Step one is an early warning system that will assist the forecaster in identifying those countries whose currencies are likely to be adjusted. Currencies are rarely devalued without prior indication of weakness. Many researchers in this area have attempted to forecast currency devaluation on the basis of key economic indicators that are critical in assessing a country's balance-of-pay-ments outlook. Some of these indicators are the international monetary reserves, international trade, inflation, monetary supply, and exchange spread between official versus market rates. These economic indicators are also used to forecast foreign-exchange controls.
International reserves International reserves reflect the solvency of a country - its ability to meet international obligations. Debt repayment obligations, profit and royalty obligations, and payments of purchases on credit represent international obligations. Continued balance-of-payments deficits decrease the international reserves of a country that maintains fixed exchange rates, unless these deficits are offset by increased short-term loans or investment. This situation increases the likelihood of devaluation or depreciation.
The balance of foreign trade Trends and forecasts for the balance of foreign trade indicate the direction in which the value of a currency is to be adjusted. If a country spends more money than it obtains from abroad over a sustained period, the possibility of devaluation increases. If the country receives more money from abroad than it spends abroad, the probability of revaluation increases.
Inflation Economic forces link the prices of real assets (inflation rates) with the prices of currencies (exchange rates). The relationship between inflation rates and exchange rates is provided by the purchasing power parity doctrine. According to this doctrine, currencies of countries with higher inflation rates than that of the USA tend to depreciate in value against the dollar. By the same token, currencies of countries with lower inflation rates than that of the USA tend to appreciate in value against the dollar.
Money supply Money supply consists of currency in circulation and demand deposits. Simply stated, inflation is the consequence of a country's spending beyond its capacity to produce. As an economy approaches full employment, any additional increase in money supply can serve only to make prices spiral upward. Some foreign-exchange forecasters rely on the money supply as a timely indicator of price changes and exchange rate changes for maintaining purchasing power parity.
Official versus market rates Many foreign-exchange forecasters use the exchange spread between official and market rates as a valid indicator of currency health. In their comparison, forecasters observe the value that outsiders place on a particular currency. Under a freely flexible exchange system, no spread exists between these two exchange rates. However, some spread is practically inevitable where currencies are pegged and exchange controls are imposed on the convertibility of local currency into hard currencies. In this situation, one measures the falling confidence in a local currency by checking the widening spread between official and free market rates.
A rise in the spread between official and market rates serves as an indication of increasing apprehension in the near future. Thus, the increasing divergence from a free market rate over an official rate may be used as a valuable piece of information to forecast devaluation.
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