have a much better idea of the specific dynamics that are at work in the currencymarket itself.
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2.1 CURRENCIES ARE DIFFERENTThe first thing to say about the currency market is that it possesses and obeys a different set ofdynamics to other financial markets. Unlike in the case of equity or fixed income markets, thevast majority of currency market practitioners are speculators of one sort or another. Globalmerchandise trade going through the currency market makes up around 1–2% of total volume.Let’s say we more than double that to allow for foreign direct investment, making a volumecontribution of around 5%. Asset market volumes have risen sharply over the past 20 yearsas barriers to capital have fallen. Having made up only a small proportion of currency marketvolume before the end of the Bretton Woods exchange rate system, they probably now makeup as much as 35% of total currency market volume on a daily basis. That still leaves 60% ofdaily currency market volume, which has to ascribe to “speculation”. Granted, these are veryrough, back-of-the-envelope figures, but they give a good idea of the proportions that areinvolved. Given this, is it any wonder that many of the traditional exchange rate models thatare based on the current account and therefore on trade flows are poor predictors of exchangerates over the short term?! Equally, this gives some clue as to why the portfolio balance approachto exchange rates also achieves unsatisfactory results.2.1.1 (In)Efficient MarketsAs we know from Chapter 1, economic theory approaches the issue of exchange rates by tryingto find a theoretical equilibrium level, against which one can measure over- or undervaluationrelative to the actual exchange rate. Such theory relies on a number of important premises withregard to the information that might affect exchange rates:
r Exchange rates reflect all available knowledge at any one timer There is perfect knowledge dispersal (such that no-one has an advantage)While it is debatable whether or not these exist in other financial markets, we do know that theseare not the reality in the currency market. Many people think of the currency or FX market asthe “perfect market”, being that in which knowledge dispersal is optimum and which respondswith perfect efficiency to stimulus. This simply isn’t the case. Information is not perfect andsome market participants can indeed gain a knowledge advantage over their counterparts. Whyis this so?
r The sheer weight of information affecting exchange rates at any one time is so huge that allcurrency market practitioners cannot possibly absorb all of it all of the time.
r Knowledge dispersal is not perfect and some do have an advantage over others. Such advantages may include knowledge about specific flows that may occur, a bank’s own “orderbook” and finally the ability to do larger currency market transactions than other marketparticipants.If knowledge is power, then such power in the currency market is not distributed equally. Thisis no accident. Indeed, it is the very intention of normal and healthy competition to try to gainadvantage over other market participants. While news information has never been as freelyavailable as now, at some point that very availability swamps the ability of the users of suchinformation to absorb it all. To some, we appear closer to a state of perfect knowledge than wehave ever been, yet I would liken this to the speed of transportation. In 1900, the average speed
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of the leading mode of transportation in the city of London (the horse) was 11 miles an hour.In 2000, the average speed of the now leading mode of transportation (the turbo fuel-injectedcar) was . . . 11 miles an hour. Progress begets more progress until you progress so far that yougo nowhere. The more information that is available to us, the less we actually have the time(or the willingness) to read. If the good news is that we are closer to perfect knowledge thanwe have ever been, then the bad news is that we are never likely to get there!Information costs money to deliver and therefore there is not “perfect” information deliverybecause not everyone gets it, either at all or at the same time. Even if it were free, “informationoverload” still means that not everyone reads and uses it at the same time. If you don’t believeme, just think of your e-mail inbox! In sum, there is neither perfect information nor perfectinformation dispersal – and there never will be. In response, an economist might argue that wehave “good” information, if not perfect information. It would be tough to argue with this, butthen “good” is not “perfect” and “perfect” is a necessary aspect of the equilibrium concept.Furthermore, this supposed equilibrium level is rarely ever reached. Real life is surely a constantstate of flux and imbalance, so why should financial markets be any different? In turn, if oneassumes that the economic fundamentals that can affect exchange rates are themselves in aconstant state of flux, one must equally assume that the equilibrium itself is in a constant stateof flux – which to an extent calls into question the idea of it being an “equilibrium” in the firstplace. In truth, it is a signpost on a road. It points you in the right direction, but it gives you noidea of when you will get there or where you might have to turn off along the way.2.1.2 Speculation and Exchange Rates: Cause, Effect and the CycleAs with the supposed efficiency of markets, which does not actually work in practice, so thereis the idea that supply and demand are completely independent of one another. If this were so,price trends could not exist because markets would instantly work to eliminate any supply ordemand imbalances. The fact that this does not happen and that price trends do occur suggeststhat there are lags, sometimes substantial lags, before such imbalances can be eliminated. Inaddition, supply and demand are not completely objective concepts. Rather, at least in part,they reflect the views expressed by those market participants that make up that supply anddemand. In other words, supply and demand are both cause and effect.So much for the theory, what does this mean in practice? Actually, to a market practitioner,these ideas are relatively obvious. Currency interbank dealers know full well that particularflows will have more effect than others and thus will materially affect the supply/demanddynamics. Say a large multinational corporation transacts an end-of-quarter hedge in the Euro–dollar exchange rate. Granted, this is the most liquid currency pair in the world, but if the flowis large enough it may affect both current market pricing and future market thinking. Of coursethe term “future” means different things to different people. To the multinational, it meansmonths at least if not years. To the interbank dealer transacting the flow in the market place itmeans minutes or hours at most. Currency markets are essentially flow-driven over short timeframes, and therefore it is vital to understand the relationship between supply and demanddynamics.Just as supply and demand are not independent of one another and are both cause andeffect, so the relationship between “speculation” and economic fundamentals is also not justone-way. Economic theory requires that markets eliminate “speculative excess”, thus restoringequilibrium. However, we have already established that “equilibrium” is actually a moving
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target. If the “speculative excess” is the extent to which markets diverge from equilibrium,then that “speculative excess” is also a moving target. Finally, the presumption of economistsis that economic fundamentals drive market pricing and thus to an extent speculative excess.Even if we accept this, it has also to be acknowledged that speculative excess can in turn affecteconomic fundamentals. This is best proven by example.ExampleLet’s use an example from the emerging markets. From October 2000 through June 2001, thePolish zloty was one of the top three strongest currencies in the world, powering ahead on theback of the irresistible combination of portfolio and direct investment inflows. It is probablysafe to assume that on the back of this trend – said trend proving that supply and demandare not independent – speculative flows also bought the Polish zloty to profit from anticipatedcapital and carry gains. Here, we define “speculative” flow as that which has no underlyingcommercial or financial market transaction behind it but instead is purely a currency markettransaction for the purpose of a directional bet. For our example, we have used the Polishzloty’s “basket” value, which is made up of 55% Euro and 45% US dollar against the zloty.In Figure 2.1, the apparent “downtrend” in the Polish zloty against its basket actually represents currency appreciation rather than depreciation. It should be immediately obvious fromthis chart that the Polish zloty has been a highly volatile currency over the last few years.Equally clear should be the idea that as the Polish zloty has gradually “fallen” on a trend basistowards the right-hand side of the chart, so this reflects trend appreciation. As the price trendlasted for so long – October 2000 to June 2001 – then we should assume that this trend isfundamentally based. If this were not so, one must presume it would have ended a lot morequickly as an increasing number of market participants would have viewed it as unjustifiable.Yet, this trend of Polish zloty appreciation took place over a period of some nine months,apparently confirming that the sum of currency market participants viewed it as fundamentallyjustified.To return to the theory, this states that exchange rates may diverge from their equilibriumlevels, that speculative excess is responsible for this and that resulting extreme (under- or over-)valuation relative to the equilibrium will be corrected over time due to economic fundamentals.In our Polish zloty example, we see a rather different picture. In 2000, the Polish economy wasstill relatively strong, growing by 4.0%. In addition, Polish interest rates were still extremelyhigh at around 20%. Investment flow seeks out the highest returns available and thus we mustassume that strong growth and high interest rates were powerful incentives for both fundamentaland speculative inflows into Poland at the time. For this purpose, we define “fundamental” flowas that related to underlying financial or commercial transactions – stocks, bonds, trade anddirect investment.Yet, those same high growth and interest rate levels, which were attracting large capitalinflows, also reflected a significant tightening of monetary conditions by the National Bank ofPoland to temper inflationary pressure. There are two aspects to overall monetary conditions.There is the cost of money – the interest rate – and the price of money – the exchange rate. Asa currency appreciates, this also reflects a tightening of overall monetary conditions. Thus, inthe last quarter of 2000, we had a situation whereby interest rates were extremely high and thePolish zloty also appreciated significantly. In effect, monetary conditions were tightened twice!The combination of interest rate- and exchange rate-related tightening of monetary conditionshurt Poland’s economic growth, triggering a recession the following year in 2001.
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Figure 2.1 Polish zloty basket chart (up-moves reflect depreciation, down-moves appreciation)Source: Reuters.
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However, to accept this fact is also to accept the suggestion that currency moves and this“speculative excess” can actually affect economic fundamentals, that they can both be causeand effect, as is the case with supply and demand. Looking at this example, we can alsosee that the way “speculative excess” affects economic fundamentals follows a clear anddiscernible pattern. Indeed, if we compare how Poland’s economy performed relative to thetrend in currency appreciation of the Polish zloty, we see the following pattern or “cycle” atwork:
r Fundamental market participants (e.g. corporations and asset managers) apparently deemedPolish zloty fixed income securities as good value around October 2000 and started buyingthem on a sustained basis, creating a trend in the Polish zloty itself.r As the zloty continued to appreciate, this tightened overall monetary conditions even further,in addition to already high interest rates. Meanwhile, the longer the zloty trend continued themore self-perpetuating it became, with speculators joining their fundamental counterparts,anticipating more or less guaranteed returns.r However, the longer the Polish zloty’s trend appreciation continued, the more monetaryconditions were tightened and the more this hurt Poland’s economy. Exporters were hurtby the increasingly uncompetitive currency, while the domestic economy was hurt by highborrowing costs and cheap imports resulting from the currency’s strength.r As the currency trend extended and continued therefore, fundamental market participantsbecame increasingly concerned about economic fundamental deterioration in the form offading economic growth and widening current account deficits, and thus increasingly startedto take profit on their positions.r For a time, this fundamental selling was more than offset by speculative buying. Eventually,however, the combination of increasing selling pressure and clear and increasing evidence ofmajor fundamental deterioration in the Polish economy proved