The degree of liquidity in a country's financial system helps forecast exchange rate returns in the near- and long-term, according to the latest research by the Federal Reserve Bank of New York.
Foreign exchange rates have experienced large fluctuations during the current credit crisis, which makes anticipating currency swings all the more important to global investors.
The fluctuations in the size of financial intermediary balance sheets is the common thread that ties together exchange rate movements with shifts in risk premiums, Tobias Adrian, assistant vice president at the New York Fed, wrote in a paper, Global Liquidity and Exchange Rates, released last month. The paper is co-authored with Hyun Song Shin, professor of economics at Princeton University, Princeton, N.J., and Erkko Etula, a Ph.D. candidate at Harvard University, Cambridge, Mass.
The economists noted that, before the current credit crunch, the global economy was often seen as awash with liquidity, meaning that the supply of credit was plentiful. Because this is no longer the case, financial institutions have a much more limited appetite for risk, which relies on the availability of funding.
Balance sheet aggregates for U.S. financial intermediaries have forecasting power for the future returns on the U.S. dollar across a wide cross-section of 23 currencies both for developed countries as well as for developing countries, the authors found.