Financial Structure and Exchange Rate
Dynamics: A Qualitative Study of Emerging
Market Currency Internationalisation
Annina Kaltenbrunner
Leeds University Business School
A.Kaltenbrunner@leeds.ac.uk
Background and Motivation
 Analyse the process of exchange rate determination in
emerging markets in the context of currency
internationalisation
 Based on a Post Keynesian theoretical and methodological
framework
 Empirical results and suggest alternative ways of conducting
research from a Post Keynesian Perspective
Outline
 Overview of the main tenants of mainstream and Post
Keynesian theories of exchange rate determination
 Alternative analytical framework for exchange rate
determination in DECs
 Methodology
 Empirical Results
Exchange Rate Determination in Theory
The Mainstream
 Exchange rate market equilibrating price - stable underlying
fundamentals – across time, countries and actors
 Importance of Financial market actors
 Rational Expectations
 Behavioural Finance
 Rationality and Ergodicity maintained
 Same fundamentals
Exchange Rate Determination in Theory
Existing Post Keynesian Exchange Rate Theory
 Exchange rate not market equilibrating price
 Expectations and positions in short-term financial markets (capital
flows) drive exchange rates– Expectations creative not reactive
 Expectations formed under fundamental uncertainty and anchored
by social convention
 No permanent fundamentals (rejection of long-run equilibrium
value)
 Fundamentals context, time and institution specific
 Harvey (2009)
 Flows (trade, fdi, portfolio) determine the exchange rate
 Flows determined by base factors and indicators
 Interest rates, unemployment, trade balance and inflation as most
important base factors and indicators and thus exchange rate
“fundamentals” in a Post Keynesian sense
Exchange Rate Determination in Theory
Critique Existing Post Keynesian Exchange Rate Theory
 Subjectivist
 Social conventions as a choice
 Social relations – credit relations (financial structure)
 General model of exchange rate determination?
 Specific to (institutional) context of developed foreign exchange
markets
 Heterogeneous group of foreign exchange market participants
 Ad-hoc specification of exchange rate “fundamentals”
 Focus on expectations under uncertainty – anything to say about
exchange rate determination beyond specific context? Theoryless?
 No: Search for underlying mechanisms, processes and structures Critical Realism
An alternative Analytical Framework
Domestic Currency as International Money
• One of the most important underlying structures in Post
Keynesian theory in the presence of fundamental uncertainty:
money
• Domestic Currency as International Money (Currency
Internationalisation)
• Keynes‘ writings on forward foreign exchange market in Tract on
Monetary Reform as early application of liquidity preference theory
and „own rate of return“ (Kregel, 1982)
• Sterling as the money of the system with durable assets comprised
of foreign currencies
An alternative Analytical Framework
Domestic Currency as International Money
• Keynes General Theory:“...it may be added that, just as there are
differing commodity-rates of interest at any time, so also
exchange dealers are familiar with the fact that the rate of interest
is not even the same in terms of two different moneys, e.g.
sterling and dollars. For here also the difference between the
“spot” and “future” contracts for a foreign money in terms of
sterling are not, as a rule, the same for different foreign moneys”
(p. 224).
An alternative Analytical Framework
Domestic Currency as International Money
 Exchange rate determined by (expectations about) currency’s net return
relative to the currency/money of the system (Pound Sterling/US$)
 Every durable asset has a measure of its „own rate of return“ in terms of
money: (q-c)+a+l
 Yield (q): returns on short-term domestic currency assets
 Carrying Cost (c) : minimal
 Appreciation (a): short-term speculative moment (animal spirit,
psychology etc.)
 Liquidity Premium (l): structural element
 Money is credit money
 Liquidity as the ability to meet outstanding external obligations
(Minsky,1975)
 Importance of credit relations and financial structure for exchange rate
dynamics
An alternative Analytical Framework
Domestic Currency as International Money

Hierarchic nature of international monetary system and consequent exchange rate
dynamics in DECs
 The money/currency as “creditor” currency: Creditor country > main
funding currency
 DEC currencies as “debtor” currencies
o External debt > Any form of short-term external liabilities
•
Sustainable value and actual exchange rate driver
o Ability to force a cash flow in its favour (trade balance/current account)
o Ability to “make position” - “Institutional” Liquidity
 Implications
 Higher interest rates to compensate for lower liquidity premium
 Higher sensitivity to changes in international liquidity preference (Dow,
1999) – importance of international market conditions for DECs
 From Financial Instability to Financial Fragility
Methodology
 Post Keynesian/Critical Realist open system ontology:
Qualitative methods to uncover underlying structures,
mechanisms and processes (Dow, Lawson)
 If expectations and positions of financial market actors are
main drivers of exchange rates have to understand how these
are formed
 52 semi-structured interviews with currency traders in banks
(commercial and investment) and funds (hedge funds and real
money funds) in Brazil and London
Results
Fundamentals in Practice
 Heterogeneous Foreign Exchange Market Participants
 Very different conceptions of fundamentals depending on
trading horizon, institution and market (onshore vs. offshore)
 Concept of fundamentals (exchange rate driver vs. equilibrium
concept)
 Nature of fundamentals of emerging market currencies (around
40 different variables mentioned)
 Interest rates, International Risk Aversion and Financial Structure (Debt
and International Investment Position) top
 No notion of long-run value and if so, little value for trading
Results
Exchange Rate Determinants in the Era of Currency
Internationalisation
Difference between Emerging Market and G10 Currency Trading
Main Difference
Lower Liquidity
Implications for Trading Strategy
More Positioning
Flow Information
Market Moving
More Macro View/Less Technicals
Funding Risk
Cross-Hedging
Higher Volatility (Risk)
Risk-Devaluation Expectations
Capital Regulation and Institutional Development
Quality Arbitrage
Central Bank Intervention
Carry
Notes: Number of valid responses: 19; responses not exclusive
Numbers of Mentioning
9
5
4
3
3
2
1
7
3
7
1
4
4
Results
Expectations Formation-Onshore Respondents
What variables do you take into consideration when taking position in the
foreign exchange market?
Onshore Respondents
16
14
Numbers of Mentioning
12
10
8
6
4
2
0
Currencies
S&P
Stock Market Commodities
Flows
Positioning
Notes: Total number of responses: 29; responses not exclusive
Domestic
Rates
US economy
Global GDP
Macro Picture
CA/BOP
Results
Expectations Formation-Offshore Respondents
What variables do you take into consideration when taking position in
emerging market currencies?
Offshore Respondents
8
7
Numbers of Mentioning
6
5
4
3
2
1
0
Fundamentals
Flows
Technicals
Positioning
Risk Aversion
Notes: Number of total responses: 16; responses not exclusive
Carry
Momentum
Current Account
Politics
Sentiment/Themes
Results
The international financial crisis – Onshore Respondents
What internal and external variables prompted you to close your position in
Brazilian Real in the international financial crisis?
Onshore Respondents
16
14
Numers of Mentioning
12
10
8
6
4
2
0
Positioning
US Markets
Feeling
Stop Loss
Notes: Total number of valid responses: 28; answers not exclusive
Relative Value
Price Action
Previous Appreciation
Results
The international financial crisis – offshore
respondents
Second Phase
First Phase
Adjustment Factor Total
Adjustment Factor Total
5
11 Liquidity (Cash)
Risk
4
10 Redemptions
Liquidity
4
7 Positioning
Decoupling
3
6 Credit Risk
Fundamentals
4
Cash (Redemptions)
4
Positioning
13
18 Total
Total
Notes: Total indicates total number of valid responses; responses are not exclusive
Conclusions
 Process of Emerging Market Currency Internationalisation
 Exchange Rates driven by expectations and positions
 Alternative view of exchange rate determination which
acknowledges that fundamentals (empirically observable
exchange rate drivers) are context and time specific
 Need to look for underlying real mechanisms, structures,
processes, and social relations
 Exchange rate as international money – importance of shortterm returns, liquidity preference and financial structure to
understand exchange rate movements (in DECs)
 Risk of Currency Internationalisation – Financial Instability