RDP 9203: Real Exchange Rates and the Globalisation of Financial Markets 4. Concluding Remarks

An important puzzle about real exchange rates in the post-Bretton Woods era concerns their non-stationarity. A presumption in much of the earlier literature is that such behaviour suggests that real exchange rates are decoupled from fundamentals, with inefficient expectations cycles dominating outcomes in a non-mean-reverting fashion. The above analysis suggests that this view is too strong, and may derive from failing to take sufficient account of the globalisation of financial markets. Three of the four real exchange rates considered, and all of the real interest differentials and cumulated current account balance differences possess a unit root. These variables are shown to be cointegrated during the floating exchange rate period in three out of the four cases examined.

This finding about the behaviour of the long-run real exchange rates was interpreted in the context of financial liberalisation and the greater integration of world capital markets. This process reduces liquidity constraints in a world where default and currency risks remain. As desired net foreign asset and debt positions shift in a non-stationary fashion, so too will long-run net interest receipts or burdens, which shifts the long-run real exchange rate over time. The cointegration finding means that unexplained residuals – possibly driven by inefficient expectations cycles – are mean-reverting. It is interesting to note here that these residuals do not themselves seem to have been affected by the process of globalisation – the notion that unfettered financial markets might display increased “noise”. Indeed, the case of France suggests that the nature of the exchange rate regime is likely to be much more important in determining unexplained residuals. There has been a marked decline in the amplitude of the FF/DM residuals as financial liberalisation has proceeded – to about 2 per cent on either side of the equilibrium rate, compared to more like 10 per cent for the yen/$ and £/DM rate over the sample period. But this unique experience is thought to be more a direct consequence of France's participation in the EMS – an example of an exchange rate target zone.

A separate careful examination of the globalisation process yields results which are consistent with the interpretation given. That closed and covered interest parity should emerge over the sample period is the predictable consequence of the removal of official impediments to the free movement of capital. This latter process, in turn, is associated with reduced liquidity constraints. But reduced liquidity constraints do not imply perfect integration of international financial and goods markets. Increasing globalisation of financial markets combined with lack of goods market integration opens the way for both net foreign assets and real interest differentials to play a role in long-run exchange rate behaviour.