External Imbalances, Valuation Adjustments and Real Exchange Rate: Evidence of Predictability in an Emerging Economy

Abstract

In this paper we provide evidence of exchange rate predictability for a selected emerging market economy (EME) at intermediate horizons, arguably, the most relevant for policy purposes. This is important because the existing literature on exchange rate predictability has mainly focused on developed economies, leaving relatively unexplored the question for EME. By making use of a unique quarterly database of external assets and liabilities for Chile, we show that a measure of external imbalances is able to predict the real exchange rate over horizons of up to two years. Robust out-of-sample evidence on predictability reflects the fact that the external balance’s importance to the exchange rate has risen in recent years and/or the precision of parameter estimates rises as sample size grows larger. When we break down our measure for external imbalances into its three component ratios (exports to imports, exports to assets, and assets to liabilities), we find that predictability is mainly driven by the last two. Our results suggest that researchers and policymakers should pay attention to external imbalances to understand the future dynamics of the real exchange rate.