FX Volatility At Risk From Pandemic

Summary:

• The US, EU, Japan and China account for 50% of world GDP. Their exchange rates have been experiencing a long-term secular decline in volatility.
• This stability is akin to the Bretton Woods era of fixed exchange rates. And relative to the stock market, March 2020 had the lowest exchange rate volatility on record.
• Driving the decline are smaller interest and inflation rate differentials, giving perhaps the clearest empirical indication that monetary policy is at the heart of exchange rate variability.
• However, stability may not last. Supply-side factors and rising debt in advanced (and especially EM) economies is creating unfamiliar macroeconomic risks.

Exchange Rate Stability Has Global Significance

One surprising feature of the pandemic so far has been the relative stability of exchange rates. Indeed, exchange rate volatility has been procyclical historically, tending to increase in US recessions.

An NBER working paper, co-authored by international macroeconomist Kenneth Rogoff, shows that this phenomenon is actually part of a longer-term secular decline among the three core currencies (dollar, yen, euro). And this decline has become particularly apparent for the EUR since the long-term interest rate hit zero in 2014 (Chart 1).

Exchange rate stability is also evident when compared with other assets. Against stock, oil and commodity price volatility, the declining trend in exchange rate volatility is even more pronounced. In fact, relative to the stock market, March 2020 had the lowest exchange rate volatility on record (since 1950). Using breakpoints, the authors show that ER stability has even accelerated during the pandemic.

Furthermore, the results hold even when including the Chinese renminbi. Combined, these four countries comprise 50% of world GDP. Therefore, the exchange rate stability seen today has a far greater global reach than that of the Bretton Woods era (1950-60s). Whether this is declared a triumph of modern independent banks is yet to be determined, but it does reflect the paralysis of monetary policy at the zero bound.

Monetary Policy Is Central to Exchange Rate Variability

The overshooting model of Dornbusch (1976) provides a framework in which monetary policy acts as the main driver of exchange rate variability. But empirically, there has been little suggestion that this is indeed the case until now. The authors argue that the current Covid-19 shock, as well as developments over the last five years, show that central bank policies are at the heart of exchange rate volatility.

To understand the paper’s hypothesis, it is important to recognise that the nominal exchange rate can be decomposed into at least three main components: (i) current and anticipated real interest rate differentials; (ii) the long-run real exchange rate (determined by PPP); and (iii) inflation differentials. Higher domestic inflation, lower domestic rates and weaker long-run RER expectations all lead to depreciation.

With this decomposition in mind, the authors look at inflation and interest rate dynamics over time. On the former, global inflation has become remarkably muted (Chart 2), with almost all high-income countries facing inflation rates in the narrow 0-2.5% since the GFC. This uniform decline means the past two decades have witnessed the lowest differentials in inflation across countries on record in the post-war period.

Source: Ilzetzki et al. (2020), page 13

Perhaps more importantly for exchange rate determination is the convergence of short- and long-term interest rates. Interestingly, not only has there been a secular decline in interest rates over time, but the authors show that there have been smaller variations in policy rates across countries as well (Chart 3). Nine of the 10 major currencies now have rates at or below 25 basis points, compared with just Japan in 2000.

Source: Ilzetzki et al. (2020), page 15

Going back further, it is possible to see that variation in policy rates across countries has been more stable in the second decade of the 21st century than it was under Bretton Woods I. This evidence implies that both short- and long-term variability in interest rates across countries has declined, with many countries converging to a zero-lower bound.

The phenomenon becomes even starker when looking at 10-year bond yields. During the Bretton Woods period, yields averaged 6% with an average annual cross-country variance of 2.2%. Over the 1970s-90s, these rose to 9% and 6.6%, respectively, while post-2000 yields averaged 5% with a variance of 2.1%. During the pandemic, nearly half of high-income economies are borrowing at negative rates, with variance across countries at historical lows (0.5%).

Exchange Rate Volatility in an Uncertain Future

What risks does the pandemic pose to the downward trend in exchange rate volatility and to the international monetary system more broadly? There is a distinct chance, in the authors’ view, that inflation, interest rates and exchange rates will eventually become much more volatile post pandemic. Why?

Firstly, aggressive central bank policy has created a dramatic rise in monetary aggregates in the US, Europe, Japan and the UK. Even if this does not lead to a large spike in inflation, it shows that policymakers are now more willing to take more risks on inflation to promote growth.

Second, Covid-19 is a significant supply shock, which in the medium-term could turn out to be negative. There is a stress on global supply chains and a fall in trade. Deglobalisation has the potential to reverse global factors that have been the leading cause of the secular decline in rates and inflation. Indeed, a lack of labour mobility and a declining effective global labour force could create inflationary pressures.

Third, inflation targeting is yet to face a test commensurate with the challenges that led to a switch from the Bretton Woods’ regime in the 1970s. Any inflationary pressures that may come as a result of the pandemic could have large consequences on exchange rate volatility.

Another risk is the threat of public and private sector debt. Although the authors believe that the near-term risks of rising US debt levels are very small and should remain so over the next several years, US borrowing in global markets is remarkable. This could have systematic global costs.

Emerging Market Risks

Despite positive vaccine news, EMs may not benefit for years. So the medium-term risks of the pandemic to EMs are immense. According to the authors, capital flowing out of emerging markets from February to April 2020 were in quantities five times greater than in a similar timeframe following the collapse of Lehman Brothers in 2008. To prop up their currencies, central banks have expended as much as a quarter of their reserves.

For some EM countries, pandemic risks appear to be more of an issue. Empirical evidence shows that fiscal conditions are correlated with the EM exchange rate decline in recent months (Chart 4). Countries with higher ratios of debt to GDP and higher deficits to GDP (both measured in 2019) saw greater exchange rate declines since February 2020.

Source: Ilzetzki et al. (2020), page 32

Foreign reserves may be key a determinant of whether a country is able to cope. According to the paper, countries entering the crisis with larger reserve holdings relative to GDP saw lower exchange rate declines. This suggests that reserves served as a buffer against exchange rate volatility. Turkey, for example, has already expended 40% of its foreign exchange reserves since the beginning of the year.

Bottom Line

The secular decline in inflation and interest rate differentials has, according to the authors, contributed to the fall in exchange rate variability since 2000. The pandemic has reaffirmed, if not accelerated, the decline, which is surprising given the procyclicality of exchange rate volatility. In the aftermath of the pandemic, however, we could yet see a reverse in this 20-year phenomenon.

Specifically, it is worth keeping an eye on vaccine distribution to emerging markets. Unlike in previous major crises, EMs now account for roughly 60% of global GDP. Also, advanced economies have become far more dependent on developments in emerging markets. If, therefore, the strains of rising debt and falling reserves are not eased in the near term, exchange rate volatility reductions could reverse in the coming years.

Click here to view paper.