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Currency Internationalisation and Exchange Rate Dynamics in Emerging Markets: a Post Keynesian Analysis of Brazil

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Currency Internationalisation and Exchange Rate Dynamics in Emerging Markets: a Post Keynesian Analysis of Brazil Kaltenbrunner, Annina (2011) Currency internationalisation and exchange rate dynamics in emerging markets: a post Keynesian analysis of Brazil. PhD Thesis. http://eprints.soas.ac.uk/14353 Copyright © and Moral Rights for this thesis are retained by the author and/or other copyright owners. A copy can be downloaded for personal non‐commercial research or study, without prior permission or charge. This thesis cannot be reproduced or quoted extensively from without first obtaining permission in writing from the copyright holder/s. The content must not be changed in any way or sold commercially in any format or medium without the formal permission of the copyright holders. When referring to this thesis, full bibliographic details including the author, title, awarding institution and date of the thesis must be given e.g. AUTHOR (year of submission) "Full thesis title", name of the School or Department, PhD Thesis, pagination. Currency Internationalisation and Exchange Rate Dynamics in Emerging Markets A Post Keynesian Analysis of Brazil Annina Kaltenbrunner Thesis submitted for the degree of PhD in Economics 2011 Department of Economics School of Oriental and African Studies (SOAS) University of London 1 Declaration for PhD thesis I have read and understood regulation 17.9 of the Regulations for students of the School of Oriental and African Studies concerning plagiarism. I undertake that all the material presented for examination is my own work and has not been written for me, in whole or in part, by any other person. I also undertake that any quotation or paraphrase from the published or unpublished work of another person has been duly acknowledged in the work which I present for examination. Annina Kaltenbrunner Signed: ____________________________ Date: 21.12.2011 2 Abstract This dissertation presents a theoretical and empirical study of exchange rate determination in emerging markets in the context of the recent process of currency internationalisation using Brazil as a case study. It develops an alternative analytical framework for exchange rate determination in emerging markets based on Post- Keynesian economic thought. Drawing on several strands of Post-Keynesian economic theory, the critical realist ontological claim of deeper structures and underlying mechanisms, and the view of the exchange rate as international money, the dissertation argues that exchange rates are driven by financial actors‘ expectations. These expectations are formed in accordance with yields on domestic financial assets and a currency‘s liquidity premium, which depends on an exogenously given liquidity preference and market participants‘ perceptions about a country‘s ability to meet its outstanding external obligations. The emphasis on expectations in short-term financial markets for exchange rate determination in Brazil is particularly warranted given the recent internationalisation process of its currency. The dissertation consequently shows the different manifestations of this process, the elements of Brazil‘s financial and macroeconomic environment which contributed to the Brazilian Real‘s internationalisation, and the implications this internationalisation had for exchange rate dynamics. To investigate the determinants of the Brazilian exchange rate in the new era of currency internationalisation, the dissertation conducts a mixed-method study combining insights from more than 50 semi-structured international currency trader interviews with advanced time series econometrics. The semi-structured interviews show the important role of short-term (balance of payments) financial flows, short-term returns, liquidity preference, and a country‘s net short-term foreign obligations for exchange rate dynamics. The interviews also point to the empirical manifestations of these underlying mechanisms. These empirical manifestations, as exchange rate drivers in the context of currency internationalisation, are econometrically triangulated using the cointegrated VAR methodology, single equation and multivariate cointegration tests and multivariate GARCH analysis. Results show that the Brazilian Real has formed a cointegration relationship with short-term capital flows over recent years. In addition, the econometric results present evidence that despite different structural characteristics, the Brazilian Real exhibits a strong co-movement with other internationally traded currencies, confirming the currency‘s internationalisation. In addition, short-term returns and international market conditions have an increasing effect on returns of the Brazilian Real. In conclusion, the dissertation discusses the important implications the internationalisation process of the Brazilian Real has for the ability of the central bank to control and influence the exchange rate and the resulting implications for exchange rate policy. 3 Acknowledgments This research has been made financially possible by an ESRC 1+3 Scholarship. In addition, financial support has been received from the Swiss National Science Foundation as part of the NCCR International Reserach Programme on Trade Regulations. I am very grateful to both funding bodies which have allowed me to conduct my studies relatively free from financial worries and pressures. I am also very grateful to my supervisor Prof. Machiko Nissanke who has made this financial support available and has stood by me over the last years. Her advice and support was invaluable. I also want to thank Prof. Jan Toporowski, Prof. Engelbert Stockhammer and Prof. Cardim de Carvalho who have accompanied and mentored me intellectually throughout my studies and have been the source of many ideas and insights. Thanks also go to all the traders, economists, central bankers and investment bankers who, through their time and patience, have given me invaluable insights into the workings of international foreign exchange markets on which this thesis builds. Thanks guys! The PhD experience would not have been the same without the wonderful people at my side who have given me so much either through discussions or just great fun. Thanks Chiara, Hannah, Reut, Radha, Elva, Giovanni, Susan, Jo, Bernd, Nuno, Iren, Alexis, Elif, Eugenia, Jeff, Duncan, and many others. Special thanks also go to Hope, Ali and Selin for the wonderful and insightful proofreading they have done; my parents for the financial and moral support and for having given me so much on my way; and my brother whose IT skills have saved my nerves. There are two people without whom this dissertation could never exist in the form in which it is now. Thanks to Juan Pablo who has shared so much with me over the last years, has taught me so much and has been a wonderful and patient friend. And last but not least, thanks to Dan, my love. This dissertation is for you for all that you mean to me. 4 Table of Contents Chapter 1: Motivation, Objectives and Structure .............................................................. 16 1.1.Introduction and Motivation .............................................................................................. 16 1.2.Thesis Objectives ............................................................................................................... 18 1.3.Research Questions, Hypotheses and Methodology .......................................................... 21 1.4.Thesis Structure .................................................................................................................. 23 Chapter 2: Theories of Exchange Rate Determination: Beyond Market Equilibrating Price ................................................................................................................. 27 2.1. Introduction ....................................................................................................................... 27 2.2. The Exchange Rate as Market Equilibrating Price ........................................................... 28 2.2.1. The Exchange Rate and External Equilibrium .................................................. 28 2.2.2. The Exchange Rate and Asset Market Equilibrium .......................................... 35 2.2.3. The Exchange Rate as Market Equilibrating Price? ......................................... 38 2.2. The Role of Asset Market Players .................................................................................... 41 2.2.1. Rational Expectations and Market Efficiency................................................... 44 2.2.2. Heterogeneous Expectations and Microstructure.............................................. 46 2.2.2.1. Private Information - Asymmetric Information and Order Flow ............... 47 2.2.2.2. Public Information - Behavioural Finance and Imperfect Knowledge Economics ............................................................................................................... 53 2.3. Conclusions ....................................................................................................................... 64 Chapter 3: An Alternative Analytical Framework for Exchange Rate Determination in Developing and Emerging Countries ..................................................... 65 3.1. Introduction ....................................................................................................................... 65 3.2. Post Keynesian Exchange Rate Theory – The Uncertainty Strand ................................... 66 3.3. Keynes on Exchange Rate Determination......................................................................... 74 3.4. The Exchange Rate as International
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