Friday, July 27, 2007

Currency adjustments: The way global financial markets works

Currencies connect the economies to each other. On the long run , there is only one price for goods adjusted by parity conditions among different currencies. The Big Mac index is a measure of that unique price, and at the same time any deviation from it .
Those deviations, measure the undervalue and overvalued value of any currency at some point in time, in other words ,its deviation from the unique price long term price.. Thus, while an hamburger actually cost in the USA U$$ 3,22 , in the euro zone cost the equivalent of U$$ 4,06.It follows that at current price parity conditions , the euro would be overvalued by 25,65%.The same exercise applied for the yen show that this currency would be undervalued by 27,95%. These mismatches currency values, implies portfolio adjustment against the dollar. Considering the dollar and the euro , the trend has been in favour of the euro . However,since 2001 up to 2006, productivity in the euro zone has been stable, while the euro has appreciated on average by 14,3% . Therefore, somehow the current high euro value,(appreciation) would reflect the port folio adjustment which is taking place among other variables ,because of expectations of further decrease (depreciation) in dollar value.-
Which are the explanations for such expectation ?:
a.- The interest rate differentials between Europe and US are falling. The Euro zone Central Bank , is increasing the interest rate .-
b.- US economy growth, can be affected by sub prime housing market correction, deeper than expected. (Sub Prime represent no more than 15% of total housing markets credit)
c.- Current account unbalances in the US economy ,which is expected to be up to 5,9% of its 2007 Gdp.-
d.- Portfolio adjustment in favour of the euro issued assets , and carry trade transaction.
Whatever the reasons ,dollar depreciation has effects on global economy. It push upward raw material prices . Most of Latin America economies strongly orientated to primary good exports ,are ,getting an external boost for their growth performance. It also means increasing risks for further inflationary pressures.-
On the other hand, some European countries are started to be worried because of the euro might be getting close to the danger zone, risking loss of competitiveness for exports .A strong Euro, has a positive impact in those economies with high productivity levels, but as long as there are differences in productivity levels, some of them get a better share of the benefit than the others, and some are left behind .At the same time, an undervalue currency (yen) is also risky because it is away from macroeconomic fundamental.-
At present ,it is important to have some perspective. Over the short run, financial flows are more important than trade flow to explain exchange rate fluctuations .It follows that unpredictable financial markets movements, are more important as an explaining factor of currency fluctuations ,than real variables. However ,in the medium and long run it is possible to substitute traded goods, and exchange rates are determined by real forces that influence their relative prices.( A fair exchange?: Theory and practice of calculating equilibrium exchange rates .IMF /WP/ 05 /229.Bayoumi,Faruqee and Lee).
So, it seems that we are looking at the sensitivity and worries of global financial markets , concerning the fundamental of the global economy. Overreaction is a short term phenomena .The long term course, will be determined by the chance of a coordinated adjustment policy between different global currencies.- Whichever these forces is stronger it will mean more or less volatility in financial global markets.-

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