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    What is behind the FX trade?

    Fatih Özatay, PhD20 September 2010 - Okunma Sayısı: 938

     

    I started to a series on exchange rate; but it was interrupted by growth figures and the recent decision on interest rate. A meeting by exporters and the CBRT (Central Bank of the Republic of Turkey) and recommendation of raising FX reserves to $100 billion are on the agenda. These are closely related with the series I am writing, so I will continue from where I stopped. Let me first summarize the first commentary of the series.

    One of the weak aspects of the economic theory is the way it explains how exchange rate is set. Taking this explanation into consideration, there is no scientific meaning of saying that the exchange rate should be at this or that level. This is the first point. Second, statements about the level of exchange rate rely on one of the weakest 'failed' exchange rate theories. According to this, exchange rate should increase at the level of the difference between domestic inflation rate and foreign inflation rate. Third, this simple theory, which is known as purchasing power parity, is based on a world where purchase and sale of FX resulting from foreign trade is significant. In 2009, world's foreign trade volume was $12.5 trillion while daily purchase and sale of foreign exchange in world FX market worth $4 trillion as per April 2010 data. Therefore, the main important factor for exchange rate is the reasons behind the FX purchase and sales in the international FX market. It is quite obvious that there are not the requirements stemming from exportation and importation.

    The following to points are of importance for the issues I will address in the rest of the series. First, that the complaints of exporters about the exchange rate are based on the weakest exchange rate theory does not necessitate us to ignore their complaints. Exchange rate is of critical importance for exports and the current level of the rate is far from satisfying exporters. Second, one of the main reasons for the 'failing' of exchange rate theories is that the expectations about the future level of the exchange rate play a critical role in determining the current level of the rate.

    It is the way the models address expectations that is problematic. Everyone agrees that the main reason of the global crisis is the bubbles in the US mortgage market and the lack of control of the system which led to the growing of the bubbles. However, until recently main assumption of exchange rate models was that bubbles cannot appear in FX markets.

    These two points will be of significance in the following commentaries on exchange rate series. The first point on the complaints of exporters puts forth the question what sort of a policy can be followed in the future. Therefore, I am seeking an answer to the question 'What must be done?'

    However in order to answer this question I have to draw a comprehensive framework. For this I have to proceed from the third point in the summary above. So this is the question: What is behind this 'terrifying' purchase-sale traffic in the exchange rate market if it is not the need of foreign exchange purchase and sales required for exports and imports? I will continue.

     

    This commentary was published at Radikal daily on 20.09.2010

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