Polish zloty bubble in the making

Speculative capital moves in search of the highest total return. Let’s assume for simplicity that the total return has two elements: the interest rate differential and the return on exchange rate appreciation. In words to make money you should borrow in low yielding currency i.e. USD and put deposit in high yielding currency i.e. PLN (Polish zloty) and pray for exchange rate to depreciate slower than the interest rate differential.
Classical economy claims that uncovered interest parity holds and expected future exchange rate is equal to the interest rate difference. Meaning that higher yielding currency should depreciate faster, flattening out the possible profit. But classical economy assumes that the valuation process is passive whereas the capital inflow is motivated primary by expectations about future exchange rates. To the extent that exchange rates are dominated by speculative capital inflows, they are purely reflexive: expectations relate to expectations. This process is self-fulfilling and self-validate but increasingly unstable as to keep it in place capital hast to flow in faster and faster.
To cut story short It all depends on how market participants co-ordinate their expectations. LPPL formula is handy tool to detect synchronization of market participant’s expectations and to estimate probable end of the bubble. Several months ago I posted here chart with LPPL formula fit into EUR/PLN exchange. In all boom and bust periods the formula fit well to the data and accurately predicted the end of the bubble or ant bubble process.
Before I will fit the LPPL formula to the current data let’s take a closer look on the stylized facts. At present zloty is top performer in the region. Some says that fundamentals are supportive for the local unit. Indeed this is true as it was in 08 when the zloty lost half of its value vs. Euro. I see main reason behind zloty strength in budget deficit and how the budget deficit will be financed. This year Polish treasury through privatization process wants to sell stakes in state own companies worth PLN 26bn or roughly EUR7bn. Most likely a large chunk of this offer will be bought by foreign investors meaning a FDI inflow. Huge expectations about FDI inflow triggered portfolio inflow and that’s how the process started. This process is very similar to the 1999-2001 period when record high privatization inflows (FDI) brought zloty down to 3.4 vs. EUR

Lomb spectral analysis applied to residuals from linear part of LPPL equation confirms a strong log-periodic component in EURPLN time series (18-02-2009 to 07-04-2010). This is a confirmation of growing synchronization among market participants about future course of events (appreciation).

More detailed analysis to follow