The 1997 Guide to Germany: Forex

In the past few years the Deutschmark has been excessively strong and this has clearly run counter to domestic economic fundamentals. However, in recent months we have seen the Deutschmark return to more realistic levels. The question is, will the Deutschmark stay where it is, or are the markets pushing for an even weaker Deutschmark in line with the recent trend.

We believe policy makers around the world now have an interest in stabilizing exchange rates where they are, as much as they had an interest in bringing forward a correction in exchange rates to rectify the severe misalignment on the forex markets between 1995 and 1996. The need to stabilise the major exchange rates at their current levels and to ensure mutual cooperation between politicians and central banks around the globe is also underlined by the fact that the fixing of the European currencies and the introduction of the euro is approaching fast and this can only take place in an environment which is very much one of stability.

From a purely German perspective, the current Deutschmark exchange rate is fairly priced. The domestic economy is weak and the German corporate sector needs all the stimulus it can get from the forex side. The somewhat weaker Deutschmark is helping to stimulate German exports. On the other hand, the weakening of the Deutschmark has had only a limited impact on prices.

In this article we address the topic of fair value for the Deutschmark with reference to DMG’s NATural Real EXchange rate (NATREX) model, as well as the impact which Emu will have on European currency markets. Finally we take a look at the increasing pulling power of the Deutschmark in Eastern Europe.

Fair value and DMG-NATREX

Over the years the concept of Purchasing Power Parity (PPP) has proven to be a durable and popular benchmark for assessing what constitutes fair-value for a given exchange rate. There is, however, extensive evidence that nominal exchange rates deviate in a significant and persistent fashion from their PPP levels. Mussa (1986) documents that, contrary to one of the predictions of the PPP approach, real exchange rates are about as volatile as nominal exchange rates and that both are approximately random walks. The NATREX approach was first introduced by Stein (1993) to explain the empirical failings of PPP. It is defined as the moving long run equilibrium between economic fundamentals and real exchange rates. It makes sense to most economists that there is an equilibrium exchange rate level which is consistent with the economic fundamentals of that country. Whenever the exchange rate deviates from this equilibrium, economic forces act to eliminate the deviation. NATREX is simply an econometric approach for identifying such equilibrium points.

The long run economic fundamentals of the NATREX approach are the productivity growth rate and the social savings rate. A higher productivity growth increases the international competitiveness of domestic firms thereby strengthening the home currency. An increase in social savings, however, reduces the rate of domestic absorption and causes the currency to depreciate in the short to medium term. At a very intuitive level, an increase in the savings rate reflects the weakening of domestic demand relative to production. As a result, the home currency depreciates and this boosts net foreign demand. In other words, the new domestic goods market equilibrium is achieved by offsetting the reduction in domestic demand by an equal improvement in the net foreign demand via the depreciation of the currency. In the longer run, however, the currency could well appreciate once again because of the effect which a change in savings will have on the country’s net external asset position. A rise in savings will reduce a country’s external financing requirement, and over time this will lead to a lower level of external indebtedness. With less external debt to finance, a country need not turn such a large trade surplus (or can afford to run a higher deficit) and the exchange rate will appreciate to bring about this trade adjustment. The NATREX approach argues that although exchange rates may not reflect these two economic fundamentals in the short run, they will do so in the longer run.

Deutsche Morgan Grenfell produced its first NATREX article back in September 1996. This article closely resembled Stein’s original paper and covered a wide range of currency pairs. Since then the approach has been developed and the econometric techniques refined. The resulting DMG-NATREX is based on the same principles as the original version, but specifically adapted for practical use in the foreign exchange markets. One of the main advantages of DMG-NATREX is that it is “cross-rate consistent”. By this we mean that one can calculate the equilibrium exchange rate between two currencies either directly or indirectly by using the crosses with a third currency, and obtain identical results. This eliminates the question of choosing between alternatives when one is confronted with many equilibrium exchange rates for the same two currencies. It also makes DMG-NATREX theoretically more appealing since it incorporates the impact of US economic fundamentals, for example, in the determination of equilibrium exchange rate between the yen and Deutschmark. To the best of our knowledge, no other equilibrium exchange rate model (academic or professional) has this desirable feature.

The other major departure has been to smooth the explanatory variables. This has, in effect, eliminated two of the major practical problems which we encountered with the original version: First of all, smoothing makes the analysis much less sensitive to the choice of explanatory variables. Second, the equilibrium exchange rate estimated using smoothed explanatory variables is more robust and does not shift dramatically from one period to the next. These are both very desirable features since one would not expect an equilibrium concept to be either too sensitive or too volatile.

How does DMG-NATREX perform?

The primary objective in estimating equilibrium exchange rates is to predict medium term currency trends. We believe that DMG-NATREX scores very highly in this respect. The table shows the directional forecasts of DMG-NATREX. These assume that the model was estimated with data up until the first quarter of 1996 with predictions then made using the information available at the beginning of each subsequent period. The results show that the model correctly predicted the direction of exchange rate movements in 23 of the 28 cases during the last four quarters.

DMG-NATREX is also quite successful in its point forecasts for the end of period exchange rates. The overall fit (adjusted R-square) of the regressions are about 50%. This represents an approximate reduction of 30% in the typical forecast error one would expect to make based upon a random guess or the application of PPP.

On the basis of these empirical results, we believe DMG-NATREX is as powerful as it is intuitively appealing and theoretically sound. It suggests that the current fair value for the $/Dm is 1.66 and for 116 for $/¥.

Emu and the Deutschmark

Changes to central bank holdings of forex reserves in EU and non-EU countries could imply large flows in the run up to Emu and beyond. The Maastricht Treaty provides for Europe’s central banks to transfer some of their forex reserves to the European Central Bank at the beginning of stage III on the January 1 1999. If all EU countries were to join this would amount to Ecu50 billion (Dm26 billion). However, this is a small fraction of Emu countries holdings of forex reserves: the Bundesbank alone holds more than Dm100 billion. Within our core group scenario, the surplus reserve holdings could be as high as Dm150 billion, equivalent to four times the level of forex reserves held by the US Federal Reserve. In Germany, which is believed to hold reserves largely in dollars, the choice is whether to continue holding these reserves in their current form (even though the Bundesbank would lose its role in terms of official forex intervention) or convert them into domestic currency. Central banks joining Emu other than the Bundesbank face a different situation. Their reserves are at present largely believed to be held in Deutschmarks but these become domestic currency post-Emu. These countries must either sell their Deutschmark for dollars or yen to retain foreign exchange reserves post-Emu, convert them into domestic currency before Emu or simply accept the de-facto transformation into domestic currency once a single currency is introduced.

Non-EU central banks could in principal be entirely unaffected by this process. Their current holdings of Deutschmarks would become euros and they could keep their aggregate holdings unchanged. There is some suggestion that central banks which have a declining need for European currencies relative to other currencies might use the opportunity of Emu to reduce their strategic weightings but in terms of aggregate world reserve holdings the impact is unlikely to be dramatic providing confidence is maintained in the euro as a sound currency.

Indeed, since the euro will command a greater share of world trade than the Deutschmark it could even, in theory, even constitute a more important international reserve currency than the Deutschmark, in which case non-European demand for euro reserves would be greater than the current holding of Deutschmark reserves. According to IMF data, central bank foreign exchange reserves contained 16% Deutschmark and 61% dollars in 1993.

Some financial centres will suffer more

Under a single currency scenario, all trading in intra-Emu currencies would obviously disappear. As the chart demonstrates, however, the share of intra-Emu currencies at present in the major foreign exchange centres is relatively low.

While Frankfurt is expected to be relatively unaffected by the replacement of the Deutschmark with the euro, other Emu centres could suffer a substantial decline in forex business. Indeed, Germany is set to capture a large share of the forex business originating from central and Eastern Europe. The detailed 1992 figures from the BIS reveal that trading against the Deutschmark within Europe has increased at a faster rate than in forex turnover generally. This trend is likely to have continued since the survey was conducted. The figures for London show the proportion of Deutschmark crosses against other EMS currencies rising from a negligible amount in 1989, to 4% in 1992, to 5% in 1995 (as a % of total turnover). In most European centres outside Germany and the UK, the share of local currency trading against the Deutschmark is roughly half of total local currency dealing. For those countries with relatively small markets, such as Luxembourg, Ireland and Austria, trading of the local currency against the mark forms the bulk of total turnover. Emu clearly threatens a significant decline in trading activity in these centres. Not only will they lose this direct business, there is also a significant risk that trading activity in non-Emu currencies against the new euro would also drift away to larger centres, notably London.

The deutschmark in eastern europe

Since the collapse of communism in Central and Eastern Europe and the move towards a market economy, the Deutschmark has been gaining increasing importance in the region. There are several reasons for this:

1. Germany has provided a good role model for the Eastern European countries reform process. Not only is Germany the largest of the middle European economies but it operates a successful social market economy. This has been more impressive since, in the opinion of the East European countries, German unification and the integration of a former communist country into the west European economic system has been managed well. In supermarkets and department stores from Prague to Novosibirsk German consumer goods remain the most popular. In addition, German cars and investment goods also enjoy the good reputation of the “Made in Germany” standard.

2.The key role of the German Bundesbank in financial markets has also played an important role. Since the unification of Germany, many governments in the region have decided to copy the German central bank system and with Germany a key player in the plans for European Economic and Monetary Union this has enhanced the Deutschmark as an international currency in the region.

3.Since the opening of the former communist block countries in 1989, Germany has become the largest trading partner with almost all of the 28 central and Eastern European countries and in particular Poland, Russia, Czech Republic and Hungary. More than 10% of German exports go to Eastern Europe compared with 10% of imports. As a result, in 1996 Eastern Europe overtook the US as the largest trading partner with Germany.

4.After the US, Germany is the biggest direct investor in Eastern Europe, strategic as well as greenfield investments.German companies of all sizes and from all sectors have established thousands of subsidiaries in the region in an attempt to benefit from low labour costs as well as tapping into new markets.

5.A wide range of East European countries have also increasingly orientated their exchange rate policy towards the Deutschmark.The large Deutschmark weight in these currency baskets reflects the sizeable trade links between the region and Germany. In the currency basket of the Czech koruna, the weight of the Deutschmark was raised form 65% to 100% as of 26 May 1997. In Slovakia and Poland the Deutschmark weight is 60% and 35% respectively where as in Hungary, since the beginning of the year the currency is pegged against the Ecu (70%) and the dollar (30%).

6.The influence of the Deutschmark also spreads to the three Baltic states. These countries exchange rate regimes are either:

* An official peg in Lithuania (the Litas, Lit,) and currency board in Estonia (the Estonian crown, Ekr) or an informal peg as in Latvia (the Lat) to the SDR.

* The longest surviving of these arrangements is the pegging of the Estonian crown to the Deutschmark, which has been in force since June 1992.

7.Ongoing discussions on the desired exchange rate tool continue to attract interest in Latvia and Lithuania. This is particularly acute because of the proposed introduction of a single European currency in the EU and to what extent these countries can prepare to re-orientate policy to the euro when it arrives. Currently, policy makers in Latvia and Ukraine seem to prefer an orientation of their currencies to the Deutschmark in order to prepare for a smoother adaptation to the euro.

8.An increasing policy dilemma has emerged in several Eastern European countries. This relates to those with either a currency basket with a dollar component (Poland and Latvia1) or those which operate a peg to the dollar (Lithuania and Russia 2). This has posed some difficulties for these countries given their strong trade links with western Europe. Since 1995, the appreciation of the dollar versus the Deutschmark and other west European currencies has led to a deterioration in competitiveness of east European products in western markets. A stronger link to the exchange rates in western Europe and in particular the Deutschmark would have helped to have avoided this situation and from today’s point of view would seem more preferable.

9.A recent example of the pulling power of the Deutschmark in Eastern Europe is the ongoing discussion regarding the planned introduction of a currency board in Bulgaria. The available options for the pegging of the lev expected from June/July 1997 are to the dollar, Deutschmark or koruna. Bulgarian officials unambiguously favour the Deutschmark. As soon as this is decided in parliament, so the dominant role of the dollar in the forex market is set to change. Currently daily forex turnover of the dollar is between 43 and 45%, compared with just 10% for the Deutschmark.

Conclusion

The exchange rate turbulence seen in 1995 has largely been unwound in the forex markets. The Deutschmark has weakened not only against the dollar but also the currencies of the high-yielding countries in Europe. We envisage a stabilization in the dollar/Deutschmark exchange rate at around 1.70 Dm/$ over the remainder of the year. And we anticipate a bias towards Deutschmark strength at the end of the year and into 1998, as the European growth cycle and hence interest rate cycle begins to move in Europe’s favour. Indeed, our NATREX model points to a fair value of $1.66/Dm and Dm70/¥.

The main risk to our scenario is a delay or cancellation of the start date for Emu. We ascribe a 35% probability to this scenario. In that case, the Deutschmark would appreciate, in particular against the formerly “soft” European currencies.

Footnotes:

The dollar has a 39% weight in the SDR In Russia the high proportion of commodities, which are priced in dollars, as a share of total exports, is behind this policy decision.