RDP 9203: Real Exchange Rates and the Globalisation of Financial Markets 1. Introduction

The failure of exchange rate models to forecast movements in currency values is widely documented. Structural equations cannot outperform the random walk model, which states that exchange rate changes are unforecastable. Proponents of the idea that markets are efficient argue that exchange rate movements are dominated by errors in the markets' forecast of fundamentals. Others argue that markets are not efficient, and the exchange rate is dominated by expectations cycles independently of the behaviour of fundamentals. For whatever reason, these observations suggest that the exchange rate is largely disconnected from information available about economic fundamentals. Even taking a longer-view of the real exchange rate, most empirical studies have failed to find mean-reverting behaviour. Thus, for example, purchasing power parity (PPP) is rejected on post-Bretton Woods data (Adler and Lehman (1983), Huizinga (1987), Meese and Rogoff (1988), and Corbae and Ouliaris (1988)). Similarly, tests to find long-run relationships between the real exchange rate and variables such as real interest differentials have failed (Meese and Rogoff (1988), Coughlin and Koedijk (1990)).

Tackling these puzzles concerning the exchange rate may require relaxing an important implicit assumption of most previous studies. This assumption is that the international financial environment is unchanging or, if changing, has no consequences for the exchange rate. An important thesis of the present paper is that explicitly recognising the effects of the progressive globalisation of world financial markets in the 1970s and 1980s has important implications for the understanding of exchange rate behaviour.

World financial market integration has proceeded rapidly in the past decade, far exceeding that in goods markets, labour markets or markets for physical capital^[1]. Capital controls and limitations on entry of foreign financial institutions into the domestic market have been dismantled in most major OECD countries and many of the smaller ones. At the same time the rapid growth of offshore financial markets, removal of exchange controls, the development of 24 hour screen-based global trading, the increased use of national currencies outside the country of issue and innovations in internationally-traded financial products have all contributed to the globalisation of capital markets.

In the extreme case of financial autarky, only a zero current account balance is sustainable, except for periods when official reserves can be run down. The real exchange rate and the rate of interest adjust to ensure that this is so. As capital controls are removed, creditworthiness and exchange risk considerations alone replace official restrictions as the only limitations on market access. These developments bring with them many benefits. With only solvency (as opposed to liquidity) constraints likely to limit access to international capital markets in the liberalised environment of the 1980s and 1990s, the scope for divergences between domestic savings and investment is greatly increased, as foreign savings are readily available to bridge such gaps. That is, countries can choose paths for consumption and investment which are largely independent of each other. The allocation of savings and investment in the world economy may be improved, and national consumption paths may be more easily “smoothed” in the face of temporary exogenous shocks to national income affecting one country differently from all others.

The internationalisation of world financial markets, permitting the emergence of large external imbalances, may have permanent effects on the equilibrium real exchange rate. This is because of the cumulation over time of net foreign assets or liabilities. There is no reason to believe that the optimal levels of such financial stocks are zero. Debt accumulation can continue as long as countries can service their obligations – no-one expects the major debtor countries to repay their cumulated debts in full nor countries like Japan to relinquish their assets within any specified time period. The process of liberalisation and globalisation then, by reducing liquidity constraints between countries, is likely to cause permanent shifts in net foreign asset and liability positions. This leads to shifts in net property income obligations which, in turn, change the underlying equilibrium trade balance, and hence the long-run real exchange rate associated with it.

The internationalisation of world financial markets, then, may be important for unravelling some of the above-mentioned puzzles about real exchange rate behaviour. Such a possibility does not seem to have been considered by others. Meese, for example, in a recent survey of exchange rate modelling, confines himself to the following remark on financial liberalisation:

“Financial innovation and the mitigation of international capital controls over the post-Bretton Woods era complicates inference just as peso problems do.” (1990, p. 129)

Section 2 of the paper introduces a model which links the long-run real exchange rate with real interest differentials and cumulated current account balances, which are driven by the process of financial liberalisation. This model is tested on data for four major real exchange rates. The model and empirical work is based on the assumptions that i) financial liberalisation and globalisation has been an important phenomenon over the sample period, and ii) that the globalisation of financial markets does not imply the integration of goods markets, so that there is no necessary tendency for real interest rate parity to emerge. Section 3 of the paper examines both of these assumptions using alternative measures of integration. The findings in this section are consistent with the interpretation of the earlier econometric results. The final section provides some concluding remarks.

Footnote

See Bryant (1987). [1]