Monday, October 20, 2008

Foreign exchange: Investors go where the insurance is

Textbooks will be re-written based on global government interventions over the last month. I am overwhelmed by the ever-changing list of new government actions being taken to quell this banking crisis, and topping the list, is the surge in global liquidity. This recent run-up in liquidity made me think of Rudiger Dornbush’s famous overshooting exchange rate theory. Could the U.S. dollar ($US) be overshooting its long-run equilibrium value because of money supply growth? Anecdotally, recent exchange rate movements – as they are erratic at best – are based on both economic fundamentals (perhaps the money supply) AND government intervention measures. This is bound to get an additional box - a new case study perhaps - when the international finance textbooks are refreshed to include the banking crisis of late.

The $US in 2008 through mid-September

The $US appreciated paradoxically, according to Rudiger Dornbush’s overshooting theory - an older theory that may be relevant when central banks are increasing liquidity at banking crisis rates. As the U.S. Fed increases the money supplies (provided it is not too restricted by the banking sectors) with huge liquidity injections, the short-term value of the $US should fall with short-term interest rates; however, in the long run, interest rates will rise with the money supply (unless central banks take back the money), and the exchange rates will stabilize. It’s a simple theory, but nevertheless, a theory.

But relative money supply shifts are not driving exchange rate movements in this time of extreme economic uncertainty. Key international money growth rates had fallen relative to that in the United States through August 2008, and according to Dornbush, this would imply – at the very least – that the $US would depreciate slightly against the same relative currencies (since interest rates are low). However, the $US appreciated substantially.

The likely reason through the middle of September is the unexpected weakening of the European and Canadian economies, where investors flocked back to the $US. The U.S. looks better, but only by default, as the Europe and Canada posted worse-than-expected growth numbers.

The $US in October

The $US started to depreciate against major currencies. Exchange rate movements react to many economic variables, including the money supply, like inflation, economic growth, interest rates, monetary policy shifts (money supply), government budget balances, expected returns, etc. However, let’s add one more variable to that list: relative deposit insurance, which has caused the $US to behave more in line with Dornbush's theories.

Recently, global central banks and governments have increased liquidity in their banking systems. There is no data available for money supply growth in September and October, but I suspect that the relative international growth rates (to the U.S. money supply growth rate) and are now positive and moving toward 1. Key economies – the U.K., Canada, the ECB – have stepped up their liquidity programs, and their money supplies have likely increased, and since late September, their currencies have generally depreciated against the $US. Perhaps Dornbush’s theory becomes more relevant, but only because of the growth in the current and expected money supply, where the expected money supply is based on government guarantees on deposits the banking system.

If the economies that lack new insurance measures are singled out – Switzerland (see currency chart above) – the safety of bank deposits becomes a determinant of the exchange rates (at least anecdotally), at least anecdotally (see exchange rate chart).

The above chart illustrates the OECD's ranking of new and temporary insurance programs offered by key developed economies as of October 7, 2008. Ranked in the order of strongest to weakest deposit guarantees are: Germany (the Euro), Denmark, United States, Canada, U.K., and Switzerland. Relative to other European economies, the Swiss Franc is doing quite poorly against the $US. Investors are fleeing Swiss deposits with the weak bank guarantees compared to other developed economies. In spite of money supply growth that may be positive, lack of deposit insurance is causing too strong a depreciation in the currency (overshoot).

As the temporary shifts in deposit insurance are repealed, exchange rate movements will return to being determined mostly by economic fundamentals (plus some speculation, of course), and the Swiss franc will appreciate (relative to the $US).


Clearly, this analysis is overly simplified and rather piecemealed, as investment trends cannot be assessed simply by money growth rates and deposit insurance. However, this joint international banking crisis has produced a set of government interventions that are without precedent, and investors are reacting to each and every measure. The biggest problem with intervention in financial markets is the moral hazard created when the government supports risky behavior by bailing firms out of their obligations. Investors (hedge funds, pensions, institutional asset managers, GSE’s, etc.) who previously under-priced the risk associated with securitized assets are enjoying new capitalization. But further, the interventions may also be forcing capital flows – as illustrates by foreign exchange movements – away from their efficient levels.

Textbooks will be re-written after this banking crisis is over, perhaps to include one extra variable that causes the exchange rates to overshoot its long-run equilibrium: temporary shifts in deposit insurance.

Rebecca Wilder


  1. great this why the US has set up its roughly $700bn in dollar help offset the inflows due to extreme risk aversion?

  2. Hi mxq. You said, "is this why the US has set up its roughly $700bn in dollar help offset the inflows due to extreme risk aversion?"

    Good point! The Fed was trying to encourage further inflows into the frozen credit system with the new swap lines. The dollar costs abroad were rising quickly, effectively shutting out foreign capital from saving the day in the U.S. credit markets.

    Thus, the Fed increased the Swap lines to $620 billion, and recently they relaxed the limit to simply "meet demand."

    You can see this effect in the exchange rate chart above. On October 13 - when the swap lines became unlimited - the $US stabilized somewhat.

    Thank you so much for reading and commenting! And thanks for adding to the story!


  3. This was a very interesting article. It's true that insurance is very confusing and sometimes stressful. Getting as much info as possible is a good idea.