Divergence indicators for currency market monitoring

Divergence indicators serve various purposes. The most general use is for analytical purposes: an indicator or a series of indicators that reveal whether or not the exchange rate is in line or not and whether policy needs to react or not. Every central bank uses several such indicators, from changes in the nominal bilateral exchange rates, changes in the effective exchange rate, changes in real exchange rates, and inflation differentials or interest rate differentials. At the same time analysis will not neglect variations in foreign exchange reserves, imbalances of the current, and capital accounts and fiscal imbalances.

When conditions for the participation in the EMU were laid down in the Maastricht Treaty, the relevant convergence indicators (just the opposite of divergence indicators) were the following: first, stability of the nominal exchange rate parity for a certain minimum time (2 years); second, long-run interest rates and inflation rates had to be within 2 percentage points of the average of the lowest three in the European Union; and, third, the fiscal deficit had to be less than 3% of GDP and public debt less than 60% of GDP. The fiscal criteria were then taken over in the Growth and Stability Pact which provides rules for those countries which are EMU members.

A. Construction of a Divergence Indicator

Beyond the analytical use of indicators there is their use as market signaling devices. This is what we defined as the possible role of an ACU divergence indicator. The goal is to present with an easily understandable measure to market participants a summary statement of the exchange rate stance. For a bilateral fixed exchange rate, a useful measure is the average deviation from the parity inside the intervention band; or, the inverse: the average deviation from intervention bands over a chosen time period. For instance, if inside the intervention band the exchange rate moves repeatedly from the positive to the negative part of the band, this would be a sign of stability. This would be very different from a case where the exchange rate is close to one intervention limit, most of the time as an obvious sign of pressure.

The drawback of such a measure is that it is necessarily defined in bilateral terms for fixed exchange rates. If the exchange rates are not fixed, there is no intervention band. But even if exchange rates are fixed, deviations inside the bands may vary substantially among different currencies. Usually the focus is on the “reference” currency. If there is no clear reference currency either because there is no exchange rate system with an official anchor currency or because there are several key currencies in terms of their shares in foreign trade, the bilateral focus is too limited. A multiple currency divergence indicator would then be preferable. In the EMS, the “reference” currency was the ECU, a basket of all participating (and even non-participating) currencies.

If a basket currency is adopted as a monitoring device for currencies in a region that has decided to foster cooperation, then any currency could be strong (or weak) with respect to all others or only with respect to some. A divergence indicator would then measure whether an exchange rate of a particular member country is strengthening or weakening with respect to the whole group or is stable with regard to the group, weakening with respect to some and strengthening with respect to others.

When a basket currency is the reference currency, then the weight of any participating currency in the basket must be taken into account. To see this, consider the definition of a basket currency, namely a set of currencies each with a pre-defined number of units. The value of such a basket can then be expressed in any participating or non-participating currency. In equation (1) currency 1 in the basket is used, without any loss of generality. It could have been any other currency:

(1) A(1) = a1 + a2E21 + a3 E31 + … anEn1

where A(1) is the value of the basket in currency 1, a1 is the number of units of currency 1 in the basket, a2 is the number of currency 2 in the basket and so on; E21 is the value of currency 2 in terms of currency 1, E31 is the value of currency 3 in terms of currency 1 and so on.

The change in the value of the basket, expressed in terms of currency 1, as a result of changes in bilateral exchange rates, is given by equation (2):

(2) dA(1) = a2dE21 + a3dE31+…… + andEn1

In case of a fixed exchange rate system, the maximal bilateral exchange rate variation in percentage terms is, say m. If currency 1 was moving with respect to all others by m, then the maximum movement with respect to the basket would be obtained. Denoting percentage variations by “^” equation (2) can be rewritten in percentage changes:

(3) Â(1) = w2Ê21 + w3Ê31+ …….+ wnÊn1 = (1 – w1)m

where wi is the share of currency i in the basket, defined as wi = ai.Ei1/A(1).

So, if for example m = 3% and w1 = 0.6 shares, then the maximum variation of currency 1 with respect to the ACU (or maximum divergence gap) would be 1.2%. If by contrast w1 = 0.1 shares then the maximum variation would be 2.7%. This reflects the fact that the higher the weight of a currency in the basket, the less can the basket value deviate from the par value of that currency. In the EMS, an alarm benchmark was defined. When a currency reached 75% of its maximum deviation as defined in equation (3) with respect to the ECU (the divergence threshold), the presumption was signaled that there was a risk of fundamental disequilibrium.

In the management of the EMS this divergence indicator played a useful role. When the divergence threshold was reached, this signaled that there should be a joint policy debate. The authorities of the currency concerned had to explain whether the stress was due to temporary factors or whether there was need for a policy adjustment. This adjustment was decided jointly in meetings in which the finance ministers and central bank governors of all EMS countries participated to ensure that the policy stance of the group of countries was coherent. Typically, adjustments to fiscal and monetary policies and the limit to exchange rate policies were at stake.

The divergence indicator was useful but, in actual operations, less than what was hoped for. There are basically three explanatory factors. First, group pressure was more effective on small rather than large countries. This will in all likelihood also be the case in other parts of the world, particularly with decisions as sensitive as the question of whether a devaluation is necessary and by how much? Second, as in the Bretton-Woods system, the pressure for adjustment was always on the weaker currencies and not on the strong currencies. This is an imminent structural problem of fixed exchange rate systems. Third, many countries did indeed observe the divergence indicator and intervened such as to avoid reaching the alarm benchmark. This last argument therefore suggests that the divergence indicator worked “behind the scenes.” A more general limitation of the divergence indicator was that although in theory, the ECU was the reference currency of the EMS, in practice, the deutschmark occupied that role. Participating countries were therefore more focused on the bilateral deutschmark rate than on the ECU rate.

B. A Divergence Indicator for ACU

In the Asian context there is no fixed exchange rate arrangement, although several countries operate fixed exchange rates. Nor is there a body in charge of fostering a cooperative approach to decision making. Nevertheless, a divergence indicator can play a very useful role for market participants. The usefulness of such a role is not only due to the high and increasing interdependency among Asian economies. If all Asian economies did not trade at all with each other but only with the United States then it would still be important to monitor how their nominal and real exchange rates deviated from each other in terms of the dollar. However, just looking at the dollar exchange rate can be very misleading if trade with the region becomes important. A better indicator would be based on two legs: first, the deviation of any Asian currency with respect to a basket of Asian currencies, the ACU; and, second, the variation of the ACU with respect to the dollar or a weighted average of dollar and euro. For example, an individual currency can have a stable dollar exchange rate and a rate depreciating with respect to the ACU because the latter is appreciating in dollar terms.

The usefulness of an ACU indicator would therefore reside in measuring the performance of a currency with respect to the rest of the currencies in the region. The more the region integrates the more important this measure will be. As there is no fixed exchange rate system sustaining the participating currencies, there should be a nominal and a real indicator. In countries that are catching up, the real exchange rate is far from constant even with flexible exchange rates. But independent of the question whether nominal exchange rates are fixed or flexible the value of the real exchange rate varies. Countries that search for more and more cooperative forms of decision making will wish to know how the real exchange rate with respect to the entire area, and not just on a bilateral basis, has moved.

For the nominal divergence indicator, equation 3 can be taken. For the real divergence indicator it suffices to replace in equation 3 the nominal bilateral exchange rates by the real exchange rates, namely for currency i:

(4) Rij = EijPj/Pi,

where Eij is the nominal exchange rate of currency i with respect to currency j and Pj is the price level in country j and Pi the price level in country i.

Such indicators will be useful for market participants, even if they play no role for policymakers. If policymakers did pay attention to such indicators in their policy analysis, that would seriously promote the importance of the divergence indicators.

Technical preparation would clarify which price indicators to use and entrust the computation of the divergence indicators to an agency in the region (e.g., a central bank, a secretariat of central banks, the ASEAN secretariat, etc.).

Increasing use and importance of the divergence indicator will also promote the idea of an Asian basket currency and the desirability of increasing regional policy cooperation.

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