Since the end of the Bretton Woods era in the early 1970s, the yen has appreciated from 360 yen to the dollar to roughly 100 yen to the dollar. More recently, the euro first fell upon its introduction in 1999 from 1.18 dollars to 0.82 dollars in 2002 before appreciating to the current exchange rate of 1.42 dollars. The importance of such large swings on financial markets and corporate earnings is self-evident and the importance to the broader economy has long been a central question in economics.
Over the centuries, economists focus on the impacts of exchange rate changes has largely been on the trade side. When there were large swings in the exchange rate, the key question was what would happen to the trade balance, what was the shape of adjustment, and what would the impact be on import prices and ultimately consumer prices. As the size of cross-border capital flows grew, economists turned to thinking about exchange rate behaviour through the lens of asset markets, but since gross and net positions were still relatively small, the focus on the role of exchange rate movements in the international adjustment process remained on its impact on trade accounts and trade prices.
A new perspective
In recent years, exchange rate economics has taken a new twist. A wave of research emphasises that exchange rate movements operate through a valuation channel, in addition to their traditional impact on real-side variables such as the trade balance.1 The valuation channel refers to the impact of capital gains and losses on the international balance sheet. While such valuation effects have always been present, their quantitative significance has grown in recent years in line with the rapid growth in the scale of cross-border financial holdings. Since currency movements are an important contributor to capital gains and losses on foreign assets and liabilities, it is especially important to understand the international financial impact of shifts in exchange rates.
For instance, unanticipated dollar depreciation improves the net international investment position of the United States by increasing the dollar value of its foreign assets (which include many foreign-currency assets) relative to its foreign liabilities (which are predominantly denominated in dollars). In contrast, many emerging markets have historically issued significant amounts of foreign-currency debt -- for these countries, currency depreciation has had an adverse impact on the net foreign asset position as the depreciation means that foreign debt is now a bigger burden in local currency terms. These examples illustrate how the operation of the valuation channel varies across countries based on the scale of the international balance sheet, the net value of the position, and the currency composition of foreign assets and liabilities.
Although there has been a significant expansion in the availability of data on many dimensions of international balance sheets in recent years, remarkably little is known about the currency composition of the foreign assets and liabilities of most countries. Accordingly, a major contribution of our project is to address this data deficit by building an empirical profile of the international currency exposures of a large number of countries.2 We exploit the estimated currency positions to create financially-weighted exchange rate indices that better capture the valuation impact of currency movements relative to standard trade-weighted indices. In turn, the interaction of the financial exchange rate indices and the gross scale of the international balance sheet allows us to capture the valuation impact of currency movements on net foreign asset positions. In addition, the currency exposure data are useful in evaluating the extent to which countries are long or short compared to the rest of the world's currencies in their overall portfolio. Accordingly, the analysis of currency exposure data may provide new insights on the interaction between financial globalisation and macroeconomic outcomes.
Our analysis yields three important findings.
- First, financially-weighted exchange rates move quite differently than trade-weighted exchange rates.
In particular, we find that the mean and median within-country correlation of trade and financial exchange rates is negative. Many countries have effectively stabilised their financial exchange rates by matching currency exposures on the liability side with corresponding asset positions, leading to stable financial exchange rates even when trade-weighted exchange rates move considerably. For others, negative net currency positions generate negative correlations with trade-weighted exchange rates or positive positions generate positive (albeit not complete) correlations with trade-weighted exchange rates. In short, trade-weighted exchange rates are not particularly informative regarding the financial impact of shifts in exchange rates, without knowing the structure of cross-border currency exposures.
- Second, in relation to the aggregate net position in foreign currencies, we find that the majority of countries have a net negative exposure, implying that unexpected depreciation generates wealth losses.
These net negative positions are quite large in many cases, and leave countries exposed to substantial valuation losses in the event of a depreciation. At the same time, over the last decade, many countries have shifted their hedging positions in a positive direction. Shifts to equity and direct-investment financing of liabilities and large increases in reserves have been the key factors moving countries to a more balanced or even positive net position. Increases in the share of international debt that is denominated in domestic currency have been quite small and thus have played little role in alleviating currency mismatches.
- Third, when it comes to the size and properties of exchange-rate valuation shocks, we find that the shocks are substantial and are not reversed by quick exchange-rate turnarounds (the autocorrelation of exchange-rate valuation shocks is in fact positive).
Furthermore, the exchange-rate valuation shocks calculated based on our indices are good predictors of the overall valuation shocks an economy faces, especially for developing countries. Their scale and long-lasting nature means that these wealth shocks may have non-trivial impacts on the wider economy. In addition, since currency movements lead to cross-border wealth redistributions, these are especially important for the international transmission mechanism relative to other asset price shocks.
Our findings highlight the importance of modelling the dual role of exchange rates in the international adjustment process, with the financially-weighted exchange rate index operating through the valuation channel and the trade-weighted index influencing the dynamics of net exports. As we have highlighted, the potential importance of the valuation channel is secularly increasing, in line with the rapid growth in the gross levels of foreign assets and liabilities. Moreover, the interaction between external wealth effects and domestic sectoral balance sheets may be important for domestic macroeconomic performance, since the net worth of banks, firms, households and the government may be affected by currency-induced valuation shifts. In this regard, an important goal for future research is to establish the conditions under which such valuation movements may have a stabilising influence versus scenarios under which the impact is pro-cyclical.
Gourinchas, Pierre-Olivier and Helene Rey (2007), “International Financial Adjustment,” Journal of Political Economy, August, 665-703.
Lane, Philip R. and Gian Maria Milesi-Ferretti (2005), "Financial Globalization and Exchange Rates") in Dollars, Debt, and Deficits---60 Years After Bretton Woods, International Monetary Fund.
Lane, Philip R. and Gian Maria Milesi-Ferretti (2007), "Europe and Global Imbalances,” Economic Policy 22, July, 519-573.
Lane, Philip R. and Jay Shambaugh (2007), "Financial Exchange Rates and International Currency Exposures," CEPR Discussion Paper No. 6473, September 2007.
Obstfeld, Maurice, (2004), “External Adjustment,” Review of World Economics 140, 541-568.
Tille, Cedric (2003), “The Impact of Exchange Rate Movements on U.S. Foreign Debt,” Current Issues in Economics and Finance 9(1).
Tille, Cedric (2005), “Financial Integration and the Wealth Effect of Exchange Rate Fluctuations,” Federal Reserve Bank of New York Staff Report No. 226.
1 Gourinchas and Rey (2007) and Tille (2003, 2005) have studied the valuation channel of exchange rate adjustment for the United States, while Lane and Milesi-Ferretti (2005, 2007) provide evidence for a broader range of countries. Also see the survey by Obstfeld (2004).
2 This article draws on "Financial Exchange Rates and International Currency Exposures," CEPR Discussion Paper No. 6473, September 2007. See also Lane and Milesi-Ferretti (2007) for alternative estimates of currency exposures for a smaller set of advanced economies.