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A review of academic studies on the relationship between Currency Devaluation and Stock Market Performance in emerging markets:


Emerging markets have a long history of currency devaluations. Argentina's central bank recently raised its benchmark interest rate three times in the space of a week to defend the peso which has lost about 40% of its value this year. In Turkey, the lira has set record lows as it continues to weaken. These examples of devaluation appeared to have been caused more by specific problems in their respective economies, but some economists stress that in practice devaluation in emerging markets could be triggered by events in developed economies. For example, in 1994 tighter monetary policy by the Federal Reserve pushed up the dollar and placed intolerable pressure on the peg of the Mexican peso against the dollar, resulting in a series of emerging market crises. To understand the current weakness among a number of emerging market currencies, US economic and foreign policies matter the most.

More isolated emerging and frontier economies are not immune from these dynamics either. In this section, we will review academic literature on currency devaluations and their relationship with local stock markets in developed and emerging markets. In the September issue we will consider the dramatic devaluation of the Rial which has been followed by a significant rally on the Tehran Stock Exchange in recent months and try to shed light on the causes of the IRR devaluation and fundamental factors regarding the impact on the stock market.

Selected Academic Papers

Back in the 1990s, there was scant academic literature on the relationship between stock prices and exchange rates in advanced economies and few studies that examined the causality relationship between these two. However now this subject is plainly of great interest to many academics and professionals. The literature on this subject is divided between two main theories. The first is the traditional approach concluding that exchange rates could lead to stock prices fluctuation by affecting the value of companies in terms of competitiveness, asset value and debt value. For example the valuation of exporting companies in a devaluation environment will increase. The second theory argues that changes in stock prices may influence significant movements in exchange rates via portfolio adjustments. For example, an upward trend in stock prices will increase the inflow of foreign capital which will strengthen the local currency.

In 1992, an article published in Applied Economics Journal found that there could be a two-way relationship between the effective exchange rates of the dollar and the S&P 500 index, at least in the short run (Bahmani- Oskooee & Sohrabian, 1992). But this study found no long-term relationship between the two variables.

In 2000, the International Monetary Fund Research Department published a working paper that examined the relationship between Devaluation Expectations and the Stock Market in Mexico in 1994/95 (Becker, Gaston Gelos, & Richards, 2000). With the Mexican currency crisis of 1994/95 marking the first of a series of such crises in the 90s, this paper examined the behaviour of stock prices around this event. Given the forward-looking nature of stock markets, this working paper explored the behaviour of different stocks around the time of the 1994/95 currency crisis and examined the extent to which the impact of devaluation on stock prices depended on the relevant companies' exchange rate exposure. The paper found that companies with high net exports showed significant positive abnormal returns, while low net exporters underperformed relative to the market during the week of the devaluation. The relative performance of high and low net exporting firms suggests that devaluation expectations may have started to build up approximately a year before the actual event. This

conclusion was drawn through constructing a measure of the "shadow exchange rate" prior to the devaluation.

3. A paper on the relationship between real exchange rates and stock prices in the Romanian economy, (Horobet & Llie, 2007), using monthly data for 1999 to 2007 on stock prices and exchange rates, found that exchange rates were the leading variables for stock prices and that the stock market adjusted dramatically to changes in the exchange rates in the space of a month.

4. Further interesting research on the causality between stock prices and exchange rates in Turkish financial markets, (KE[micro]se, Doganay, & Karabacak, 2010), found that there is a unidirectional causality from stock prices to exchange rates, using daily observations from Feb 2001 to Nov 2009.

5. An empirical study suggests that there are significant relationships between exchange rates and stock prices in the Brazilian economy (Tabak, 2006). Tabak found no long-run relationship but a linear causality from stock prices to exchange rates. Stock prices lead exchange rates with negative correlation. On the other hand, the findings suggest that there is evidence for nonlinear causality from exchange rates to stock prices where exchange rates lead stock prices. The empirical results suggest that the two markets are indeed related and one has predictive power to forecast the other. One practical application of these findings is in portfolio management to monitor exchange rate and equity returns movements to hedge portfolios against currency movement and build forecasting models. The table below summarizes the findings of these selected papers.

Countries with higher capital mobility, such as Brazil, Turkey and Mexico, indicated a bidirectional causality relationship between the foreign exchange market and stock market. Countries with lower capital mobility (e.g. Romania) showed a unidirectional causality relation from exchange rate to stock market.

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Publication:Iran Investment Monthly
Date:Aug 1, 2018
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