APPROACHES TO FORECASTING

Assuming the inefficient market school is correct that the foreign exchange market’s estimate of future spot rates can be improved, on what basis should forecasts be prepared? Here again, there are two schools of thought. One adheres to fundamental analysis, while the other uses technical analysis.

Fundamental Analysis

Fundamental analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. The variables contained in these models typically include those we have discussed, such as relative money supply growth rates, inflation rates, and interest rates. In addition, they may include variables related to balance-of-payments positions.

Running a deficit on a balance-of-payments current account (a country is importing more goods and services than it is exporting) creates pressures that may result in the depreciation of the country’s currency on the foreign exchange market.23 Consider what might happen if the United States was running a persistent current account balance-of-payments deficit (as it has been). Because the United States would be importing more than it was exporting, people in other countries would be increasing their holdings of U.S. dollars. If these people were willing to hold their dollars, the dollar’s exchange rate would not be influenced. However, if these people converted their dollars into other currencies, the supply of dollars in the foreign exchange market would increase (as would demand for the other currencies). This shift in demand and supply would create pressures that could lead to the depreciation of the dollar against other currencies.

This argument hinges on whether people in other countries are willing to hold dollars. This depends on such factors as U.S. interest rates, the return on holding other dollar-denominated assets such as stocks in U.S. companies, and, most importantly, inflation rates. So, in a sense, the balance-of-payments situation is not a fundamental predictor of future exchange rate movements. For example, between 1998 and 2001, the U.S. dollar appreciated against most major currencies despite a growing balance-of-payments deficit. Relatively high real interest rates in the United States, coupled with low inflation and a booming U.S. stock market that attracted inward investment from foreign capital, made the dollar very attractive to foreigners, so they did not convert their dollars into other currencies. On the contrary, they converted other currencies into dollars to invest in U.S. financial assets, such as bonds and stocks, because they believed they could earn a high return by doing so. Capital flows into the United States fueled by foreigners who wanted to buy U.S. stocks and bonds kept the dollar strong despite the current account deficit. But what makes financial assets such as stocks and bonds attractive? The answer is prevailing interest rates and inflation rates, both of which affect underlying economic growth and the real return to holding U.S. financial assets. Given this, we are back to the argument that the fundamental determinants of exchange rates are monetary growth, inflation rates, and interest rates.

Technical Analysis

Technical analysis uses price and volume data to determine past trends, which are expected to continue into the future. This approach does not rely on a consideration of economic fundamentals. Technical analysis is based on the premise that there are analyzable market trends and waves and that previous trends and waves can be used to predict future trends and waves. Since there is no theoretical rationale for this assumption of predictability, many economists compare technical analysis to fortune-telling. Despite this skepticism, technical analysis has gained favor in recent years.24

Currency Convertibility

Freely Convertible Currency

A country’s currency is freely convertible when the government of that country allows both residents and nonresidents to purchase unlimited amounts of foreign currency with the domestic currency.

Externally Convertible Currency

Nonresidents can convert their holdings of domestic currency into foreign currency, but the ability of residents to convert the currency is limited in some way.