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The medium-term currency outlook
2
Long Range
Planning
Vol. 13
April 1980
The Medium-Term
Currencv Outlook
David Kern*
The article examines the experience of the major international currencies over the period since 1953 and assesses their prospects in the early 1980s. It summarizes the historical background, drawing a distinction between the Bretton Woods arrangement, when the world operated under a notional fixed exchange rate system, and the post 1971 experience which has involved a good deal of ‘dirty floating’ in the absence of any formal system. The paper focuses on the factors which influence exchange rate movements, and examines the practical uses of the analytical tools available, assessing the value, and possible misuse, of exchange rate forecasts in the decision-making process of the Long Range Planner. The author draws certain conclusions about economic policy and the international monetary system and offers some thoughts about the implications of the European Monetary System.
results tend to used in various
produced by different trade-weighted models be quite similar, and the simple bilateral model Table 1 provides a very reliable measure of the currencies’ relative perf0rmances.t
The long-term trends since 1953 can be analyzed most conveniently by focusing separately on three different periods: (i) 1954 to 1961; (ii) 1962 to 1969; and (ii) I970 to date.
Table 1 summarizes the main features of the post-1953 experience for 18 major currencies. Each figure in the table is expressed as a ‘trade-weighted’ index, which is calculated by using bilateral trade flows to measure the relative importance of each country’s imports and exports (taken together) in the trade of each of the other 17 countries included in our particular ‘basket’. A trade-weighted calculation seems appropriate because the more traditional convention of measuring the value of individual currencies in relation to the dollar has become inadequate in a world of floating exchange rates.
The first two periods were dominated by the postWorld War II decision to organize international monetary affairs within a framework of ‘fixed but adjustable’ exchange rates, known as the Bretton Woods System. Among the main features of this ‘liberal’ system were: (a) the dismantling of trade restrictions and exchange controls on current account transactions, at least for the major industrialized countries; and (b) a fairly high deg ree of exchange rate stability within specified narrow margins. This was in contrast to the competitive devaluations and the trade restrictions which had been common during the 1930s. At the same time, the Bretton Woods System made appropriate allowance for the need to adjust parities once the existence of ‘fundamental disequilibrium’ in a country’s balance of payments was established. With hindsight, it seems clear that the Bretton Woods System operated remarkably well until the late 1960s; and during the two decades prior to the 1973 oil crisis, the industrialized world enjoyed a period of steady and rapid growth in prosperity.
A number of trade-weighted indices are now being published, and one can identify important differences both in composition and in the precise methods used in their calculation. For example, one could focus on each country’s weight in world trade rather than in the bilateral trade of the other countries. Another possibility would be to take into account specifically the effect of a change in the exchange rate between two countries on their trade with a third country. There are naturally considerable variations in the country-coverage of the various indices. Fortunately, experience suggests that the
The year 1953 provides a useful starting point for this analysis, because the disturbances resulting from the Korean War were then coming to an end, and the effects of the major I949 parity adjustments had already been worked out. In the immediate aftermath of the Korean War exchange rates were initially remarkably stable, but after 1956 a few notable adjustments were made. The most important of these were the devaluations of the French franc in I957 and 1958, and the revaluations of the deutschemark and Dutch guilder in 1961. These changes provide a suitable background for the second
‘Mr. Kern is manager of the Economic Analysis Section of the National Westminster Bank Ltd. He writes in a personal capacity. The author is grateful to Linda Smith, Leo Doherty, Barry Coulthurst and Steven Fox, members of his Section, for research assistance.
tFor rate (1) (2)
I. Historical Background
further references to the subject of trade-weighted exchange indices, please see the following : HM Treasury, Economic Progress Report, No. 84. March 1977. Euromoney. April and May 1978 and June 1979.
The Medium-Term Table
1. The historical
experience
of 18 currencies: 1978 Index (I 953 average = 100)
U.S.A. Canada Japan Germany France Italy U.K. Netherlands Belgium Switzerland Norway Denmark Sweden Finland Austria Australia South Africa Spain
89.44 82.97 163.36 184.34 59.94 58.09 55.1 I 131.05 125.75 196.40 123.22 103.71 97.32 46.16’ 119.90 81.50 71.42 45.79
Source: National Westminster exchange-rate
index
trade-weighted
1954-l
3
rates
1954-l
961
+0.38 -0.30 +0.15 +I .33 -3.92 +I.00 +o-50 +0.95 +0.76 +0.44 +0*31 +0.25 +0.53 -3.67 -0.01 +0.10 +0.16 -4.14
1962-l
969
+0.48 -0.65 +0.29 +0.70 -0.48 +O.I 8 -I .66 +0.28 +0.24 +0.30 +0.70 -0.64 +0.66 -2.77 +0.14 +0.19 +0.46 -1.46
1970-l
978
-I .92 -I .06 +5.55 +5.17 -1.40 -6.68 -5.21 +I.96 +I.70 +7.31 +I *52 +0.79 -I .28 -2.31 +I*95 -2.24 -4.02 -3.12
: I8 countries, 1977 trade weights, geometric calculation, 1953 average = 100.
While the world’s economic problems have undoubtedly become more serious in recent years, one should not exaggerate the changes which have taken place in the international currency markets. In 1978 we witnessed some dramatic developments in exchange rates, though it is doubtful whether they signify any structural changes in some of the basic relationships. Sizable currency movements may now occur more frequently than before 1970, but it is important to remember that large movements were not uncommon under the Bretton Woods System. Indeed, abortive attempts to protect an unrealistic currency structure (for example, the attempt to prevent a sterling devaluation before 1967), masked large imbalances and a massive scale of intervention which only added to the underlying instability.
difficult
978
-0.42 -0.69 +2.14 +2.51 -I .91 -2.03 -2.25 +I.10 +0.93 +2.87 +0.86 +0.16 -0.08 -2.90 +0.74 -0.72 -1.24 -2.92
The third period, covering the years from 1970, witnessed many dramatic changes in the international currency markets. A succession of crises led to the final collapse of the Bretton Woods System during 1971, and the emergence of managed (or ‘dirty’) floating in 1973. The oil crisis, which erupted late in 1973, added to the international monetary diffLzulties, and many countries have since experienced an unpleasant mixture of high inflation, recession, payments imbalances and currency instability.
1. A Qualitative Revietu Although it is extremely
Outlook
Average % change per annum
period, covering the years 1962-1969. From 1964 onwards, serious pressure started to build-up, particularly against sterling; and in spite of strong official resistance, the U.K. was forced to devalue in November 1967. This change signalled the beginning of considerable upheavals on the international markets. The French franc was devalued in August 1969, while the German mark was forced upwards in October of that year.
II. The Fundamental
exchange
Currency
Factors to offer a fully
satis-
factory explanation of all the complex processes determining exchange rate movements, both standard economic theory and practical experience provide a conceptual framework within which to discuss the issues. One of the oldest and most appealing theories is that currency movements reflect differing rates of inflation. Although this approach (sometimes referred to as the ‘ urchasing power parity theory’) is widely accepted, t Kere are also many other factors which are often considered important-for example, the balance of payments, interest rates, cyclical pressures and forward exchange rates. It is not surprising that one often finds wide differences of opinion concerning the relative importance of these factors. Statistical studies are often inconclusive; while at the practical level, foreign exchange dealers operating under strong commercial pressures have to react rapidly to changing political and economic developments. A close examination of the historical record provides strong support for the view that in the longer term (say, 5 years or more) relative rates of inflation are the single most important factor explaining currency movements. Such a view is entirely consistent with the existence of a significant short-term relationship between exchange rates and various other factors, the most important of which is probably the balance of payments position on both current and capital accounts. To be more specific, the historical evidence is consistent with the view that relative rates of inflation have a distinct long-term influence on currency trends, over and above any indirect effect which inflation may have on the trade balance or on the rate of interest. However, the emphasis on the long-term nature of the relationship is extremely important, because large deviations from the trend can and do emerge in reaction to many outside events. The existence of a close statistical link between exchange rate movements and relative rates of inflation still leaves
Long Range Planning Vol. 13
4
April 1980
unanswered many difficult questions concerning the causal relationship involved. Thus, it is often argued that the chain of causation goes from exchange rates to inflation rather than the other way round; and when faced with such a problem one must honestly admit that it is not easy to provide a conclusive answer. Nevertheless, although some of the issues cannot at present be resolved in a definitive manner, it seems important not to over-emphasize the intellectual problems. At a practical level, particularly for the business planner, it is usually _sufficient to establish robust statistical relationships which can be applied successfully in forecasting work, without getting entangled in interminable theoretical arguments about cause and effect. Recent analytical developments, particularly the growing emphasis on ‘monetarism’, have led some to the view that the money supply is a basic underlying factor which influences both inflation and exchange rates. This type of argument is interesting when dealing with broad issues of government policy, but in a practical business environment such an approach appears too narrow and is usually inadequate. Given the requirements of the long range planner, his most sensible strategy would be to form a view about basic inflation trends (whether determined by the money supply, by earnings, or indeed by other factors) and then translate this inflation projection into an exchange rate forecast. It seems to me most plausible to think about a long-term sequence which goes from inflation to exchange rates, though in the short term one can identify strong influences which operate in both directions. Such an approach will help the business planner to focus on his getting embroiled in practical priorities, without futile arguments which are often influenced by rapidly changing intellectual fashions. 2. The Statistical Evidence Table 2 summarizes some of the available evidence about Table 2. The economic background Variable
to exchange-rate
in spot rate of
Average % annual change exchange-rate index
in trade-weighted
3
Average
% annual
change
in wholesale
prices
4
Average
% annual
change
in consumer
prices
5
Average
% annual
change
in export
6
Balance GNP’
of payments
7
8
Data: Variables
A more detailed investigation of the regression results brings out two interesting features which appear to conflict with n priori expectations concerning the relationships involved. First, the slope of the regression line for the period 1954-1978 is -1.19, thus differing from its expected value of - 1. The implication of this result is that a 1 per cent widening in the inflation difference between the United States and a particular country would produce a decline in the dollar’s longterm value which is a little larger than 1 per cent. The second unusual feature of the regression results is that the constant term (the point where the regression line touches the vertical axis) differs from zero; and for the
U.S.A. Average % annual change currency against dollar
2
The figures in Table 2 throw interesting light on the different experiences of the major countries over the past quarter of a century, and they also emphasize the importance of distinguishing between different inflation indicators. In the context of exchange rate analysis it seems clear that, although most inflation indices have a close association with exchange rate movements, wholesale prices exhibit the strongest statistical link. The strength and consistency of the long-term relationship between currency movements and relative wholesale prices is very striking, particularly if one takes into account the limitations and inaccuracies inherent in any type of economic data. In contrast, the long-term relationship between exchange rate movements and the other economic factors appears surprisingly weak.
movements:
number 1
the historical relationships between exchange rate movements and other economic variables such as inflation, the balance of payments, money supply and interest rates. The analysis again focuses on 18 major industrialized countries, and the calculations are expressed as annual averages over the period since 1953. The figures illustrate the existence of a close relationship between inflation and currency movements. A more formal statistical link is shown in the correlation matrix presented in Table 3, and in the regression analysis shown in Table 4 and in Figure 1.
Average mid-year cent per annum Average SUPPlY
% annual
prices
current account
official discount
change
1954-1978 Japan
Germany
France
U.K.
Italy
-
2.38
3.13
-0.80
-1.07
-1.38
-0.42
2.14
2.51
-1.91
-2.03
-2.25
3.64
2.72
2.25
4.56
5.90
6.36
351
6.11
3.17
5.58
6.05
6.46
4.03
1 ,49
2.15
5.11
4.81
6.40
0.75
0.43
2.34
0.21
0.46
0.34
4.29
6.52
‘4.05
5.65
4.82
6.95
4.13
15.79
10.53
14-55
6.21
% of
rate-per
in narrow
money 9.41
l-3, annual averages for the period 1954-l 978 inclusive. Variables 4-8, annual averages for the period 1954-l Sources: International Financial Statistics, IMF; National Westminster exchange-rate index. ‘The balance of payments figures are for the period 1956-l 977 inclusive, except those for France, which cover only 1967-l
977 inclusive. 977.
-0.9374
1 .oooo
-0.5166 -0.3477
0.5477 1 .oooo
1 .oooo
1 .oooo
-0.5531
0,8351
0.6151
-0.5476
0.4090
0.4250
V6
1 .oooo
0.8388
-0.8553
-0.8585
v5
Balance of payments current account as % of GNP
0.8133
-0.7253
-0.7149
v4
Average % Average % annual change in annual change consumer prices in export prices
0.9993
-0.9347
-0.9326
V3a
Average % annual change in wholesale prices gap
Input data for each variable comprises the average for the period 1954-l 977 inclusive. The main exceptions are: (a) the balance of payments figures are for the period 1956-I 977 inclusive, except those for France, which cover only 1967-l (b) industrial production-Japan’s figures are for 1955-l 977 and Switzerland’s 1957-l 977 (both inclusive) ; (c) the calculations relating to the official discount rate exclude Australia for which no data is available. Figures show the value of the correlation coefficient I between any pair of variables.
1 .oooo
-0.9360
0.9830
1 .oooo
v3
v2
Vl
Average % Average % annual change annual change in average spot in trade-weighted Average % rate of currency exchange annual change in against dollar rate index wholesale prices
Table 3. Correlation matrix
977 inclusive;
1 .oooo
-0.3254
0.5314
0.5913
0.5587
0.5671
-0.5671
-0.5603
V7
Average midyear official discount rate% per annum
VB v9
-0.1890 0.2002 0.8766 1 .oooo
-0.2179 0.2557 1 .oooo
v7
V6
v5 -0.1766
0.0352
v4
V3a
v3
v2
Vl
Variable No.
0.5151
0.1673
0.1714
-0.1391
-0.1661
v9
0.6484
0.3257
0.3349
-0.2863
-0.2906
VB
Average o/o Average % % annual change % annual in industrial change in narrow production money supply
6
April 1980
Long Range Planning Vol. 13
Table 4. Exchange rates and wholesale price inflation 1954-1978
inclusive
Y= 1.27 - 1.19x r= = 0438
1954-1961
inclusive
Y = -0.25 - 0.99x r2 = 0.74
1962-1969
inclusive
Y = 0.20 - 0.87x r2 = 0.68
1970-1978
inclusive
Y = 3.31 - 1.29x r2 = 0.86
Dependent variable (Y)
Average annual % change of spot exchange rate of each currency against the U.S. dollar
Independent variable (x)
Average annual % change of wholesale prices in each country, relative to those in the U.S.A.
Note: Input data comprises average annual % changes over the periods specified for 18 industrialised countries.
entire period 1954-1978 its value is 1.27. The implication of this result is that, over the period since 1953, there has been a ‘devaluation bias’ against the dollar. It suggests that, even without an inflation gap, the dollar would have been expected to fall by a little over 1 per cent per annum. Although somewhat surprising the results are quite plausible, and simply quantify the downward influence on the dollar of its key role in the world’s monetary system. Table 4, which compares the results analyzing the entire period 1954-1978 with those focusing on each of the three shorter sub-periods (1954-1962, 1961-l 969 and 1970-1978), is interesting for a number of reasons. First, although the relationship covering the longer Y L
x Switzerland
period is the most reliable one, very useful statistical links can also be established for shorter periods of about 8 years. In addition, the separate equations for the three shorter periods produce interesting statistical evidence about changes in the structure of the currency markets, particularly the increased vulnerability of the U.S. dollar in recent years. The equation for the period 1970-1978 has the largest constant term and the steepest slope, indicating the build-up of pressures against the dollar in recent years which possibly led to a temporary fall below its underlying long-term value.
III. The Value and Dangers of Forecasting in Business Planning Forecasting exchange rate movements has become a major ‘growth area’ in recent years. Notwithstanding the very large errors in many forecasts, the demand for currency projections has expanded rapidly. The increased complexity of the foreign exchange markets during the period of floating rates has probably contributed to this phenomenon. Nevertheless, it is still pertinent to raise the question whether systematic forecasts of exchange rates, and indeed of other economic values, can provide useful help to the planner and the practical businessman. There are two fundamental difficulties with this subject. Firstly, the forecasters do not take enough care to emphasize that specific projections are simply logical deductions based on what may be regarded as ‘reasonable assumptions’ about key variables. Consequently, another set of assumptions, perhaps equally reasonable, may produce different forecasts. Secondly, the recipients of economic forecasts sometimes confuse a projection with a prophecy. Regression Currency
Analysis:
Inflation
Inflation Differences and Spot Rates Against the U.S. Dollar xWest Germany
Versus
Movements Exchange
3 Austrk
\ JapanX
N&herlkds 2
ielgium \
18 Countries 1954-1978 r = 0.99 y = 1.27 - 1.19(x) Where
=
y = Average Yearly % Change in Spot Rate of Each Currency Against U.S. Dollar x = Average Yearly % Change -’ in Wholesale Prices in each Country Less Average Yearly % Change in Wholesale Prices in the U.S.
Figure 1
Spainx
The Medium-Term
Currency
Outlook.
7
which involves a great deal ofjudgment, intuition and experience. The task of a competent forecaster is to present those making decisions with a balanced view of the key options and not face them with a wide range of scenarios and possibilities which can only cause confusion and misunderstanding. The various figures in Table 5 should be seen as ‘trend’ projections for 1984. It should be remembered that these ‘trend’ values, even if broadly accurate, will not necessarily coincide with the actual rate prevailing at that time. It is highly likely that there will be significant deviations about the trend, as a result of random shocks or important short-term influences such as the balance of payments.
It cannot be emphasized too strongly that the accuracy of a forecast can never be guaranteed. The best one can hope for is that systematic projections, based on a detailed analysis of the underlying factors, will provide better results on average than an uninformed and random opinion. It is obviously a delusion to assume that one can buy forecasting services which will always be right. However, it is equally wrong to go to the other extreme, and simply assume that one can make business decisions without forecasting key variables such as output, investment, profits and exchatge rates. Admittedly, the operational manager or the planner may decide that he can produce projections which are superior to those issued by the ‘professional forecaster’; and on many occasions this view could well prove correct. Nevertheless, the essential point is that a forecasting framework is an important requirement for making major business decisions, irrespective of whether it is issued by a specialized unit, by the planners, or by the operational managers themselves. Ultimately, the forecast must be seen as a mental discipline involving explicit assumptions about the key factors which appear relevant to those responsible for making decisions.
IV. Conclusions
Following the above introduction to the value and pitfalls of forecasting it may be interesting to formulate a specific numerical projection for the international currency outlook over the next few years. One of the key factors determining the figures presented in Table 5 is the close relationship between wholesale prices and exchange rates, though other important influences have also been taken into account. However, it must be clearly understood that different assumptions about the underlying economic factors would produce different exchange rate forecasts. The main point which must be emphasized is that forecasting, however extensively computerized, is not a mechanical activity, but one
The exchange rate pattern described in Table 5 suggests a number of important conclusions about future international monetary developments. Thus, the U.S. dollar, in spite of its gradually diminishing role, will remain the basis for international trading and investment transactions. There is good reason to believe that rhe ‘dollar crisis’ will slowly fade away over the next 2 or 3 years. Although remaining vulnerable in the short term, the dollar could show a sharp technical recovery once some of the immediate uncertainties are resolved. Taking a longer view, the most sensible assumption would be that, after the immediate technical disturbances have worked themselves out, the dollar could show a gradual trade-weighted appreciation over the next few years. However, a limited number of currencies such as the yen, Swiss franc and deutschemark will continue to exhibit a long-term appreciation potential against the dollar. Strong commitment to monetary restraint, producing below-average rates of inflation in the longer
Table 5. The medium term prospects for 18 currencies-an
illustrative view
Wholesale price inflation average % change per annum
1954-l U.S.A. U.K. West Germany France Italy Switzerland Netherlands Belgium Denmark Norway Sweden Finland Austria Spain Canada South Africa Australia Japan
3.64 6.36 2.25 4.56 5.90 1 .84 2.96 2.57 4.38 3.99 4.68 6.46 3.23 7.15 4.32 5.18 4.10 2.72
Illustrative projection 978 1980-l
984
8.80 9.90 5.50 10.50 12.00 4.50 6.50 7.50 9.50 9.50 9.00 11.00 6.50 10.00 9.80 13.00 11.50 6.50
1978 Exchange rates average position
Illustrative 1984 projection average position
Spot rate against $
Trade-weighted* Index
Spot rate against $
Trade-weighted* Index
1 .oooo 1.9195t 2.0086 4.5128 848.6600 1.7880 2.1634 31.4100 - 5.5146 5.2423 4.5185 4.1173 14.6220 76.6630 0.8766t 0.8696 0.8736 210.4700
89.4367 55.1116 184.3351 59.9377 58.0879 196.4006 131.0528 125.7486 103.7070 123.2198 97.3182 46.1611 119.8995 45.7890 82.9711 71.4221 81.5023 163,3587
1 ,oo 2.01 t 1.62 4.53 932.00 1 .43 2.02 29.80 5.90 5.40 4.60 4.20 12.80 74.40 0.80 0.94 1.02 204.00
89.7644 55.7353 223.0068 55.7866 48.8239 230.6941 128.7729 122.9663 91.0413 114.0591 92.1333 43.2300 121-5908 45.1132 75.4680 62.2841 67.7538 169.6889
*National Westminster exchange-rate index : 18 countries, 1977 trade-weights, tNumber of U.S. dollars per pound sterling and Canadian dollar.
geometric calculation. 1953 = 100.
8
Long Range Planning Vol. 13
April 1980
term, must lead to the conclusion that these three currencies will move along an underlying upward trend. The worsening inflation background in the U.S.A. over the past few years is a difficult problem; more serious in its consequences than the sizable, but probably temporary, balance of payments deficits. Nevertheless, the firm policies adopted by the U.S. administration, and the change of public mood in the U.S.A. towards reducing public spending and taxes, suggest that long-term American inflation will be contained around 84-9 per cent. This is higher than in Germany, Japan and Switzerland, but lower than the expected rate of inflation in many other countries, both inside and outside Europe. On the basis of present policies, it seems reasonable to assume that countries such as France, Italy, Britain and Sweden, to name but a few, will experience higher inflation rates than the U.S.A. and the dollar should exhibit a gradual long-term appreciation against their currencies. For Europe, the implications of such a view are clear. In spite of commendable efforts to achieve greater economic and monetary integration, the realities of the situation continue to suggest that inflation differences will remain significant. Consequently, the exchange rate pattern within Europe will have to be adjusted fairly regularly. This conclusion may disappoint some people, but the aim of greater monetary integration contains many desirable features, even if complete monetary union and total exchange rate stability is unlikely to be achieved. The existence of the European Monetary System (EMS), and similar arrangements, should encourage the various European nations to pursue policies designed to systematically narrow the
economic differences between them. Furthermore, in doing so, a gradual lowering of Europe’s average rate of inflation is likely to be achieved. Thus the efforts towards achieving greater monetary stability should prove highly beneficial. At the same time, it is important not to aim for unrealistic targets. For example, it would be highly undesirable, and in the long run destabilizing, to try to freeze an exchange rate pattern when economic fundamentals, particularly inflation rates, do not permit it. Admittedly, earlier hopes that exchange rate flexibility would provide a panacea have been proved wrong, and there is greater emphasis today on the need for stability. However, to have a measure of exchange rate flexibility remains extremely important, preventing some of the more unpleasant upheavals which used to occur before ‘managed’ floating became widely accepted in recent years. A degree of floating will remain very important in the future relationship between major currency blocs, such as those increasingly likely to centre around the yen, the dollar and the deutschemark. A system permitting limited exchange rate flexibility is inevitable and indeed desirable. However, governments would be wise to remember that flexibility cannot solve the problems resulting from excessive money creation, and that in certain circumstances, unlimited flexibility can become the mechanism which speeds up the inflationary consequences of such a policy. Fortunately, the dangers of high inflation are better understood throughout the entire industrialized world today, and those responsible for planning and decision-making will undoubtedly benefit from a period of low inflation and greater stability in the financial markets.
Long Range
Planning
Vol. 13
April 1980
The Medium-Term
Currencv Outlook
David Kern*
The article examines the experience of the major international currencies over the period since 1953 and assesses their prospects in the early 1980s. It summarizes the historical background, drawing a distinction between the Bretton Woods arrangement, when the world operated under a notional fixed exchange rate system, and the post 1971 experience which has involved a good deal of ‘dirty floating’ in the absence of any formal system. The paper focuses on the factors which influence exchange rate movements, and examines the practical uses of the analytical tools available, assessing the value, and possible misuse, of exchange rate forecasts in the decision-making process of the Long Range Planner. The author draws certain conclusions about economic policy and the international monetary system and offers some thoughts about the implications of the European Monetary System.
results tend to used in various
produced by different trade-weighted models be quite similar, and the simple bilateral model Table 1 provides a very reliable measure of the currencies’ relative perf0rmances.t
The long-term trends since 1953 can be analyzed most conveniently by focusing separately on three different periods: (i) 1954 to 1961; (ii) 1962 to 1969; and (ii) I970 to date.
Table 1 summarizes the main features of the post-1953 experience for 18 major currencies. Each figure in the table is expressed as a ‘trade-weighted’ index, which is calculated by using bilateral trade flows to measure the relative importance of each country’s imports and exports (taken together) in the trade of each of the other 17 countries included in our particular ‘basket’. A trade-weighted calculation seems appropriate because the more traditional convention of measuring the value of individual currencies in relation to the dollar has become inadequate in a world of floating exchange rates.
The first two periods were dominated by the postWorld War II decision to organize international monetary affairs within a framework of ‘fixed but adjustable’ exchange rates, known as the Bretton Woods System. Among the main features of this ‘liberal’ system were: (a) the dismantling of trade restrictions and exchange controls on current account transactions, at least for the major industrialized countries; and (b) a fairly high deg ree of exchange rate stability within specified narrow margins. This was in contrast to the competitive devaluations and the trade restrictions which had been common during the 1930s. At the same time, the Bretton Woods System made appropriate allowance for the need to adjust parities once the existence of ‘fundamental disequilibrium’ in a country’s balance of payments was established. With hindsight, it seems clear that the Bretton Woods System operated remarkably well until the late 1960s; and during the two decades prior to the 1973 oil crisis, the industrialized world enjoyed a period of steady and rapid growth in prosperity.
A number of trade-weighted indices are now being published, and one can identify important differences both in composition and in the precise methods used in their calculation. For example, one could focus on each country’s weight in world trade rather than in the bilateral trade of the other countries. Another possibility would be to take into account specifically the effect of a change in the exchange rate between two countries on their trade with a third country. There are naturally considerable variations in the country-coverage of the various indices. Fortunately, experience suggests that the
The year 1953 provides a useful starting point for this analysis, because the disturbances resulting from the Korean War were then coming to an end, and the effects of the major I949 parity adjustments had already been worked out. In the immediate aftermath of the Korean War exchange rates were initially remarkably stable, but after 1956 a few notable adjustments were made. The most important of these were the devaluations of the French franc in I957 and 1958, and the revaluations of the deutschemark and Dutch guilder in 1961. These changes provide a suitable background for the second
‘Mr. Kern is manager of the Economic Analysis Section of the National Westminster Bank Ltd. He writes in a personal capacity. The author is grateful to Linda Smith, Leo Doherty, Barry Coulthurst and Steven Fox, members of his Section, for research assistance.
tFor rate (1) (2)
I. Historical Background
further references to the subject of trade-weighted exchange indices, please see the following : HM Treasury, Economic Progress Report, No. 84. March 1977. Euromoney. April and May 1978 and June 1979.
The Medium-Term Table
1. The historical
experience
of 18 currencies: 1978 Index (I 953 average = 100)
U.S.A. Canada Japan Germany France Italy U.K. Netherlands Belgium Switzerland Norway Denmark Sweden Finland Austria Australia South Africa Spain
89.44 82.97 163.36 184.34 59.94 58.09 55.1 I 131.05 125.75 196.40 123.22 103.71 97.32 46.16’ 119.90 81.50 71.42 45.79
Source: National Westminster exchange-rate
index
trade-weighted
1954-l
3
rates
1954-l
961
+0.38 -0.30 +0.15 +I .33 -3.92 +I.00 +o-50 +0.95 +0.76 +0.44 +0*31 +0.25 +0.53 -3.67 -0.01 +0.10 +0.16 -4.14
1962-l
969
+0.48 -0.65 +0.29 +0.70 -0.48 +O.I 8 -I .66 +0.28 +0.24 +0.30 +0.70 -0.64 +0.66 -2.77 +0.14 +0.19 +0.46 -1.46
1970-l
978
-I .92 -I .06 +5.55 +5.17 -1.40 -6.68 -5.21 +I.96 +I.70 +7.31 +I *52 +0.79 -I .28 -2.31 +I*95 -2.24 -4.02 -3.12
: I8 countries, 1977 trade weights, geometric calculation, 1953 average = 100.
While the world’s economic problems have undoubtedly become more serious in recent years, one should not exaggerate the changes which have taken place in the international currency markets. In 1978 we witnessed some dramatic developments in exchange rates, though it is doubtful whether they signify any structural changes in some of the basic relationships. Sizable currency movements may now occur more frequently than before 1970, but it is important to remember that large movements were not uncommon under the Bretton Woods System. Indeed, abortive attempts to protect an unrealistic currency structure (for example, the attempt to prevent a sterling devaluation before 1967), masked large imbalances and a massive scale of intervention which only added to the underlying instability.
difficult
978
-0.42 -0.69 +2.14 +2.51 -I .91 -2.03 -2.25 +I.10 +0.93 +2.87 +0.86 +0.16 -0.08 -2.90 +0.74 -0.72 -1.24 -2.92
The third period, covering the years from 1970, witnessed many dramatic changes in the international currency markets. A succession of crises led to the final collapse of the Bretton Woods System during 1971, and the emergence of managed (or ‘dirty’) floating in 1973. The oil crisis, which erupted late in 1973, added to the international monetary diffLzulties, and many countries have since experienced an unpleasant mixture of high inflation, recession, payments imbalances and currency instability.
1. A Qualitative Revietu Although it is extremely
Outlook
Average % change per annum
period, covering the years 1962-1969. From 1964 onwards, serious pressure started to build-up, particularly against sterling; and in spite of strong official resistance, the U.K. was forced to devalue in November 1967. This change signalled the beginning of considerable upheavals on the international markets. The French franc was devalued in August 1969, while the German mark was forced upwards in October of that year.
II. The Fundamental
exchange
Currency
Factors to offer a fully
satis-
factory explanation of all the complex processes determining exchange rate movements, both standard economic theory and practical experience provide a conceptual framework within which to discuss the issues. One of the oldest and most appealing theories is that currency movements reflect differing rates of inflation. Although this approach (sometimes referred to as the ‘ urchasing power parity theory’) is widely accepted, t Kere are also many other factors which are often considered important-for example, the balance of payments, interest rates, cyclical pressures and forward exchange rates. It is not surprising that one often finds wide differences of opinion concerning the relative importance of these factors. Statistical studies are often inconclusive; while at the practical level, foreign exchange dealers operating under strong commercial pressures have to react rapidly to changing political and economic developments. A close examination of the historical record provides strong support for the view that in the longer term (say, 5 years or more) relative rates of inflation are the single most important factor explaining currency movements. Such a view is entirely consistent with the existence of a significant short-term relationship between exchange rates and various other factors, the most important of which is probably the balance of payments position on both current and capital accounts. To be more specific, the historical evidence is consistent with the view that relative rates of inflation have a distinct long-term influence on currency trends, over and above any indirect effect which inflation may have on the trade balance or on the rate of interest. However, the emphasis on the long-term nature of the relationship is extremely important, because large deviations from the trend can and do emerge in reaction to many outside events. The existence of a close statistical link between exchange rate movements and relative rates of inflation still leaves
Long Range Planning Vol. 13
4
April 1980
unanswered many difficult questions concerning the causal relationship involved. Thus, it is often argued that the chain of causation goes from exchange rates to inflation rather than the other way round; and when faced with such a problem one must honestly admit that it is not easy to provide a conclusive answer. Nevertheless, although some of the issues cannot at present be resolved in a definitive manner, it seems important not to over-emphasize the intellectual problems. At a practical level, particularly for the business planner, it is usually _sufficient to establish robust statistical relationships which can be applied successfully in forecasting work, without getting entangled in interminable theoretical arguments about cause and effect. Recent analytical developments, particularly the growing emphasis on ‘monetarism’, have led some to the view that the money supply is a basic underlying factor which influences both inflation and exchange rates. This type of argument is interesting when dealing with broad issues of government policy, but in a practical business environment such an approach appears too narrow and is usually inadequate. Given the requirements of the long range planner, his most sensible strategy would be to form a view about basic inflation trends (whether determined by the money supply, by earnings, or indeed by other factors) and then translate this inflation projection into an exchange rate forecast. It seems to me most plausible to think about a long-term sequence which goes from inflation to exchange rates, though in the short term one can identify strong influences which operate in both directions. Such an approach will help the business planner to focus on his getting embroiled in practical priorities, without futile arguments which are often influenced by rapidly changing intellectual fashions. 2. The Statistical Evidence Table 2 summarizes some of the available evidence about Table 2. The economic background Variable
to exchange-rate
in spot rate of
Average % annual change exchange-rate index
in trade-weighted
3
Average
% annual
change
in wholesale
prices
4
Average
% annual
change
in consumer
prices
5
Average
% annual
change
in export
6
Balance GNP’
of payments
7
8
Data: Variables
A more detailed investigation of the regression results brings out two interesting features which appear to conflict with n priori expectations concerning the relationships involved. First, the slope of the regression line for the period 1954-1978 is -1.19, thus differing from its expected value of - 1. The implication of this result is that a 1 per cent widening in the inflation difference between the United States and a particular country would produce a decline in the dollar’s longterm value which is a little larger than 1 per cent. The second unusual feature of the regression results is that the constant term (the point where the regression line touches the vertical axis) differs from zero; and for the
U.S.A. Average % annual change currency against dollar
2
The figures in Table 2 throw interesting light on the different experiences of the major countries over the past quarter of a century, and they also emphasize the importance of distinguishing between different inflation indicators. In the context of exchange rate analysis it seems clear that, although most inflation indices have a close association with exchange rate movements, wholesale prices exhibit the strongest statistical link. The strength and consistency of the long-term relationship between currency movements and relative wholesale prices is very striking, particularly if one takes into account the limitations and inaccuracies inherent in any type of economic data. In contrast, the long-term relationship between exchange rate movements and the other economic factors appears surprisingly weak.
movements:
number 1
the historical relationships between exchange rate movements and other economic variables such as inflation, the balance of payments, money supply and interest rates. The analysis again focuses on 18 major industrialized countries, and the calculations are expressed as annual averages over the period since 1953. The figures illustrate the existence of a close relationship between inflation and currency movements. A more formal statistical link is shown in the correlation matrix presented in Table 3, and in the regression analysis shown in Table 4 and in Figure 1.
Average mid-year cent per annum Average SUPPlY
% annual
prices
current account
official discount
change
1954-1978 Japan
Germany
France
U.K.
Italy
-
2.38
3.13
-0.80
-1.07
-1.38
-0.42
2.14
2.51
-1.91
-2.03
-2.25
3.64
2.72
2.25
4.56
5.90
6.36
351
6.11
3.17
5.58
6.05
6.46
4.03
1 ,49
2.15
5.11
4.81
6.40
0.75
0.43
2.34
0.21
0.46
0.34
4.29
6.52
‘4.05
5.65
4.82
6.95
4.13
15.79
10.53
14-55
6.21
% of
rate-per
in narrow
money 9.41
l-3, annual averages for the period 1954-l 978 inclusive. Variables 4-8, annual averages for the period 1954-l Sources: International Financial Statistics, IMF; National Westminster exchange-rate index. ‘The balance of payments figures are for the period 1956-l 977 inclusive, except those for France, which cover only 1967-l
977 inclusive. 977.
-0.9374
1 .oooo
-0.5166 -0.3477
0.5477 1 .oooo
1 .oooo
1 .oooo
-0.5531
0,8351
0.6151
-0.5476
0.4090
0.4250
V6
1 .oooo
0.8388
-0.8553
-0.8585
v5
Balance of payments current account as % of GNP
0.8133
-0.7253
-0.7149
v4
Average % Average % annual change in annual change consumer prices in export prices
0.9993
-0.9347
-0.9326
V3a
Average % annual change in wholesale prices gap
Input data for each variable comprises the average for the period 1954-l 977 inclusive. The main exceptions are: (a) the balance of payments figures are for the period 1956-I 977 inclusive, except those for France, which cover only 1967-l (b) industrial production-Japan’s figures are for 1955-l 977 and Switzerland’s 1957-l 977 (both inclusive) ; (c) the calculations relating to the official discount rate exclude Australia for which no data is available. Figures show the value of the correlation coefficient I between any pair of variables.
1 .oooo
-0.9360
0.9830
1 .oooo
v3
v2
Vl
Average % Average % annual change annual change in average spot in trade-weighted Average % rate of currency exchange annual change in against dollar rate index wholesale prices
Table 3. Correlation matrix
977 inclusive;
1 .oooo
-0.3254
0.5314
0.5913
0.5587
0.5671
-0.5671
-0.5603
V7
Average midyear official discount rate% per annum
VB v9
-0.1890 0.2002 0.8766 1 .oooo
-0.2179 0.2557 1 .oooo
v7
V6
v5 -0.1766
0.0352
v4
V3a
v3
v2
Vl
Variable No.
0.5151
0.1673
0.1714
-0.1391
-0.1661
v9
0.6484
0.3257
0.3349
-0.2863
-0.2906
VB
Average o/o Average % % annual change % annual in industrial change in narrow production money supply
6
April 1980
Long Range Planning Vol. 13
Table 4. Exchange rates and wholesale price inflation 1954-1978
inclusive
Y= 1.27 - 1.19x r= = 0438
1954-1961
inclusive
Y = -0.25 - 0.99x r2 = 0.74
1962-1969
inclusive
Y = 0.20 - 0.87x r2 = 0.68
1970-1978
inclusive
Y = 3.31 - 1.29x r2 = 0.86
Dependent variable (Y)
Average annual % change of spot exchange rate of each currency against the U.S. dollar
Independent variable (x)
Average annual % change of wholesale prices in each country, relative to those in the U.S.A.
Note: Input data comprises average annual % changes over the periods specified for 18 industrialised countries.
entire period 1954-1978 its value is 1.27. The implication of this result is that, over the period since 1953, there has been a ‘devaluation bias’ against the dollar. It suggests that, even without an inflation gap, the dollar would have been expected to fall by a little over 1 per cent per annum. Although somewhat surprising the results are quite plausible, and simply quantify the downward influence on the dollar of its key role in the world’s monetary system. Table 4, which compares the results analyzing the entire period 1954-1978 with those focusing on each of the three shorter sub-periods (1954-1962, 1961-l 969 and 1970-1978), is interesting for a number of reasons. First, although the relationship covering the longer Y L
x Switzerland
period is the most reliable one, very useful statistical links can also be established for shorter periods of about 8 years. In addition, the separate equations for the three shorter periods produce interesting statistical evidence about changes in the structure of the currency markets, particularly the increased vulnerability of the U.S. dollar in recent years. The equation for the period 1970-1978 has the largest constant term and the steepest slope, indicating the build-up of pressures against the dollar in recent years which possibly led to a temporary fall below its underlying long-term value.
III. The Value and Dangers of Forecasting in Business Planning Forecasting exchange rate movements has become a major ‘growth area’ in recent years. Notwithstanding the very large errors in many forecasts, the demand for currency projections has expanded rapidly. The increased complexity of the foreign exchange markets during the period of floating rates has probably contributed to this phenomenon. Nevertheless, it is still pertinent to raise the question whether systematic forecasts of exchange rates, and indeed of other economic values, can provide useful help to the planner and the practical businessman. There are two fundamental difficulties with this subject. Firstly, the forecasters do not take enough care to emphasize that specific projections are simply logical deductions based on what may be regarded as ‘reasonable assumptions’ about key variables. Consequently, another set of assumptions, perhaps equally reasonable, may produce different forecasts. Secondly, the recipients of economic forecasts sometimes confuse a projection with a prophecy. Regression Currency
Analysis:
Inflation
Inflation Differences and Spot Rates Against the U.S. Dollar xWest Germany
Versus
Movements Exchange
3 Austrk
\ JapanX
N&herlkds 2
ielgium \
18 Countries 1954-1978 r = 0.99 y = 1.27 - 1.19(x) Where
=
y = Average Yearly % Change in Spot Rate of Each Currency Against U.S. Dollar x = Average Yearly % Change -’ in Wholesale Prices in each Country Less Average Yearly % Change in Wholesale Prices in the U.S.
Figure 1
Spainx
The Medium-Term
Currency
Outlook.
7
which involves a great deal ofjudgment, intuition and experience. The task of a competent forecaster is to present those making decisions with a balanced view of the key options and not face them with a wide range of scenarios and possibilities which can only cause confusion and misunderstanding. The various figures in Table 5 should be seen as ‘trend’ projections for 1984. It should be remembered that these ‘trend’ values, even if broadly accurate, will not necessarily coincide with the actual rate prevailing at that time. It is highly likely that there will be significant deviations about the trend, as a result of random shocks or important short-term influences such as the balance of payments.
It cannot be emphasized too strongly that the accuracy of a forecast can never be guaranteed. The best one can hope for is that systematic projections, based on a detailed analysis of the underlying factors, will provide better results on average than an uninformed and random opinion. It is obviously a delusion to assume that one can buy forecasting services which will always be right. However, it is equally wrong to go to the other extreme, and simply assume that one can make business decisions without forecasting key variables such as output, investment, profits and exchatge rates. Admittedly, the operational manager or the planner may decide that he can produce projections which are superior to those issued by the ‘professional forecaster’; and on many occasions this view could well prove correct. Nevertheless, the essential point is that a forecasting framework is an important requirement for making major business decisions, irrespective of whether it is issued by a specialized unit, by the planners, or by the operational managers themselves. Ultimately, the forecast must be seen as a mental discipline involving explicit assumptions about the key factors which appear relevant to those responsible for making decisions.
IV. Conclusions
Following the above introduction to the value and pitfalls of forecasting it may be interesting to formulate a specific numerical projection for the international currency outlook over the next few years. One of the key factors determining the figures presented in Table 5 is the close relationship between wholesale prices and exchange rates, though other important influences have also been taken into account. However, it must be clearly understood that different assumptions about the underlying economic factors would produce different exchange rate forecasts. The main point which must be emphasized is that forecasting, however extensively computerized, is not a mechanical activity, but one
The exchange rate pattern described in Table 5 suggests a number of important conclusions about future international monetary developments. Thus, the U.S. dollar, in spite of its gradually diminishing role, will remain the basis for international trading and investment transactions. There is good reason to believe that rhe ‘dollar crisis’ will slowly fade away over the next 2 or 3 years. Although remaining vulnerable in the short term, the dollar could show a sharp technical recovery once some of the immediate uncertainties are resolved. Taking a longer view, the most sensible assumption would be that, after the immediate technical disturbances have worked themselves out, the dollar could show a gradual trade-weighted appreciation over the next few years. However, a limited number of currencies such as the yen, Swiss franc and deutschemark will continue to exhibit a long-term appreciation potential against the dollar. Strong commitment to monetary restraint, producing below-average rates of inflation in the longer
Table 5. The medium term prospects for 18 currencies-an
illustrative view
Wholesale price inflation average % change per annum
1954-l U.S.A. U.K. West Germany France Italy Switzerland Netherlands Belgium Denmark Norway Sweden Finland Austria Spain Canada South Africa Australia Japan
3.64 6.36 2.25 4.56 5.90 1 .84 2.96 2.57 4.38 3.99 4.68 6.46 3.23 7.15 4.32 5.18 4.10 2.72
Illustrative projection 978 1980-l
984
8.80 9.90 5.50 10.50 12.00 4.50 6.50 7.50 9.50 9.50 9.00 11.00 6.50 10.00 9.80 13.00 11.50 6.50
1978 Exchange rates average position
Illustrative 1984 projection average position
Spot rate against $
Trade-weighted* Index
Spot rate against $
Trade-weighted* Index
1 .oooo 1.9195t 2.0086 4.5128 848.6600 1.7880 2.1634 31.4100 - 5.5146 5.2423 4.5185 4.1173 14.6220 76.6630 0.8766t 0.8696 0.8736 210.4700
89.4367 55.1116 184.3351 59.9377 58.0879 196.4006 131.0528 125.7486 103.7070 123.2198 97.3182 46.1611 119.8995 45.7890 82.9711 71.4221 81.5023 163,3587
1 ,oo 2.01 t 1.62 4.53 932.00 1 .43 2.02 29.80 5.90 5.40 4.60 4.20 12.80 74.40 0.80 0.94 1.02 204.00
89.7644 55.7353 223.0068 55.7866 48.8239 230.6941 128.7729 122.9663 91.0413 114.0591 92.1333 43.2300 121-5908 45.1132 75.4680 62.2841 67.7538 169.6889
*National Westminster exchange-rate index : 18 countries, 1977 trade-weights, tNumber of U.S. dollars per pound sterling and Canadian dollar.
geometric calculation. 1953 = 100.
8
Long Range Planning Vol. 13
April 1980
term, must lead to the conclusion that these three currencies will move along an underlying upward trend. The worsening inflation background in the U.S.A. over the past few years is a difficult problem; more serious in its consequences than the sizable, but probably temporary, balance of payments deficits. Nevertheless, the firm policies adopted by the U.S. administration, and the change of public mood in the U.S.A. towards reducing public spending and taxes, suggest that long-term American inflation will be contained around 84-9 per cent. This is higher than in Germany, Japan and Switzerland, but lower than the expected rate of inflation in many other countries, both inside and outside Europe. On the basis of present policies, it seems reasonable to assume that countries such as France, Italy, Britain and Sweden, to name but a few, will experience higher inflation rates than the U.S.A. and the dollar should exhibit a gradual long-term appreciation against their currencies. For Europe, the implications of such a view are clear. In spite of commendable efforts to achieve greater economic and monetary integration, the realities of the situation continue to suggest that inflation differences will remain significant. Consequently, the exchange rate pattern within Europe will have to be adjusted fairly regularly. This conclusion may disappoint some people, but the aim of greater monetary integration contains many desirable features, even if complete monetary union and total exchange rate stability is unlikely to be achieved. The existence of the European Monetary System (EMS), and similar arrangements, should encourage the various European nations to pursue policies designed to systematically narrow the
economic differences between them. Furthermore, in doing so, a gradual lowering of Europe’s average rate of inflation is likely to be achieved. Thus the efforts towards achieving greater monetary stability should prove highly beneficial. At the same time, it is important not to aim for unrealistic targets. For example, it would be highly undesirable, and in the long run destabilizing, to try to freeze an exchange rate pattern when economic fundamentals, particularly inflation rates, do not permit it. Admittedly, earlier hopes that exchange rate flexibility would provide a panacea have been proved wrong, and there is greater emphasis today on the need for stability. However, to have a measure of exchange rate flexibility remains extremely important, preventing some of the more unpleasant upheavals which used to occur before ‘managed’ floating became widely accepted in recent years. A degree of floating will remain very important in the future relationship between major currency blocs, such as those increasingly likely to centre around the yen, the dollar and the deutschemark. A system permitting limited exchange rate flexibility is inevitable and indeed desirable. However, governments would be wise to remember that flexibility cannot solve the problems resulting from excessive money creation, and that in certain circumstances, unlimited flexibility can become the mechanism which speeds up the inflationary consequences of such a policy. Fortunately, the dangers of high inflation are better understood throughout the entire industrialized world today, and those responsible for planning and decision-making will undoubtedly benefit from a period of low inflation and greater stability in the financial markets.