Factors determining long-term

Overview
In the long run, we would expect that equivalent
goods in different countries should cost the same in
a free market after conversion into a particular currency.
The profit opportunities from cross-border trade
should only be temporary. If prices and exchange
rates are flexible, they should change in such a way
that these opportunities for arbitrage gradually disappear.
The price alignment process starts when
goods which are cheaper abroad are imported. This
will cause demand for foreign currencies. The increase
in demand for a foreign currency will result in its
costing more. This in turn will cause a gradual increase
in the price of the foreign goods, and this process
will continue until the goods cost the same in
both countries and the exchange rate evens out the
purchasing power of both currencies. Different prices
for market goods are thus a driving force behind
exchange rate movements. In a world where goods
and capital move freely, it would therefore be natural
to expect the prices of similar products to be in proportion
to the exchange rate. This equilibrium will
emerge across a long period, during which all prices
have been aligned. In this trading environment with
prices that are balanced out, absolute purchasing
power parity applies. The “law of one price” applies,
i.e. all goods and services cost the same after conversion.
Example:
Absolute purchasing power parity
and the Big Mac
The British magazine “The Economist” uses a special
international product to measure purchasing power
parity: the Big Mac. It is prepared using the same
recipe and ingredients by McDonald’s in more than
80 countries. Global Big Mac purchasing power
parity would be reached if Big Macs were to cost the
same in all countries after conversion using actual
exchange rates. Comparing the purchasing power of
2. Factors determining long-term
currency market trends
Absolute purchasing power
parity: exchange rates
even out price differences
12
the USD with other currencies gives the following
picture:
Big Mac purchasing power parity (PPP)
Country Price in Price in USD Actual ex- Implied Local currency
local currency in April change rate PPP of under (–) or
1996 on 25 April the dollar over (+) valuation
2000 versus the dollar
USA USD 2.51 USD 2.51
Chile CLP 1260 USD 2.45 514 502 –2%
China CNY 9.90 USD 1.20 8.28 3.94 –52%
Germany DEM 4.99 USD 2.37 2.11 1.99 –6%
France FRF 18.50 USD 2.62 7.07 7.37 +4%
Russia RUR 39.50 USD 1.39 28.50 15.7 –45%
Sweden SEK 24.00 USD 2.71 8.84 9.56 +8%
Switzerland CHF 5.90 USD 3.48 1.70 2.35 +39%
Taiwan TWD 70.0 USD 2.29 30.6 27.9 –9%
Czech Republic CZK 54.37 USD 1.39 39.1 21.7 –45%
Hungary HUF 339 USD 1.21 279 135 –52%
The price of a Big Mac in local currency in April 2000
is divided by its price in the USA (= USD 2.51). This
figure shows the purchasing power of the local currency
against the dollar. For example, on 25 April
2000 a Big Mac cost SEK 24.00 in Sweden. If the
exchange rate had been USD/SEK 9.56, the Big Mac
would have cost the same in both countries. However,
the actual exchange rate on the day in question
was USD/SEK 8.84. In other words, the Swedish Big
Mac cost USD 2.71, USD 0.20 more than if it had
been bought in the USA, implying that the SEK was
8% overvalued against the dollar.
A comparison of prices shows clearly that exchange
rates and purchasing power parity can differ widely.
There are a number of reasons for this “infringe-

ment” of purchasing power parity. Transport costs
can affect the price of the final products. This means
that the same products should be priced differently
in different places: they should be cheapest close to
where they are produced. But trade barriers too –
such as customs duties or import restrictions – can
lead to a gap between domestic and foreign prices.
In addition, the cross-border mobility of the working
population is low. This can result in permanent wage
differentials. Finally, a variety of goods and services
which help make up the final price are not marketable.
For example, you can buy real estate abroad,
but you cannot use it as a retail site in your own
country.
However, this “interference” with marketability does
not necessarily prevent the establishing of a longterm
parity benchmark for currencies. Instead of individual
prices, comparisons can be made between
price levels calculated from baskets of goods. Changes
in price levels can express shifts in the purchasing
power of one currency relative to another. The most
common benchmark for price levels in a country is
the retail price index. This measures the price of a
basket of goods typically consumed by private households.
The growth of the prices combined in the basket can
be used to identify the rate of price increases, in
other words inflation. The key factors determining
exchange rate movements according to purchasing
power parity are the prices of the marketable goods
measured in the producer price index. In the case of
relative purchasing power parity, movements in the
exchange rate should reflect changes in the price
level of the marketable goods in the countries concerned.
This does not affect actual purchasing power
itself. The important factor is therefore the development
of the relative price level in the relevant countries.
Any change in the relative price level is simply
the difference between the inflation rates in the two
Relative purchasing power
parity: differences in
inflation determine
currency appreciation and
depreciation
14
countries. The principle of relative purchasing power
parity should therefore mean that a change in exchange
rates corresponds to the difference in manufacturing
price inflation between the countries being
analyzed. In other words, the real exchange rate
should be constant.
Example:
Producer prices in France and Germany
Comparing producer price inflation in Germany and
France with changes in the DEM/FRF exchange rate
shows that long-term exchange rate trends can be
determined by differences in the inflation rate for
traded goods. Between 1979 and 1987 producer price
inflation was far higher in France than in Germany.
As a result, the FRF depreciated against the DEM.
The exchange rate has only been relatively stable
since 1988, i.e. since the time both countries have
had similar inflation rates.
Producer prices in France and Germany
and DEM/FRF
3.6
3.4
3.2
3.0
2.8
2.6
2.4
2.2
2.0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
10
5
0
–5
Difference of
producer price inflations
(right-hand scale)
DEM/FRF
(left-hand scale)
15
The purchasing power parity alignment processes
have a direct impact on the creation of income in an
economy. Exchange rates are the major factor affecting
the prices of imports and exports.
Exports are the sale of domestic goods and services
abroad. Imports are purchases of foreign goods and
services for domestic consumption. “Net exports”
refer to the aggregate international trade in a country’s
goods and services. They are calculated as total
exports less imports over a specific period. Positive
net exports mean that more has been exported than
imported.
Flows of goods and services reflect the creation and
utilization of income. Exports result in the creation
of domestic income. Imports represent spending by
residents and thus reflect the utilization of income.
If more is exported than imported in terms of value,
domestic net assets increase during the accounting
period due to the net inflow of income. If net exports
are negative, domestic net assets drop because there
has been an outflow of net income.
Foreign trade and the
creation of income
Exports Imports
Net exports
Investment
GDP
State spending
Private
consumption
16
The creation and utilization of all income generated
in a country is recorded in the national accounting
system. This also includes all foreign transactions.
The gross domestic product (GDP) is the total income
generated within the country. It corresponds to
aggregate consumer spending by private households,
public-sector spending on goods and services, capital
expenditure and net exports.
The commercial transactions of a domestic economy
with the rest of the world are recorded in the balance
of payments. This contains not only all imports and
exports of goods, but also all capital movements relating
to investments, capital spending and publicsector
capital transactions. In reality, the term “balance
of payments” is doubly misleading. On the one
hand, it is not only international payments which are
recorded in the balance of payments, but also the
underlying flows of goods and services. On the other,
Capital account
+ change in SNB’s net status
Current account
(current transactions)
Balance of payments
Invisible account
(including wages and salaries and return on capital)
Balance of unilateral
transfers
Trade balance
Net exports
Balance of payments diagram
Balance of payments:
total movements of goods
and capital
17
the term “balance” is inaccurate from the accounting
perspective, as the balance of payments records flows
over a period, rather than holdings and inventories at
one particular time. At the most, the sub-accounts of
the balance of payments are balanced purely fortuitously.
In aggregate terms, however, their balances
must always bring the overall balance of payments
to equilibrium. Strictly speaking, there can be neither
a balance of payments surplus nor a deficit. When
people talk of balance of payments surpluses or deficits,
they have misunderstood the concept of the
balance of payments.
What they actually mean are imbalances in subaccounts
or balances, such as the trade balance,
current account, or capital account.
If a country records a current account deficit, for
example because it has imported more than it has
exported, it has to assign a receivable for the surplus
of goods imported from abroad. The current account
deficit is therefore offset by a surplus in the capital
account. More sustained balance of payments
deficits can only exist as long as residents want to
borrow abroad or foreigners are willing to invest in
the domestic economy. These capital transactions
represent changes in net assets. The result of a
current account deficit is thus to reduce domestic
net assets.
Example:
US net foreign assets
The USA has run a current account deficit every year
since President Reagan’s first term of office. This
situation was triggered by a sharp reduction in US tax
rates. Since this was initially only accompanied by a
slight reduction in State spending, the result was a
budget deficit that could not be financed solely out
of domestic savings. The USA were thus forced to import
foreign capital to finance government spending
by running up a deficit on its balance of payments on
current account. While the US have built net foreign
Current account deficit =
increase in net foreign debt
18
Net foreign assets and
exchange rates
assets up to over USD 400 bn in the period up to
1980, they have subsequently declined from this time
on. Today, the USA are the world’s biggest debtor.
Portfolio considerations play an increasing role in setting
exchange rates. An investment portfolio consists
of a mix of domestic and foreign investments. These
investments in a number of countries are not completely
interchangeable because diversification and
risk spreading considerations mean that investors will
only ever invest part of their assets in a particular
country. If a current account surplus is maintained
with a trading partner over several years, the number
of foreign investments in the domestic portfolio will
increase. The moment the specified portion of investments
in the country with the current account deficit
is exceeded in the domestic portfolio, surpluses of
these investments flow onto the international capital
market. Investors seek to replace these investments
with domestic or other foreign investments. The
result is a surplus supply of the currency of the surplus
investment. The exchange rate reacts to this
change in the investment portfolio: the capital mar-
US net foreign assets
600
400
200
0
– 200
– 400
– 600
– 800
– 1000
– 1200
USD bn
1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995
19
kets can only be balanced by devaluing the foreign
currency. After devaluation, the value of the foreign
currencies, expressed in the domestic currency,
again equals the specified portion of the investment
portfolio.
Over the long term, therefore, a situation can be
reached where the current account is in equilibrium.
Net creditor countries must accept that their currency
is stronger than would be necessary for a balanced
trade account. Inflows of investment income must be
compensated by a trade deficit for the current
account to be balanced. In turn, substantial longerterm
current account deficits result in the long-term
devaluation of the currency of the country concerned.
This is why even over a very long period, the currency
may not reflect the purchasing power parity on the
markets for goods.
According to purchasing power parity theory, real
exchange rates (i.e. purchasing power parity adjusted
to take account of producer price inflation) should
remain constant, at least in the long run. In fact, the
impact of a reduction in net foreign assets stretches
beyond an inflation-related change in the exchange
Long-term consequences of
borrowing: devaluation
Change in real exchange rates and cumulative
current account surplus/deficit (1995)
3.0
2.5
2.0
1.5
1.0
0.5
0
– 0.5
– 1.0
– 1.5
– 1500 – 1000 – 500 0 500 1000
USD
CAD
CHF
DEM
JPY
FRF
ITL
GBP
Cumulative current account
surplus/deficit USD bn
Real appreciation p.a.
in %
20
rate to depreciation of the currency. Approximate net
foreign assets can be calculated from past cumulative
current account deficits/surpluses because the current
account reflects changes in net foreign assets.
The best example of this is Japan. The yen has appreciated
in real terms as a result of the sustained
surplus on its balance of payments on current
account.
Nowadays, transactions directly related to trade in
goods account for less than 5% of trading volumes
on the international foreign exchange markets. Most
transactions are based either on transactions indirectly
triggered by the commercial sector or on business
or financial market investment. The reason behind
this is that in recent years capital has become extremely
mobile, firstly because of the leap in technology,
and secondly because barriers to capital
movements are increasingly being eliminated.
The devaluation of the USD as a result of rising producer
price inflation is shown by purchasing power
parity (PPP). Clearly the relative rise in Switzerland’s
net asset position means that in the medium term the
USD/CHF exchange rate should be below the level
implied by purchasing power parity. Accordingly, in
the long run Switzerland should have a trade deficit,
at least with the USA.
PPP – exchange rate
fixing by UBS
Growing importance of
capital transactions

The description of the long-term factors affecting
exchange rates shows clearly that it is quite possible
to identify exchange rate trends based on macroeconomic
arguments. In fact, PPP is relatively well
suited to forecasting exchange rate movements over
several months. For daily operations and currency
risk management, however, they are not sufficiently
powerful. The following chapter will therefore look
at the factors which have an immediate impact on
exchange rates.