# How can the exchange rate be virtually constant with major inflation rate difference and a widening trade deficit?

I have recently had a discussion with a colleague about what seems to be a rather strange macroeconomic aspect in Romania (which has RON currency):

All these factors seem to put pressure on RON to lose value when compared to EUR and yet it is rather constant for quite a while.

The only factor I know is very different between EUR and RON is the base interest rate and I guess is acting in the opposite direction:

What could maintain such a robust exchange rate for the EUR-RON pair? Namely, how can RON not lose value in this context for a rather long time (many months)? I am interested in a mostly qualitative answer.

• The inflation rate differences and bank overnight rate differences seem consistent with uncovered interest rate parity, which would not incentivize movement in the FX markets. Aug 7, 2022 at 10:40
• @Giskard If you have the time, can you please provide more details about this in an answer? Aug 12, 2022 at 6:36
• Have you looked up what uncovered interest rate parity is? Where? What part of the explanation causes you trouble? Aug 12, 2022 at 7:48
• I have checked this resource. Not sure if understand correctly: investors do not hope to gain something by selling RON for EUR because EUR bonds or similar instruments offer a low enough interest rate when compared to RON instruments interest rate. Aug 12, 2022 at 9:20
• The investment would also involve a timeframe, that is how interest comes into play. I parsed through your link and I don't think I can provide a better explanation than the one available there. Aug 12, 2022 at 10:07

You are right, all your points suggest that there is downward pressure on RON (it should depreciate). Also, (un)covered interest rate parity would suggest that RON should depreciate!

The UIP equation looks like this:

$$(1+i_{\\\})={\frac {E_{t}(S_{{t+k}})}{S_{t}}}(1+i_{c})$$

or rearranged:

$${{S_{t}}}\frac {(1+i_{\\\})}{(1+i_{c})} = E_{t}(S_{{t+k}})$$

EDIT

UIP is traditionally about expected (future) exchange rates. You can technically solve to imply spot, but that would require you to know the future expected FX rate. Since one observes (or say at the beginning of the year observed) spot, and has interest rate data, one typically uses this relationship to compute the expected FX rate. Either way, you can turn the equation around as much as you want, the higher interest rate country's currency is expected to depreciate over time.

I did not use the OP data because I copy pasted this example (and swapped USD for RON). Also, the data provided in the question is insufficient. You can find current spot, that EURIBOR is $$\approx 0 \%$$ and ROBOR 3m is $$>8 \%$$. In real applications (say Bloomberg's FXFA), one would use the associated interest rates for a tenor (maturity / date in the future) from bootstrapped Swap curves and cross currency basis curves as opposed to simply spot rates. Ultimately, for the purpose of the question, all that matters is what happens to the higher interest rate currency relative to the other. To make it a bit closer to the OP data, I will use the approximate values.

For EURRON (how many RON per EUR, say 4.8931 at the time of writing according to the Source provided in the question, if the RON interest rate is 8% and the EUR rate is 0% you get the value of (assuming for a full year, to avoid having to compute year fractions for the interest rate),

$${4.8931}*\frac {(1+0.08)}{(1+0.0)} \approx 5.284548$$

In other words, you need more RON per EUR - the RON depreciated, EUR appreciated.

The image below is from a Quant SE answer and shows the Turkish inflation rate as well as the USDTRY exchange rate.

As you can see, the currency of the country with the higher inflation (Turkey) tends to depreciate against the currency of the country (US) with lower inflation rates (also Turkey has higher interest rates compared to the US).

Why RON does not depreciate?

In the case of RON, there are a few aspects, like forex inflows generated by diaspora (especially during the summer season where lots of people return home). Also, interest rates did increase relative to the EUR zone in the last few months, which will results in immediate upward pressure (potentially counterbalancing the general downward pressure), just like the USD appreciated against the EUR in the last months (the US also increased rates).

• on May 10th 2022: central bank of Romania raised its key monetary policy rate by 75bps to 3.75%
• on July 6th, 2022: raised by 100bps to 4.75%
• on August 5th, 2022: raised by 75bps to 5.5%

However, the biggest factor is likely (direct) intervention by Romania's central bank (NBR). NBR's governor Mugur Isarescu explained that the monetary authority would remain active and not leave the national currency to weaken below RON 5 to EUR. The statement alone may help the RON exchange rate (even if there were no actual interaction by the NBR) as long as the central bank is credible because market participants may not try to bet against the RON if it is seen as an uphill fight against a central bank. A good example for a strong central bank being able to fight speculative attack is the Hong Kong Monetary Authorities history of being able to maintain the peg.

The article about Isarescu is in Romanian but Google translate works well usually. The main quote of interest is at the very beginning:

The EURO will remain below 5 LEI as long as necessary. You don't let go of a control tool when you have war at your door.

NBRs inflation report (PDF download) states on P.31 that

the stability of the EUR/RON exchange rate was an essential concern throughout this period.

ING FEB 2022 mentions that

the increased turnover around 4.95 suggests official offers have been protecting the leu.

in the base case the NBR will most likely try to keep the FX rate stable through a combination of FX interventions and spiking carry rates if needed.

Erste Group Research also states that

the NBR is trying to curb the slide of the national currency

but mentions that depreciation pressures should persist.

A bit of context

A common misconception is that higher interest rates will lead to an appreciation in the future, but in fact, UIP claims the opposite: any higher interest in one country will be offset by a depreciation in that countries currency so that an investor will be equally well off. In other words it doesn't matter where you invest.

Forwards follow covered interest rate parity. Uncovered interest rate parity is the same arbitrage condition but unhedged with FX forwards (hence uncovered). If you have access to Bloomberg, you can look at FRD for the former, and FXFA for the latter.

FRD:

$$\color{blue}{SP}$$ stands for Spot, Pts (Points, the most common way of quoting FX forwards)) represent what is added to Spot, Fwds are the forwards computed from quoted Spot and Pts. The darker values at the bottom indicate that these are implied (computed) from interest rates via no arbitrage. This is done when there aren't enogh liquid market quotes. You can see that a substantial depreciation of RON relative to EUR is quoted / implied at the time of writing. FXFA is the tool to compute this systematically.

FXFA: Interest rates are deliberately chosen to follow your EURIBOR / ROBOR example. Note, that you see the warning Mismatched yield curves because it would not be the curves conventionally used but market standards do not matter for the purpose of this question and the next screenshot from the results section shows that the implied forward is not even that different from the actual market quoted forward. The column 7) FX Swap corresponds to the market quote, which combined with yield curves (column 8) EUR Yield and 9) RON Yield) can be used to compute FX Swap implied (the highlighted column). The column with red and green values shows the difference bewteen the market quoted forwards and implied forwards.

Bottom line, these BBG screens should just help to showcase that (un)covered interest rate parity also suggests that RON should depreciate.

Shouldn't higher interest rates lead to an appreciation in that currency because it is more favourable? Usually higher interest rates (if unanticipated) will result in the higher rates currency appreciating very quickly (if it was fully anticipated, that effect happened already before the hike). This is the basis of the so called overshooting models that were developed to explain the excess volatility puzzle (typically, FX volatility exceeds that of the underlying economic fundamentals substantially). Since FX reacts asap but goods prices are delayed, the spot rate must overshoot its value in the short run, followed by a depreciation (UIP) afterwards.

Overshooting models are also called sticky price monetary models. They combine capital markets, goods markets and money markets. Dornbusch (1976) was the first to develop this theory.

• 1. "RON should depreciate" Could you perhaps clarify whether you mean a current imbalance and impending depreciation (according to UIP of course), or a slow long-term depreciation? Aug 12, 2022 at 11:08
• 2. Why are you not using the numerical data provided in the OP instead of "For EURRON (how many RON per EUR, say 5.0, if the RON interest rate is 10% and the EUR rate is 5% you get"? Aug 12, 2022 at 11:08