Ten Common Myths in International Finance - dummies

Ten Common Myths in International Finance

By Ayse Evrensel

Following are ten short reminders of what not to think about international finance. These points imply ideas that you may be inclined to have, but that may be incorrect.

Don’t expect to make big bucks every time you speculate in foreign exchange markets

You can lose big money in foreign exchange markets. Most speculative activity in foreign exchange markets is short term, with a time horizon of less than a year. There is high short-term volatility exists in exchange rates in spot foreign exchange markets. The term high emphasizes that the changes in exchange rates are greater than the changes in well-known fundamentals of exchange rates, such as inflation rates, interest rates, and growth rates.

A Big Mac in Paris doesn’t cost the same price as in your hometown

The Law of One Price doesn’t work in reality. You can’t buy a similar good, even one as standardized as a Big Mac, at the same price everywhere in the world after converting local prices into a common currency. Local production costs and market conditions vary among countries.

Don’t ignore policymakers when it comes to exchange rates

The monetary authority of a country is influential on long-term exchange rates because, through monetary policy (indirect intervention), central banks have an influence on nominal interest rates, inflation rates, and, consequently, real interest rates. Through direct interventions into foreign exchange markets by buying and selling currencies, central banks can have short-term influence on exchange rates or can help steer exchange rates into the desired direction.

Don’t give up on theory too easily

Macroeconomic fundamentals don’t explain short-term changes in exchange rates, but they’re not necessarily wrong or meaningless. Differences in nominal interest rates, inflation rates, and output growth rates are important predictors of exchange rates in the long run. If you’re interested in exchange rates and understand where they’re headed in the long run, keep track of these variables.

Don’t forget about high short-term volatility in exchange rates

In terms of their characteristics, foreign exchange markets are closer to asset markets than to commodity markets. Therefore, fundamentals cannot explain their short-term volatility. Even though the macroeconomic fundamentals of exchange rates, such as money supply growth, inflation rates, nominal interest rates, and output growth rates, are helpful in predicting long-term exchange rates, they don’t have much explanatory power in the short term.

Therefore, if you have to involve foreign exchange markets for a couple days, weeks, or months, do make use of derivatives to hedge against foreign exchange risk.

All changes in the exchange rate aren’t traceable to changes in fundamentals

Not every change in the exchange rate has an explanation based on a change in monetary policy. Models of exchange rate determination that include short-run nominal rigidities and overshooting demonstrate the relevance of adjustments when examining the changes in exchange rates. These adjustments are due to short-run rigidities (sticky prices) and the timing of the change in expectations.

Foreign exchange markets aren’t just another market

For the purpose of exchange rate determination, the demand–supply model is a good approximation and provides predictions about the changes in exchange rates, which empirical studies confirm. You know by now that these predictions are long-term predictions. In light of high short-term volatility in exchange rates, thinking about foreign exchange markets (at least in the short term) as asset markets is helpful.

The rules of the game are quite different in asset markets where expectations have positive and, therefore, self-fulfilling feedback, and where the characteristics of market participants (rational or irrational) may matter.

Don’t assume that central bank interventions are meaningless

You may think about the usefulness of a central bank’s direct intervention in foreign exchange markets. Thinking that these markets are so large that even a concerted effort by a number of central banks may not change the exchange rate is plausible. And you may be more puzzled if the direct intervention is sterilized.

If the Fed wants to support the dollar against the euro, it purchases dollars in foreign exchange markets in exchange for its euro reserves. If the Fed doesn’t do anything afterward, the U.S. high-powered money supply declines by the amount of dollars purchased. If the Fed doesn’t want to have this change in the domestic money market, it can offset the decline in the money supply by buying government papers such as T-bills from financial markets, increasing the high-powered money supply to its original level.

So what has changed? The portfolio balance has changed. This effect implies that even though money supply didn’t change, the relative supply of government papers did. Sterilization decreased the quantity of U.S. government papers held by the public and probably increased that of the euro-denominated government papers.

Pegged exchange rates aren’t a great idea

Sure, pegged exchange rates can act as a nominal anchor and signal stability in a country that hasn’t had much stability. But pegged exchange rates don’t automatically provide stability. They don’t signal stability for long if macroeconomic stability doesn’t exist. Especially when a country wants to attract foreign portfolio investment and pegs its currency to eliminate exchange rate risk for foreign investors, the country must be very careful.

Foreign investors will bring in hot money: It will come fast and leave the country even faster. Investors will always look for reasons that may force the country to break the peg because this scenario is disastrous for them. Investors seemingly have learned from their experience in emerging markets with pegged exchange rates, and they pay attention to various characteristics of the country.

In addition to the obvious sources of trouble, such as expansionary fiscal and monetary policies, weaknesses of the financial sector attract investors’ attention. If a financial crisis occurs, the fiscal and monetary authority will provide bailout funds to prevent the crisis from getting larger, which will again break the peg.

Don’t be nostalgic about the gold standard days

A metallic standard doesn’t automatically mean stability. If anything, the experiences of the 19th century until the end of the Bretton Woods era in 1971 have demonstrated the appearance of the same problems in all major eras of the metallic standard. A metallic standard is one of fixed exchange rates. Persistent and large current account deficits or surpluses occur under fixed exchange rates and these are not desirable.