A Framework for Foreign Exchange Valuations Dr Robert S Gay Fenwick Advisers February 18, 2013

FX Fundamentals Over horizons that might span as long as a decade, a few fundamentals tend to dominate a currency’s value regardless of the noise embodied in short-term volatility and distortions that might persist for years. Relative inflation rates (concept of purchasing power parity) Current account position, which reflects a country’s competitive advantages or natural endowments, especially if a country has persistent surpluses or deficits. Net foreign assets or liabilities as well as both their quality and quantity – Net foreign liabilities of the banking sector tend to pose systemic risks to domestic banking industry – Net foreign assets of companies and households tend to represent accumulated savings and investments that engender significant benefits in form of repatriated income flows – Both the quality and quantity of net foreign assets are a major considerations in determining a country’s ability to service foreign debt and also influence its willingness to service debt. – Income flows from foreign assets tend to prolong trends in currency values long beyond the time when superior fundamentals and/or comparative advantages rule. – As with all saving, the key to their effect on market valuations depends in large part on whether the saving was invested wisely or foolishly.

Net Foreign Assets as a Proxy for Creditworthiness and Long-term Currency Trends

Short-term ‘Noise’ For short horizons of 3-6 months, exchange rates are buffeted by a host of factors that may or may not be the source of a trend in valuation. Significant disparities in nominal interest rates can encourage hot-money ‘carry’ trades if local debt instruments are liquid and accessible Surprising economic data or political events that may portend changes in monetary or government policies Technical trading that underpins a currency’s volatility Large cross-border transactions

Medium-term Influences On a longer horizon of one to five years, factors affecting exchange rates tend to be rooted in domestic economic fundamentals relative to those abroad. Relative strength of domestic demand at home and abroad Changes in current account balances Mix of imports and exports (demand elasticities) Competitiveness of key industries Prices of key commodities Technology transfer to lower-wage countries Safe haven status Monetary and fiscal policy settings

Medium-term Influences (cont) Of particular interest are the monetary policy settings relative to those elsewhere. Classic policy mix for appreciation: tight money/loose fiscal policy Classic policy mix for depreciation: loose monetary conditions/tight fiscal policy Otherwise, currencies often bear the burden of adjustment if a country’s policies and/or economic performance is somehow asynchronous with those elsewhere. Such disparities can cause a currency to become over- or undervalued for long periods until the mispricing eventually takes a toll on the nation’s competitiveness or foreign investment. Capital controls tend to reduce volatility associated with short-term influences but raise the chances of amplifying the effects, for better or worse, of mispriced exchange rates over medium terms.

FX and Leverage Propositions: During periods of increasing leverage, distortions in currency values can persist for many years without self-correcting. During periods of widespread deleveraging, distortions in currency values tend to be undermined by recession/deflation and creditor nations fill the financing void left by global banks.