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FX Ringside
24 March 2015
Authors:
Richard Falkenhäll
Johanna Behm
New and updated long-term fair value estimates
In 2011 we first published our SEBEER-model to
estimate long-term equilibrium exchange rates for
various currencies. We have now revised it to include
2010-2013 data. Key conclusions include the
suggestion that Scandinavian currencies are still
undervalued against most others, based on present
EUR/SEK and EUR/NOK fair values of 8.51 and 7.96,
respectively. Moreover, it shows that the EUR/USD
equilibrium exchange rate has remained fairly stable
over time at around 1.20.
Using model estimates, we have calculated the equilibrium
exchange rate for each currency against the USD, based
on the latest available fundamental data from 2013.
According to our fair value estimates the USD is almost
fairly valued against the GBP and CHF. In particular, the
NOK, SEK and JPY appear undervalued against the USD, as
is the EUR and CAD, although to a lesser extent. We find
the NZD expensive, and also the DKK although estimates
for this currency are more uncertain, due to its particular
FX-arrangements.
Long-term Fair Value (SEBEER), 2015-03-23
Ccy Cross
Curr. Spot
Updated est.
Old est.
EUR/USD
EUR/SEK
EUR/NOK
USD/SEK
USD/NOK
USD/JPY
EUR/GBP
EUR/CHF
GBP/USD
USD/CHF
AUD/USD
USD/CAD
NZD/USD
NOK/SEK
1.08
9.30
8.68
8.60
8.02
119.9
0.73
1.06
1.49
0.98
0.78
1.26
0.76
1.07
1.18
8.51
7.96
7.21
6.74
101
0.77
1.18
1.53
1.00
0.74
1.17
0.62
1.07
1.25
8.33
6.83
6.67
5.47
106
0.81
1.28
1.54
1.02
0.87
1.15
0.63
1.22
EUR/USD FAIR VALUE STABLE AROUND 1.20. The
EUR/USD estimate is always critical. Firstly, the euro has a
shorter history than most other currencies having only
existed as a single currency since the late 1990s. This may
influence the precise fair value of the currency pair.
Secondly, the dollar has been unusually weak for most of
this period (compared to historically), due to structural
rebalancing flows out of the currency since the euro was
introduced. This may have created an upside bias in the
empirical estimate for the euro. Still, the current long-term
fair value (LTFV) estimate for the EUR/USD is 1.18 and
appears to have been fairly stable around this level for
some time, as shown in the chart below. Since 2001, it has
fluctuated between 1.12 and 1.26, consistent with other
findings for the currency pair. The new EUR/USD estimate
is slightly lower than we previously suggested, although
the difference is fairly small.
The table below includes new fair value estimates based
on the updated SEBEER-model. As the model specification
alone has been subject to only limited changes (see below)
these remain very similar to their predecessors.
SEK AND NOK AMONG MOST UNDERVALUED G10CURRENCIES. Our new LTFV model confirms there is
significant downside potential in EUR/SEK and EUR/NOK
from current traded levels. With respective LTFVs of 8.51
and 7.96, the Scandinavian currencies are the two most
You can also find our research materials at our website: www.mb.seb.se. This report is produced by Skandinaviska Enskilda Banken AB (publ) for institutional
investors only. Information and opinions contained within this document are given in good faith and are based on sources believed to be reliable, we do not represent that they are accurate or complete. No
liability is accepted for any direct or consequential loss resulting from reliance on this document. Changes may be made to opinions or information contained herein without notice.
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undervalued G10 currencies against the dollar. This is also
in line with previous findings. The SEK particularly appears
to have been systematically undervalued against the EUR
for most of the last 12 years. It only traded around its LTFV
very briefly in 2011 and 2012 as the euro was under
pressure, due to speculation concerning a possible
breakdown in the common currency system during the
euro zone crisis.
The structural undervaluation of the Scandinavian
currencies may be explained by the fact that they are
generally small and illiquid and consequently traded at a
premium. To reflect this structural undervaluation we have
added a small premium to the updated fair-value
estimates for the SEK and NOK. The new model shows a
fair-value estimate for EUR/SEK of 8.51, slightly higher
than its predecessor. Nevertheless, according to the model
the LTFV for the krona has increased in recent years
suggesting that the currency should be stronger.
strong fundamentals. Estimating the NOK’s fair value we
have tried to account for this situation by isolating the
mainland economy.
EQUILIBRIUM EXCHANGE RATE MODEL (SEBEER).
Economic literature includes many methods of calculating
the equilibrium exchange rate, which are also known as
fair values. For example, the Purchasing Power Parity
(PPP) approach emphasizes the relationship between
relative price levels in different countries and their
respective currencies.
There are also other more fundamental approaches that
focus instead on internal and external balances. Internal
balance is typically reached when the economy operates at
full employment output in a low inflation environment. In
turn, external balance is usually characterized by a
sustainable balance of payments position, ensuring
optimal net flows of resources and sustainable levels of
external debt.
In addition to these more theoretical approaches there are
various empirical methods that focus more on the actual
behaviour of exchange rates (e.g. Behavioural Equilibrium
Exchange Rate, BEER) where equilibrium exchange rates
(EER) are estimated by a reduced–form equation of
fundamental or economic variables. Economic research
also suggests many fundamental variables that may
impact the EER. In the estimation process we have chosen
to include the following variables:
(1) Relative prices (Exp. sign: –)
According to the new model the updated LTFV for
EUR/NOK increases to 7.96 from previously 6.83.
However, the substantial change seems to be attributable
more to the fact that the estimate rose sharply last year
rather than the new model estimates. In the previous year,
the new LTFV estimate for EUR/NOK was 7.18, which is
fairly similar to the previous estimate. However, empirical
LTFV estimates involving the Norwegian krona must
nevertheless be more uncertain, due to the special
situation affecting the country’s currency flows, including
large transfers to the national oil-fund partly to neutralize
export related capital inflows.
LTFV will be affected by relative prices between countries
as stated by the classical PPP theory. To capture this effect
the model includes differences in international price levels
that we expect will negatively impact EER. As all currencies
are estimated against the USD, a negative effect means
that increased prices in a particular country will weaken its
EER against the USD.
(2) Terms of trade (TOT) (Exp. sign: +)
Improvements in the ToT are generally associated with a
higher equilibrium exchange rate, as a relative increase in
prices of exports over imports usually has a positive
income/wealth effect through higher profits. Normally, the
positive effect on EER results in greater domestic demand,
causing interest rates to increase. However, it also more
directly attracts investment inflows to the country
concerned.
(3) Relative productivity (Exp. sign: +)
Countries becoming increasingly competitive due to faster
productivity gains will be able to sustain exchange rate
appreciation while retaining external competitiveness.
Consequently, the relative productivity development will
cause the equilibrium exchange rate to appreciate.
Consistent with common practice, we use the difference in
GDP per capita as a proxy for relative productivity with an
expected positive effect on EER.
(4) Net investment income (Exp. sign: +)
As intended, this set-up has probably kept the NOK
weaker than it otherwise would have been considering its
Over the longer term the NII surplus should have a positive
effect on the equilibrium exchange rate, as a higher NII
should mean positive net inflows from the rest of the
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world, which is why it has been included in the model.
However, short term capital flows could cause such a
relationship to break down.
(5) Interest rate differentials (Exp. sign: +)
Although interest rates should not be regarded as a
fundamental variable, interest rate differentials may cause
the exchange rate to deviate from what would otherwise
be its LTFV. A country with a positive interest rate
differential to other countries attracts capital inflows and
should therefore see its exchange rate appreciate. To
capture this well-known effect we incorporate the real
interest rate differential in the model.
ESTIMATING THE MODEL. In our analysis we estimate
equilibrium exchange rates based on a simultaneous series
of projections for a panel set of currencies. Through the
panel approach we can increase the number of
observations in the data sample, improving the accuracy
of each parameter estimate, without the need to extend
the time period used in the analysis. In addition, this
enables a simultaneous estimation of several equilibrium
exchange rates, ensuring a consistent approach to all
currencies. The method used is Panel Dynamic OLS
(PDOLS), which is less biased than the POLS of finite
samples.
The model is estimated based on annual data from 1980
to 2013. Our parameter estimates are identical for 28 cross
sections (representing 27 country exchange rates and the
euro area vs. the US dollar). Country- and region-specific
differences are captured by individual intercepts,
representing a so-called fixed-effect estimation technique.
After confirming co-integration between variables we
estimate the model through PDOLS. In the final model
specification all of our chosen variables are included
except for the variable NII as it does not seem to add any
extra value to the model. The estimated model has
significant coefficients consistent with the theory, and as a
whole shows a high degree of explanatory power. Our fair
value estimates will be updated again later this year when
we are able to access latest data for 2014.
References
Alshehabi, Omar & Ding, Shuang, 2008, “Estimating equilibrium
exchange rates for Armenia and Georgia”, IMF Working Paper No 08/110.
Chudik, Alexander & Mongardini, Joannes, 2007, “In search of
equilibrium: Estimating equilibrium real exchange rates in Sub-Saharan
African countries”, IMF Working Paper No 07/90.
Clark, Peter B & MacDonald, Ronald, 1998, “Exchange Rates and
Economic Fundamentals: A methodological Comparison of BEERs and
FEERs”, IMF Working Paper No 98/67.
Isard, Peter, 2007, “Equilibrium Exchange Rates: Assessment
Methodologies”, IMF Working Paper No 07/296.
Krugman, Paul R. & Obstfeld, Maurice, 1991, “International Economics:
Theory and Policy”, HarperCollins Publishers Inc.
MacDonald, Ronald, 1997, “What Determines Real Exchange Rates? The
long and short of it”, IMF Working Paper No 97/21.
Ricci, Luca Antonio, Milesi-Ferretti, Gian Maria, and Lee, Jaewoo, 2008,
“Real Exchange Rates and Fundamentals: A cross-country perspective”,
IMF Working Paper No 08/13.