enceto the “animal spirits,” that elemental force that drives financial markets in herd-like fashion,he was referring to the stock market. More than most, he should have defined such a termas he was one himself, having been an extremely active stock market speculator as well asone of the last century’s most pre-eminent economists. However, he might as well have beenreferring to the currency market, for the term sums up no other more perfectly. A market thatis volatile and unpredictable, a market that epitomizes such a concept as the “animal spirits”surely requires a very specific discipline by which to study it. That is precisely what this bookis aimed at doing; providing an analytical framework for currency analysis and forecasting,combining long-term economic valuation models with market-based valuation techniques toproduce a more accurate and user-friendly analytical tool for the currency market practitionersthemselves. In terms of a breakdown, the book is deliberately split into three main sectionswith regard to the currency market and exchange rates:
r Part I (Chapters 1–4): Theory and Practicer Part II (Chapters 5 and 6): Regimes and Crisesr Part III (Chapters 7–10): The Real World of the Currency Market PractitionerWe begin this process with Chapter 1 (Fundamental Analysis: The Strengths and Weaknesses of Traditional Exchange Rate Models), which as the title suggests examines the contribution of macroeconomics to the field of currency analysis. As we have already seen brieflyin this Introduction, economics has created a number of equilibrium-based valuation models.Generally speaking, such models try to determine an equilibrium exchange rate based on therelative pricing of goods, money and trade. In turn, this concept of relative pricing can bebroken down into four main types of long-term valuation model, which focus on internationalcompetitiveness, key monetary themes, interest rate differentials and the balance of payments.I would suggest that while such equilibrium exchange rate models are an indispensable tool foranalysing long-term exchange rate trends, their predictive track record for short-term moves ismixed at best. Moreover, as we noted above, they are based on the concept of an equilibrium,which rarely exists in reality and if it does exist is in any case a moving target. This is in noway to attempt to downplay the immense contribution that economics has made to currencyanalysis, rather it is to emphasize the different focus of the two disciplines. Whereas economicsseeks to determine the “big picture”, currency analysis seeks specific exchange rate forecastsover specific time frames. Neither is “better” or “worse”. They are merely different analyticaldisciplines responding to a different set of requirements. In the very act of attempting practicalmodifications to the classical economic approach towards exchange rates, one pays homage tothe original work.
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Introduction
Precisely because currency markets are affected by so many different factors, it has proved anextremely difficult (if not impossible) task for economists to design fundamental equilibriummodels with predictive capacity for exchange rates for anything other than the long term. Thus,Chapter 2 (Currency Economics: A More Focused Framework) seeks to go beyond thesetheoretical models outlined in Chapter 1 to capture those elements of economics relevant tothe currency market and tie them into a loose analytical framework capable of giving a morerelevant and accurate picture of short- and medium-term currency market dynamics. Whereasthe classical economic approach has been to start with general economic rules and impose themon exchange rates, the emphasis here is to start with the specific currency market dynamicsand use whichever aspects of economics are most appropriate to these, as characterized bythe label “currency economics”. The attempt here is not to create or define a new economicdiscipline, but instead to use the existing qualities of economic and other analytical disciplinesto create a framework of exchange rate analysis that is more relevant and useful for currencymarket practitioners.For this purpose, we cannot rely on economics alone. As we analyse the specific dynamics ofthe currency market we see that other analytical disciplines may also be relevant. In Chapter 3(Flow: Tracking the Animal Spirits) we look at the first of these, namely that of “flow”analysis. It is interesting to note that where once this discipline was not even recognized ashaving worth, it is now at the forefront of financial analysis. As barriers to trade and capitalhave fallen over the last three decades, so the size and the importance of investment capitalhas grown exponentially. While the classical approach has traditionally taken the view of theefficient market hypothesis, namely that information is perfect and that past pricing holds norelevance in a market place where all participants are rational and profit-seeking, there havebeen a number of recent academic works looking at how “order flow” can in fact be a crucialdeterminant of future prices. Thus Chapter 3 seeks to take this view a stage further and look atusing order flow – that is the sum of client flows going through a bank – as a tool for forecastingand trading exchange rates.The tracking of capital flows of necessity involves looking for apparent patterns in flowmovement. Linked in with this idea is the discipline of tracking patterns in price. This disciplineis that of technical analysis. While the economic community appears to have finally taken thediscipline of flow analysis to its heart, there remains considerable resistance to any similaracceptance of technical analysis. Chapter 4 (Technical Analysis: The Art of Charting)looks at this discipline, how it evolved and how it professes to work. Whatever the scepticismand criticism of this discipline, the reality is that flow and technical analysis have succeeded toa far greater degree where equilibrium exchange rate models have failed in seeking to predictshort-term exchange rate moves. Technical analysis has come a very long way, even to thepoint where some market practitioners base their investment decisions solely on the basis oftechnical signals. Several public institutions have sought to investigate the phenomenon oftechnical analysis and why it works, including no less than the Federal Reserve Bank of NewYork. The reasons vary from market herding patterns, as noted by the field of behaviouralfinance, to economic and financial cycles matching each other. Whatever the case, the resultsof technical analysis are impressive, enough to persuade investment banks and hedge funds totrade off them.Having looked at flow and pricing patterns in Chapters 3 and 4, it is also important to examinethe structural dynamics that determine those patterns, which is the focus of Chapters 5 and 6.Currency markets are widely viewed as volatile, yet there is also the perception that a cleardifferentiation can be made between “normal” and “crisis” trading conditions. The structural
Introduction
11
dynamics of the currency market can determine when and how this differentiation occurs.A key structural dynamic concerns the type of exchange rate regime, which can significantlydistort both fundamental and technical signals. Thus, in Chapter 5 (Exchange Rate Regimes:Fixed or Floating?) we look at how the type of exchange rate regime can have potentiallymajor impact on the business decisions of currency market practitioners. To most modern-dayreaders, at least those within the developed markets, the exchange rate norm is and has alwaysbeen freely floating. While this is now true for the most part within the developed markets it isnot so much the case in the emerging markets where the series of currency crises in the 1990swould appear to confirm that the type of exchange rate regime remains a pertinent issue forinvestors and corporations alike. This chapter takes a brief but illuminating look at the historyof exchange rate regimes, noting a clear trend within the dynamic tension between governmentsand the market place towards either completely freely floating exchange rate regimes or hardcurrency pegs since the break-up of the Bretton Woods system in 1971–1973. There remainsa rich debate within academia as to the optimal currency regime, with free market ideologuescalling for freely floating exchange rate regimes as the only solution in a world of free and opentrade and capital markets, while at the other end of the spectrum some still call for a return tofixed exchange rates. Where there appears at least some degree of agreement is the idea thatwithin these two extremes semi- or “soft” currency peg regimes are no longer appropriate ina world without barriers to the movement of capital. We touch on this academic debate onlyfor the purpose of seeing how the issues are relevant for currency market practitioners. Indeed,to round off the chapter, we look at the issues of “exchange rate sustainability” and the “realworld relevance of the exchange rate system”, noting points that currency market practitionersshould be on the lookout for with regards to the relationship between the exchange rate regimethey are operating under and the specific currency risk they are exposed to.The implicit assumption in Chapter 5 is that “normal” trading conditions apply. Yet, withincurrency markets, there are periods of turbulence and distress so extreme that the dynamics of“normal” trading conditions may no longer apply. Logically enough, we term this hurricaneor typhoon equivalent in the currency markets a “currency crisis”. As with our meteorologicalcounterparts, currency analysts have tried to examine currency crises in order to be able topredict them. As with hurricanes, this is no easy task. Chapter 6 (Model Analysis: CanCurrency Crises be Predicted?) takes a look at the effort by the economic community tomodel and predict currency crises. For the reason that I have worked on this subject for someyears, I enclose my own effort entitled the Classic Emerging Market Currency Crisis (CEMC)model, which looks at the typical emerging market pegged exchange rate regime. In addition,I enclose a model focusing on the “speculative cycle”, which takes place in freely floatingexchange rate regimes. Here, I make no claim to a definitive breakthrough. However, I do feelthese two models capture the essential dynamics of the currency crisis on the one hand and thecurrency cycle on the other. The emphasis in this chapter is on the emerging markets for themost part, largely because ever since the 1992–1993 ERM crises the developed markets haveno longer presented such easy targets. All major developed market exchange rates have beenfreely floating, and the 15% ERM bands in the run up to the creation of the Euro on January 1,1999 were sufficiently wide to eliminate the risk of a repeat attack on the mechanism. Underfreely floating exchange rates, currency crises take on a different form and are more reflective ofa loss of market confidence rather than an actual crisis involving a pegged exchange rate, whichultimately involves desperate and futile defence followed by de-pegging and devaluation.One could well argue that one of the prerequisites for developed country status is a freelyfloating currency, though to be sure the creation of the Euro somewhat clouds the issue. In any
12
Introduction
case, the emerging markets have provided a rich if unwanted source of currency crises to study,including those of Mexico (1994–1995), Asia (1997–1998), Russia (1998), Brazil (1999) andmost recently Turkey (2001). Needless to say, following these violent and destructive eventsthe attempt at generating models able to predict currency crises has been greatly accelerated,albeit with mixed success to date.In Chapters 5 and 6, we have looked at exchange rate regimes, how they might affectcurrency risk and in turn how they might drive the ultimate expression of currency markettension, the currency crisis. In Chapters 7–10, we again seek to take the study of currencymarkets to the next level and try to apply many of the lessons that we have learned to thereal world of the currency market practitioner. The first chapter in this section, Chapter 7(Managing Currency Risk I – The Corporation) looks at how the multinational corporationshould manage currency risk. Before looking at currency hedging strategies and structures,we first have to establish what kinds of currency risks exist. For the multinational corporation,there are three types of currency risk or exposure: transaction, translation and economic, eachof which requires a different approach. As with some investors, there are corporations ideologically fixated with the idea of not hedging. Others focus on the “natural” approach to hedgingthrough the matching of currency assets and liabilities. There is an understandable desireon the part of some corporate executives to leave the issue of currency risk to the likes ofcurrency dealers and speculators and to “just get on with the company’s underlying business”.Unfortunately, few things in life are as simple as one would like them. Whether it likes it ornot, a corporation that has currency exposure is by definition a currency market practitioner. Itmay not seek to manage currency risk but even by doing so it is taking an active decision. Thereis no opt-out with regards to currency risk or exposure. Fortunately, most major corporationshave realized this and have gone to great effort to establish sophisticated Treasury operations.There are still some who hold out, and in any case even for these “progressives” there remainswork to be done in developing and maintaining skill levels to match those of their currencymarket counterparties. Finally, after establishing what currency risk should be managed andwhy, we shall look at the “how” by examining such concepts as optimization, balance sheethedging, benchmarks for currency risk management, strategies for setting budget rates, thecorporation and predicting exchange rates and a menu of advanced hedging strategies.The worlds of the corporation and the investor may seem very different on the face of it, butin fact they are very similar in a number of ways. Both view currency risk as an annoyance andindeed there remain some on both sides who refuse to acknowledge it exists. Still to this day,I come up against investors who have an almost ideological aversion to the idea of managingcurrency risk. For the most part, this is on the view that investing in a country is equivalentto investing in that country’s currency. If Chapter 8 (Managing Currency Risk II – TheInvestor) succeeds in nothing else than to disabuse readers of such a view, then it will havesucceeded utterly and entirely. The case of South Africa already mentioned in this Introductionmay be seen as an extreme example, but it is far from unique. The structural dynamics of assetmarket risk and currency risk are fundamentally different, and thus they should be managedseparately and independently. This is not to say that they have of necessity to be managed bydifferent people. However, the crucial point to be made is that these risks should be manageddifferently and separately from one another, reflecting those different dynamics. When pressed,both the investor and the corporation for the most part seek defensive strategies, which canmanage currency risk by reducing that exposure, limiting the vulnerability of either the incomestatement or the portfolio. Indeed, readers will note that some strategies mentioned in Chapters7 and 8 are interchangeable between the corporation and the investor. Thus, in this chapter,
Introduction
13
we will take a look into the world of the sophisticated institutional investor and how theymanage currency risk. As with the corporation, investors can choose both passive and activecurrency risk management approaches for this purpose. Investors can also use optimizationas an important risk management tool, and the setting and use of currency benchmarks is afurther similarity. For both, the bottom line is that the currency exposure should be managedin such a way as to limit any reduction and potentially enhance the total return.The third set of currency market practitioners that we will examine is on the one hand thelargest grouping within the currency market and on the other the most misunderstood – thecurrency “speculator”. For many, the very term triggers an instinctive reaction, frequently onethat is far from positive. For our purpose here, I define currency speculation as the trading ofcurrencies with no underlying attached asset within the transaction. Clearly, such a definitionis inexact, but it provides nonetheless a useful framework with which to analyse the subject.Chapter 9 (Managing Currency Risk III – The Speculator) takes a look at the fascinatingbut much misunderstood world of the currency speculator, how it works and how to be a betterspeculator! Speculators have periodically been demonized by governments of the developedand emerging countries alike, frequently in the wake of violent currency crises. Such crisesare however rarely caused by speculators, who are I would contend a symptom rather thanthe disease itself. Indeed, in some cases speculation can actually be the cure, as when sterlingwas ejected from the recessionary shackles of the ERM in September 1992, only for the UKeconomy to recover strongly thereafter. Speculation can be both a positive and a destructiveforce, but its intention is neither, rather to make a profit. In this, it is neither moral nor immoral,but rather amoral.Currency speculation does not take place within a vacuum, but instead is a market andindeed a human response to changes in ordinary fundamental and technical dynamics. For themost part, currency speculators follow the same economic and technical analytical signpostsas corporations and investors. On occasion, both investors and corporations can act as currencyspeculators. The term is certainly not limited to dealers or hedge funds. Moreover, currencyspeculators generally provide exchange rate liquidity for the more productive elements of theeconomy. It is my hope that readers of whatever hue will find this chapter both interesting andinformative, concerning a subject, which deserves at the least a chapter of its own if not anentire and separate book. Undoubtedly, the issue of currency speculation is likely to remaincontroversial for the foreseeable future. The aim here has been to take out some of the emotionalaspects of the issue and try to look at it coolly and dispassionately.Speculators can accelerate change but they cannot cause it in the first place. Moreover,speculation provides a valuable need for the rest of the market in the form of liquidity. Yet,speculation also remains only one part of the overall picture of the currency markets. As thetitle might suggest, Chapter 10 (Applying the Framework) seeks to bind together all thestrands of thought that we have looked at up to now into a coherent framework for analysingthe currency markets. One can have a reasonably informed idea about the prevailing currencyeconomics, the technical picture and the flows, but it is only by combining those that one sees thewhole picture and therefore can come to an informed decision about how to manage currencyrisk. For this purpose, I use a very simple “signal grid”, which combines the individual signalsof currency economics, technical analysis, flow analysis and long-term equilibrium modelvaluation, into a combined currency view. The signal grid should provide an informed view asto exchange rates but at its most basic it will only say “buy” or “sell”. What it cannot do is tosuggest the type of currency instruments or structures needed. For that, we need to apply thecombined result of the signal grid to the currency market practitioner’s own risk profile. For
14
Introduction
both the corporation and the investor, their risk profile is a function of their tolerance of thevolatility of their net profit or total return.In addition, as mentioned in the Preface to this second edition, I have added to part III aChapter 11, entitled Emerging World: New Growth Markets for Global FX, which looksat the explosive growth potential across Emerging Markets, but particularly in Asia.No book should claim it can by itself make the reader an expert in its subject. Rather, thisis a book aimed at those who are already experts in their own respective fields, whether that itis in fixed income or equity investment, managing multi-billion dollar corporations, or tradingcurrency pairs such as Euro–dollar or dollar–rand. The purpose therefore of this book is tohelp these experts become more proficient in currency risk management to the extent whereit makes a real and measurable difference to their bottom line. In sum, this book aims a lothigher than most written to date on exchange rates. I leave it to the reader to decide whetheror not it has succeeded in this regard.Callum HendersonSingaporeDecember 2005
Part OneTheory and Practice
1Fundamental Analysis: The Strengthsand Weaknesses of Traditional ExchangeRate ModelsThe starting point of “fundamental” currency analysis is the exchange rate model, or theattempt by economists to provide a logical framework with which to forecast exchange rates. Inresponse to the break-up of the Bretton Woods exchange rate system, the economics professionhas spent the last three decades trying to improve its exchange rate forecasting ability, mainlyby refining the traditional exchange rate models and occasionally coming up with new ones.To date, the results of this worthy effort have been mixed at best. We will go into why this isthe case later. In the meantime, it is worth spending some time looking at the various models,their practical uses and individual track records, for to say their results have been mixed is notto suggest they are without use. On the contrary, traditional exchange rate models provide avaluable framework for analysing exchange rates, without which strategists would have fewlong-term guides as to where exchange rates should be priced.Most traditional exchange rate models derive from some form of equilibrium, which isbased on the relative pricing of a given commodity. Since an exchange rate is made up oftwo currencies, it should logically reflect the relative pricing of a commodity between the twocountries concerned. Traditional exchange rate models are identified by the approach they taketowards determining or forecasting exchange rates, and therefore by the commodity whoserelative pricing they use for this purpose:
r The exchange rate as the relative price of goods – Purchasing Power Parityr The exchange rate as the relative price of money – The Monetary Approachr The exchange rate as the relative price of interest – The Interest Rate Approachr The exchange rate as the relative price of current and capital flows – The Balance of PaymentsApproach
r The exchange rate as the relative price of assets – The Portfolio Balance ApproachMany readers will be familiar with some or all of these models. The attempt here is not merelyto describe them, thus perhaps going over old ground, but to discover their individual strengthsand weaknesses by relating them to the real world of currency trading.
1.1 PURCHASING POWER PARITYPurchasing Power Parity (PPP) or the “law of one price” is probably the best-known exchangerate model within currency analysis. The basic idea behind PPP is that in a world withoutbarriers to free trade the price of the same good must be the same everywhere over time. As aresult, the exchange rate must move towards a long-term equilibrium value that ensures this is
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Currency Strategy
true. PPP or the law of price should hold if:
r There are no barriers to trade or arbitrage in the goodr There are no transaction costsr The good being traded is perfectly homogeneous
This is best shown by an example. Say, for argument’s sake, the price of exactly the samesports car in the Czech Republic and Germany is CZK1 million and EUR100,000. If we usethis sports car as broadly representative of the price differential between these two countries,then we derive from this that the PPP equilibrium value of the Euro–Czech koruna exchangerate should in turn be 10 (i.e. 1,000,000/100,000). Obviously, the prices in this example arenot meant to be representative of the actual price of a sports car. Rather, we have used thesenumbers to illustrate the basic concept more easily.If the PPP equilibrium value of the Euro–Czech koruna exchange rate is 10, we can derivefrom this firstly that the actual exchange rate should revert towards this over time and secondlythat the actual exchange rate reflects a quantifiable degree of over- or undervaluation relativeto that PPP value. At the time of writing, the actual Euro–Czech koruna exchange rate wasaround 31.50. If we used our example to reflect the Euro–Czech koruna’s PPP value, this wouldsuggest the Czech koruna was significantly undervalued relative to PPP and should appreciateover time to eliminate that undervaluation. In a world where there are no barriers to trade orknowledge, a German car buyer will be fully aware that the same car is cheaper in the CzechRepublic. Hence, if there are no laws against such practice, he or she will travel there, buythe car and drive back. Whether or not this is realistic misses the point. Rather, it is meant toillustrate the principle at work within the PPP concept. The transmission mechanism that isat work in this example and more generally that would cause an eventual elimination of thatCzech koruna undervaluation is as follows:Cheap currency → Attracts buyers → Increased demand to buy goods →Currency appreciates
In this book, every effort will be made to spare the reader from complex mathematical formulae,which though impressive do little to advance the argument in the face of incomprehension.There are however a few basic mathematical constructs, which have to be defined, and PPP isone of those. Thus, the basic mathematical expression of PPP is:PE=P*Or, another way to express this is:P = E × P*whereE = The PPP long-term equilibrium exchange rate valueP = Domestic price level of goodsP * = Foreign price level of goodsThis reflects the fundamental view of PPP, which is that the long-term equilibrium value of anexchange rate is a direct function of the ratio between the “internal” prices of the same tradablegoods between two countries. Currency market practitioners, however, think of exchange rateswith regard to the base and the term currencies, naturally using the base currency first, as the
Fundamental Analysis: The Strengths and Weaknesses of Traditional Exchange Rate Models
19
point of reference. Thus, the exchange rate between the US and Japan is not seen as yen perdollar, but expressed instead as dollar–yen. This is how foreign exchange traders quote and thisis how clients ask for those quotes. Thus, in our PPP formula, we could express this slightlydifferently as:E=
PtPb
where:E = The PPP long-term equilibrium exchange rate valuePt = Price level in the term currencyPb = Price level in the base currencyReturning briefly to our sports car example, this is indeed how we derived the supposed PPPvalue of the Euro–Czech koruna exchange rate using the price levels given.1.1.1 Reasons for “Misalignments”Exchange rates that do not reflect the PPP value are said to be “misaligned” and it is assumedtherefore that they have to revert towards PPP. Such misalignments are seen as being causedby temporary distortions, either to the price of the good or the exchange rate, which shouldquickly be eliminated by a rational, profit-seeking market. In reality, such “misalignments”can last for months or even years. In other words, traders, investors or corporations who baseshort-term financial decisions on the PPP model of exchange rate value do so at their own risk.The track record of the PPP model over the short term leaves a lot to be desired, to the extentit is known in the market as the “Pretty Poor Predictor”. How can such misalignments occur ina free market economy where the price adjustment mechanism should be immediate? If thereis free trade between nations, a price differential in a good (or basket of goods) should createan arbitrage opportunity – you buy the good in the cheaper country. Such buying should pushup the currency in the cheaper country relative to the more expensive one. Yet still, this is notnecessarily what happens over the short term. Why?
r We do not have perfectly free trade – Such a concept would imply zero import tariffs,zero export subsidies and perfect competition across all business sectors. Needless to say,this is not the case. Whatever progress we have made, we are not there yet. As a result, thereremain significant trade-related price (and therefore exchange rate) distortions.r The adjustment mechanism is not necessarily immediate – During periods of marketvolatility, corporations may delay setting prices and budget exchange rates until they have abetter idea of where the appropriate levels should be to retain competitiveness and margin.r The price of goods may not be the most important exchange rate determinant – A basicPPP assumption is that the relative pricing of goods is the main driver of exchange rates.However, since the liberalization of capital markets, this may no longer be the case.r The good or basket of goods may not be exactly the same in different countries – Theconsistency of the good should not be taken for granted as the same good may vary betweencountries in terms of quality, cost and speed to market.r Base-year effects – There is also the question of when to start the PPP analysis. Logic mightsuggest starting from the end of the Bretton Woods exchange rate system in the 1971–1973period, yet this took place at a time of very high inflation, thus significantly distorting theresults.
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Currency Strategy
1.1.2 Tradable and Non-Tradable GoodsThere is a further point, which is that clear differentiation has to be made between tradable andnon-tradable goods. PPP may not hold for non-tradable goods such as services. The dry worldof economics is frequently best explained through example and anecdote. Thus, a haircut mightbe cheaper in New York than London (most things are and this is not one of the exceptions), butfew people would be prepared to fly to New York from London just to get that cheaper haircut.This is not just because to do so you would have to pay for a London–New York return flight,which would negate any haircut-related gains you would make. Even supposing the air ticketwas free would you really fly 8 hours for a cheaper haircut? The PPP concept assumes thereare no barriers to the arbitraging of price differentials, yet with non-tradable goods this maynot be the case. Granted, there may always be some wayward individuals who would actuallytake that flight!PPP or the law of one price holds better of necessity for homogeneous commodities that aretraded internationally, with arbitrage opportunities being quickly eliminated. However, evenhere, care is needed. While PPP may hold generally, prices even of homogeneous commoditiesmay vary widely between countries depending on local supply/demand dynamics. Indeed, thevery fact that the price of a McDonalds Big Mac, which is a homogeneous commodity, canvary between countries for even a short period of time proves this point.1.1.3 PPP and Corporate Pricing StrategyThe law of one price assumes the exchange rate will move over time so that the price of thesame good is the same everywhere. However, corporations do not necessarily follow this asthey may vary national prices of the same good to reflect a variety of factors in those countriessuch as local supply/demand dynamics, delivery costs, cultural tastes, customer price tolerance,target margin, competitor prices, market share considerations and so forth. To an economist,such price variations represent temporary distortions, which should over time be eliminatedby market efficiency. To a corporate executive, faced with the frequently competing real-worldpriorities of profit maximization and raising market share, there may be nothing temporaryabout such “distortions”. As a result, PPP may in some cases not hold over the “short term”for homogeneous goods since such pricing strategies may not allow it to hold.Example 1In the mid-1990s, US–Japanese trade relations went through one of their periodic bouts of bitterdispute, with the US side accusing Japan of a host of uncompetitive practices including “pricedumping”. Having followed this situation closely when I was a foreign exchange analyst livingin New York, I think it is a good practical example of the theoretical principle of PPP facedwith the real world of corporate pricing strategy. It was certainly a heated time, with newsheadlines from trade representatives of both sides causing wild gyrations in the dollar–yenexchange rate.From a purely objective viewpoint, it should be instructive to look at the various transmissionmechanisms that were at work. PPP, of course, states that the price of the same good should bethe same everywhere over time and that the exchange rate should adjust to ensure this. Howthen does an economist deal with a clear disparity in pricing? PPP suggests that this disparityis unsustainable and that the market will move to eliminate it over time. Corporate pricing
Fundamental Analysis: The Strengths and Weaknesses of Traditional Exchange Rate Models
21
strategy may however be an obstacle to this. In the case of the US–Japan trade deficit, a keyissue – undoubtedly only one of many – was the US view that Japanese auto manufacturers wereselling their export production to the US at cheaper prices than those charged domestically inJapan for the same production. Whatever the merits of this view, this makes perfect economicsense. A Japanese manufacturer’s cost base is likely to be considerably higher than elsewhere.Thus in order to maintain margin domestically it has little choice but to charge higher pricesdomestically relative to those that would be tolerated elsewhere, such as in the US. A tradenegotiator, fixated with the idea that trade is some kind of national war-game, would cry foul.However, a higher domestic cost base means of necessity that a manufacturer of whatevernationality either deliberately undercuts the domestic price structure, thus making a loss, orkeeps export prices lower than domestic ones.The higher cost base and consumer price tolerance work hand in hand. In the US, because USconsumers are used to a system, which exemplifies a very high level of competition, this drivesdown retail prices, reducing consumer “price tolerance”. PPP theory states that the exchangerate should adjust for price differentials in the same good. Thus, the currency where the goodis priced cheaper should appreciate relative to that where it is priced more expensively. Inthis case, the US dollar should appreciate relative to the yen. Assuming that trade in autoscan affect exchange rates over a sustained period of time, this is what should take place inthe exchange rate as a result of the relationship between PPP and a potential price disparitybetween Japanese autos sold in the US and Japan.In reality, this is