If the fundamentals are weak, the exchange rate will expose you?

Ken Ofori-Atta and Vice President Bawumia in Parliament ahead of the budget presentation in 2019

The formation of the Foreign Exchange (FX) Development Committee chaired by the Minister for Finance, Ken Ofori-Atta, has revived discussions about a statement by Vice President, Dr. Mahamudu Bawumia.

In 2014, Dr. Mahamudu Bawumia, while commenting on the continuous depreciation of the cedi, said that “… if the fundamentals are weak, the exchange rate will expose you”.  At that time, his party, the New Patriotic Party (NPP), was in opposition. In response to the cedi’s depreciation in 2019, Dr. Bawumia, as Vice President of Ghana and head of the Economic Management Team (EMT), defended his claim about exchange rates and macroeconomic fundamentals as follows:

“You will recall that I stated in 2014 that if the fundamentals are weak the exchange rate will expose you. That was true then and it is true now. It is 100% correct. So if the fundamentals are weak the exchange rate will expose you. But is warped logic to jump from that to a conclusion that if there is depreciation in your currency then the fundamentals must be weak. It is a very warped logic. If the fundamentals are weak, the exchange rate will expose you but if the exchange rate moves, you cannot jump to that conclusion that the fundamentals are weak. That defies logic. There could be other external factors causing the exchange rate depreciation.”

Of course, logic 101 tells that the converse of a statement is not necessarily true: “If X, then Y” does not necessarily imply “If Y, then X”. Bawumia’s point was that a country’s fundamentals may be strong but other unfavourable external factors may be strong enough to cause depreciation in the external value of a currency. The Minister of Finance, Ken Ofori-Atta, has also attributed the depreciation of the cedi to external pressures and indicated that strong fundamentals should stabilize the cedi.

Indeed, external factors affect exchange rates. But those external factors are also fundamentals. In the determination of exchange rates, a country’s own fundamentals (e.g., inflation, interest rates, GDP growth, trade balance, budget deficits, money supply, etc) are not the only explanatory variables. In fact, the variables used are relative fundamentals (i.e., the country’s fundamentals relative to the fundamentals of a foreign country). For example, a seminal paper published in 1983 on the  determination of exchange rates by Richard Meese, then at the University of California (Berkeley), and Kenneth Rogoff of Harvard University used the following variables: the ratio of the U.S. money supply to foreign money supply,  ratio of U.S. to foreign real GDP, the short-term interest rate differential between the US and a foreign country, the expected long-run inflation differential between the US and a foreign country, and  the accumulated U.S. and foreign trade balances. Thus, “other external factors” are part of fundamentals.

If a country’s fundamentals were the only determinants of its exchange rate, its currency will either depreciate against all currencies at the same time (for example, when its fundamentals are weak) or appreciate against all currencies at the same time. In reality, this is not always the case. It is common for the same currency to depreciate relative to some currencies but appreciate relative to other currencies at the same time. It is not the absolute strength of your fundamentals that matters. It is the relative strength of your fundamentals. Therefore, if other external factors caused the depreciation of the cedi in 2019, it was reasonable to claim that Ghana had weak fundamentals relative to the fundamentals of its trading partners.

In the aforementioned paper, Meese and Rogoff (1983) compared the forecasting accuracy of various exchange rate models. Surprisingly, they found that that a random walk model performed as well as any estimated model at one to twelve month horizons for the dollar/pound, dollar/mark, dollar/yen and trade-weighted dollar exchange rates.

The random walk model used the current exchange rate as a predictor of future exchange rates. It did not use fundamentals and yet performed as well as fundamentals-based models. Attempts to overturn this result, known as the Meese-Rogoff puzzle, has been the focus of researchers for several years. It has stood the test of time. In fact, there is ample evidence of a weak or non-existent relationship between exchange rates and fundamentals over short periods. Maurice Obstfeld and Kenneth Rogoff coined the term “exchange rate disconnect puzzle” for the weak short-run relationship between the exchange rate and macroeconomic fundamentals (e.g., Obstfeld and Rogoff, 2001). In subsequent studies, researchers found that models based on fundamentals performed better than the random walk model for horizons longer than a year. The consensus is that the macroeconomic fundamentals have little effect on exchange rates at short horizons, but do have an impact at longer horizons (e.g., Mark, 2005). Therefore, even if a country’s fundamentals are relatively strong, they may not be good predictors of daily, weekly, or monthly exchange rates. The fact that fundamentals have much less variability than exchange rates during short periods may account for the exchange rate disconnect puzzle (Meese, 1990). Based on surveys of foreign currency traders in the US and Hong Kong, some researchers found that interest rates matter more than other fundamentals (Lui and Mole, 1998; Cheung and Chinn, 2001). Using a large sample of individual professionals’ forecasters, Dick et al. (2015) concluded that exchange rate “… forecasters largely agree that an interest rate increase relates to a currency appreciation, but only good forecasters get expected interest rates right.”

The preceding discussion suggest that exchange rates are not only determined by current fundamentals but also by expectations of fundamentals. It turns out that expected (future) fundamentals weaken the relationship between current fundamentals and the exchange rate. Recent models have included order flow in forex markets as a proxy for expectations of future macroeconomic fundamentals (Lyons, 2001). Order flow is defined as the difference between buyer-initiated and seller-initiated currency transactions (especially by large currency traders like banks) and is a measure of net buying pressure on a particular currency. You may think about it as the gap between demand for and supply of foreign currency. Evans and Lyons (2007) showed that Citibank customer order flow had substantial predictive power for future GDP, inflation and money supply.  Rime et al, (2010) also found that order flows were linked to macroeconomic fundamentals.

According to Rime, Sarno, and Sojli (2010), “Previous research has found that order flow has strong explanatory power for exchange rate movements, whereas macroeconomic fundamentals have weak explanatory power… We provide evidence that (i) order flow is intimately related to a broad set of current and expected macroeconomic fundamentals and (ii) more importantly, order flow is a powerful predictor of daily movements in exchange rates … This finding may provide a rationale for the high explanatory power of order flow found in the literature. Furthermore, it suggests that macroeconomic fundamentals are indeed relevant for exchange rate determination, but that the order flow channel is key to link exchange rates to fundamentals.”

The seasonal, short-run, or periodic episodes of significant deprecation of the cedi are unlikely to be affected by moderate and favorable levels of conventional and current macroeconomic fundamentals (e.g., current inflation and growth rates). Thus, in the short run, we should go back to what everyone knows: basic demand and supply analysis, something akin to order flows and expected macroeconomic fundamentals. These are the outflows and inflows of dollars: demand for imports; dollar inflows from COCOBOD, FDI; periodic repatriation of profits and dividends by foreign firms; unfavourable foreign exchange retention agreements or weak enforcement of such agreements, etc. For example, the cedi — having depreciated for several months — appreciated from GH¢5.9/US$ in the last week of March 2019 to GH¢5.1/US$ in the third week of April 2019 after the government of Ghana raised $3 billion through a Eurobond issue (see Addison, 2019). Ah, demand and supply of dollars. Borrowing money to prop up the cedi is not a sustainable solution. Ultimately, the most important fundamental is the heavily import-dependent nature of our economy. I am not the first to make this point. It is not rocket science.

In conclusion, “if the relative fundamentals are weak, the exchange rate will expose you in the long run” and “If the exchange rate exposes you in the long run, then the relative fundamentals are weak.”


Addison, E. (2019). Achieving Sustainable Exchange Rate: Our Options. Graphic Business/Stanbic Breakfast Meeting, April 23, 2019.

Cheung, Y-W., and Chinn, M.D. (2001). Currency traders and exchange rate dynamics: a survey of the US market. Journal of International Money and Finance 20: 439 – 471.

Dick, C.D., MacDonald, R., and Menkhoff, L. (2015). Exchange rate forecasts and expected fundamentals. Journal of International Money and Finance 53: 235-256.

Evans, M.D.D. (2002). FX Trading and Exchange Rate Dynamics. Journal of Finance 57: 2405 – 2447.

Evans, M.D.D. and Lyons, R.K. (2002). Order Flow and Exchange Rate Dynamics. Journal of Political Economy 110: 170 – 180.

Evans, Martin D. D. and Lyons, R.K. (2007). Exchange Rate Fundamentals and Order Flow. National Bureau of Economic Research Working Paper 13151.

Lui, Y-H., and Mole, D. (1998). The use of fundamental and technical analyses by foreign exchange dealers: Hong Kong evidence. Journal of International Money and Finance 17:  535 – 545.

Lyons, R.K. (2001). The Microstructure Approach to Exchange Rates. MIT Press.

Mark, N. C., (2005). Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability. American Economic Review 85: 201 – 218.

Meese, R. (1990). Currency Fluctuations in the Post-Bretton Woods Era. Journal of Economic Perspectives 4: 117-134.

Meese, R. and Rogoff, K. (1983). Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample? Journal of International Economics 14, 3 – 24.

Obstfeld, M, and Rogoff, K. (2001). The six major puzzles in international macroeconomics: is there a common cause? In NBER macroeconomics annual 2000 15: 339 – 412.

Rime, D., Sarno, L. and Sojli, E. (2010). Exchange Rate Forecasting, Order Flow and Macroeconomic Information. Journal of International Economics 80: 72 – 88.

Atsu Amegashie is a D&D Fellow at CDD-Ghana. He is a Professor of Economics at the University of Guelph in Canada and a Fellow of the Center for Economic Studies and the Ifo Institute for Economic Research (CESifo) in Munich, Germany and the Tshepo Institute of Wilfrid Laurier University, Canada. His fields of specialization are Public Economics, Development Economics, and Microeconomics.

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