Exchange Rate Reconnect

Abstract

It is surprisingly difficult to find economic variables that strongly co-move with exchange rates, a phenomenon codified in a large literature on “exchange rate disconnect.” We demonstrate that a variety of common proxies for global risk appetite, which did not co-move with exchange rates prior to 2007, have provided significant in-sample explanatory power for currencies since then. Furthermore, during 2007-2012, U.S. purchases of foreign bonds were highly correlated with these risk measures and with exchange rates. Our results support the narrative that the US dollar's role as an international and safe-haven currency has surged since the global financial crisis.

The Financial Channel of the Exchange Rate and Global Trade

“…As a result, U.S. housing activity could be a proxy for international capital flows into the United States. However, Lilley et al (2019) find that international capital flows were disconnected from exchange rate fluctuations in the period before 2007. Our sample starts in 1988, and the housing-dollar relationship also holds in the pre-crisis sample.…”

Exploring Determinants of Saving and Financing Aspects in Islamic Banks: An Insight from Indonesia

“…The exchange rate represents the rate at which one foreign currency is exchanged for another and is used in a variety of transactions, including international trade, tourism, international investment, and short-term money flow between nations that transcend geographical or legal boundaries (Feng, Yang, Gong, & Chang, 2021). The exchange rate is an external factor affecting the number of third-party funds (Lilley, Maggiori, Neiman, & Schreger, 2022). Thus, in the case of Indonesia, the rupiah's depreciation against the US dollar reflects the country's uncertain economic outlook, which will result in a negative response from the business community.…”

“…In addition to experiencing commercial difficulties as a result of the turbulence, bank debtors will also be unable to pay principal and interest on their loans (Feng et al, 2021). As a result, banks experience liquidity issues, which raises the cost of financing and causes them to be unable to meet their obligations to third-party funds (Lilley et al, 2022). With the withdrawal of funds from various Indonesian companies, banks face a liquidity crisis, a decline in the value of assets in the form of credit and securities purchased by banks, a reduction in the capital adequacy ratio (CAR) due to losses originating from reserves for a decrease in the quality of productive assets, and loan interest default.…”

Liquidity premiums, interest rate differentials, and nominal exchange rate prediction

“…This is the well‐known “exchange rate disconnect puzzle” (Obstfeld & Rogoff, 2000) and is a hot research topic in empirical international finance. Several articles work on this puzzle and find evidence to beat the random walk in out‐of‐sample contests of exchange rates by focusing on linear long‐horizon prediction equations at long forecast horizons (Mark, 1995), by applying nonlinear long‐horizon prediction equations at medium forecast horizons (Kilian & Taylor, 2003), by using an unconstrained Taylor‐rule‐based model at short forecast horizons (Molodtsova & Papell, 2009), by adopting a factor‐based model at medium and long forecast horizons (Engel et al, 2015; Wang & Wu, 2015), and by employing macro‐financial fundamentals (Lilley et al, 2020) at short forecast horizons.…”

“…Several articles have shown that macro-financial factors connected with global risk appetites help explain and predict exchange rates in the postglobal financial crisis period (Adrian & Xie, 2019;Avdjiev et al, 2019;Kremens & Martin, 2019). Lilley et al (2020) identify a close relationship between various global riskappetite factors and the broad US dollar during the crisis and several years of its aftermath. Further, they identify that US foreign bond purchases strongly correlate with these risk appetites and the broad US dollar.…”