Factors that influence the krone exchange rate.

• Author: Bernhardsen, Tom
• Position: Norwegian exchange rate model - Statistical Data Included

This article examines how the krone exchange rate is influenced by factors such as the oil price and turbulence in international financial markets. The article contains an analysis of the krone exchange rate against the German mark (the euro from 1 January 1999) and against an average of our trading partners' currencies. In the long term, the krone exchange rate is found to be dependent on the oil price and the price differential between Norway and other countries. In the short term, the krone exchange rate is also influenced by international financial turbulence and by the interest rate differential against other countries. International financial turbulence has had a particular effect on the krone exchange rate since January 1997, when there was a sharp increase in the daily volatility of the krone exchange rate. In this period, effects stemming from international foreign exchange markets appear to have had at least as great an impact as the oil price on monthly movements in the krone exchange rate.

The estimation results indicate that the krone exchange rate against trading partners is at present considerably weaker than its long-term equilibrium rate. This being the case, it would be natural to expect a strengthening of the effective krone exchange rate over time. However, the model predicts that, measured against the euro, the krone will depreciate somewhat in the longer term. If both effects are to occur at the same time, the euro will have to appreciate considerably in relation to its present level.

1. Introduction

   Exchange rates affect a country's economy in many ways. For instance, the krone exchange rate affects demand for Norwegian goods and services, the return on financial investments in Norway compared with investments in other countries, and domestic inflation through prices for imports. Since the Norwegian economy is small and very open, the krone exchange rate is of relatively great importance to economic development. This is why Norway has traditionally had the objective of a fixed or stable exchange rate. Today, monetary policy is geared towards maintaining exchange rate stability against European currencies, which Norges Bank has defined as the euro.

   Since the krone exchange rate has an influence on economic developments in general and since monetary policy is aimed at achieving exchange rate stability, it is important to determine which factors affect the krone exchange rate. There is, of course, no single definitive krone exchange rate, since the exchange rate depends on the currency or basket of currencies against which the krone is measured. For instance, the krone may appreciate against the euro and depreciate against the dollar at the same time. Consequently, when the international value of the krone is measured, it should be measured against a basket of currencies. There are several indices which measure the effective krone exchange rate in various ways. One such exchange rate index is the trade-weighted exchange rate index, which measures the value of the krone against a weighted average of the currencies of Norway's trading partners.(2)

   In the long term there is a tendency for a country's exchange rate to move in line with domestic price and cost inflation relative to that of other countries. This is in accordance with the hypothesis of purchasing power parity (PPP) between countries. Although PPP does not apply in the short term, a number of international studies indicate that there is a certain degree of convergence towards PPP in the long term (see Froot and Rogoff, 1995). If the price level in one country rises more swiftly than that in other countries, there is a tendency for that country's currency to depreciate correspondingly over time. Akram (2000a) finds evidence for PPP between Norway and its trading partners in the long term.

   Experience shows that it is difficult to construct robust models of short-term developments in the exchange rate (see Frankel and Rose, 1995). Random walk models, in which the exchange rate is expected to remain at the current level in the future, are often just as useful for forecasts as sophisticated models. It is hardly surprising that it is difficult to construct good models for forecasting developments in exchange rates in the short and medium term. Were it simple, it would also be easy to make money on currency speculation. However, in well functioning markets such profit opportunities would soon be exhausted. Of course, this does not prevent some market participants from making a large profit on currency speculation, but it does mean that one cannot expect to make large profits without taking considerable risks.

   In this article, we take a closer look at the factors which determine exchange rate movements, focusing, unlike previous articles on the subject, on how turbulence in international financial markets affects the krone exchange rate. The article includes analyses of movements in the exchange rate between the krone and the German mark (from 1 January 1999 the euro) and developments in the trade-weighted exchange rate index. Short- and long-term exchange rate movements are modelled.

   There appears to be a perception among market participants that the oil price influences the krone exchange rate. According to economic theory, a sustained rise in oil prices will result in more favourable terms of trade for an oil-exporting country such as Norway. This, in isolation, implies a strengthening of the exchange rate. There is also a tendency for terms of trade to have an effect on the exchange rate in other commodity-exporting countries, such as Canada, Australia and New Zealand. Akram (2000b) has studied the relationship between the oil price and the krone exchange rate. His findings show that a fall in the oil price leads to a weakening of the krone exchange rate, but that the relationship is non-linear. For instance, when the oil price is in the range USD 14 to USD 20 per barrel, the relationship is weak or non-existent.

   The relationship between the krone exchange rate and the oil price probably depends on the degree of dependence of the domestic economy on the petroleum sector. If the level of domestic activity is largely independent of petroleum revenues, there is likely to be a weaker relationship between the krone exchange rate and the oil price. The Government Petroleum Fund may therefore contribute to making the krone exchange rate less dependent on the oil price.

   In addition to oil prices, experience indicates that turbulence in international financial markets also affects the krone exchange rate. In the international foreign exchange market, the Norwegian krone is regarded as a "peripheral" currency. In periods of high volatility in international financial markets, there is a tendency for international agents to seek to reduce the krone holdings in their portfolios. This leads to a depreciation of the krone.

   Our model of the krone exchange rate includes the price differential and the interest rate differential against other countries, as well as the oil price and an indicator of international financial turbulence. The main findings are that in the long term the krone exchange rate, measured against both the mark and the currencies of Norway's trading partners, is dependent only on the oil price and the price differential against other countries. In the short term, it is also affected by international financial turbulence and the interest rate differential. From a short-term perspective, turbulence in international financial markets appears to have been an important factor contributing to the fluctuations in the krone exchange rate since January 1997. The exchange rate between the krone and the mark is also dependent in the short term on the exchange rate between the mark and the US dollar.

   The article is structured as follows: section 2 contains an introductory discussion of krone exchange rate movements using charts; section 3 presents the model of the krone exchange rate; the estimation results are presented and analysed in section 4, and conclusions are presented in section 5. There is also an annex which describes the indicator used for turbulence in international foreign exchange markets.

2. Analysis of the charts

   Before the estimated model of the krone exchange rate is presented, it may be useful to look at some charts showing movements in the krone exchange rate, measured against the mark (since 1 January 1999 the euro) and against the currencies of Norway's trading partners (trade-weighted exchange rate index), as well as some of the explanatory variables in the model. However, it is...