Globalization and International Financial Management - Research Paper Example

Globalization and International Financial Management Globalization has integrated the economies of the country extraordinarily. Indulgence in international trade and finance has now become imperative for the country where economic boost and development is desirable. There are several factors which regulate the international trade and commerce, and exchange rate is regarded as the prime. Exchange rate measures the value of currency in terms of the other currencies. An appreciation in the exchange rate denotes that the currency of a particular company is strengthening, representing a stable and flourishing economy. In contrast, a country with high inflation rate, unstable political conditions and rising unemployment is bound to have a declining exchange rate. Factors such as relative interest rate, real interest rate, relative income level and other government controls are few which affect the determination of exchange rate. Governments all across the globe vigilantly monitor their exchange rates and actively make direct and indirect intervention for control purposes. Measuring the change in the exchange rate is easier as compared to evaluating the intricacy of the factors responsible for it. In order to analyze the cause and effect of change in exchange rate, the concept of exchange rate equilibrium can be utilized. The concept is based on the basics of the law of demand and supply. Like a commodity, the foreign currency is also traded in markets where their exchange rates are determined based on the current demand and supply of that particular currency in the global economy. In order to grasp the concept, let us take two currencies into comparison: United States Dollar ($) and Euro (€). The exchange rate of Euro will be determined by the conditions of demand and supply of the currency in Europe. In addition, the demand of Euro in United States will also be a major factor in determining the exchange rate of the currency. Similarly, and considering the parity, the USD exchange rate will also be dependable on its demand in the European countries. The relative exchange rate is determined at the point where the demand and supply factors come into equilibrium. The following illustration depicts the equilibrium exchange rate of Euro and USD. The demand and supply factors of a country do not always remain in equilibrium due to the continuous change in several aspects of an economy. Inflation rate holds significance in determining the spot exchange rate of a country. Inflation rate casts direct impacts on the trading activity of a country. Higher inflation in one country would cause its goods to become less desirable in other parts of the world and thus its exchange will deteriorate as the demand for the currency of that particular currency will decline. Interest rates are also one of the factors responsible for fluctuation in the exchange rate. Interest rate can categorize into relative interest rate and real interest rate in order to determine the effect of change in exchange rate as a result of its hike and decline. Considering the relative interest rate, it can be defined as change in the interest rate of country when compared with any other country. If the interest rate in country A rises while the one in country B remains constant, the investors in country in A will deter from demanding the currency of country B as for them it is much more lucrative to invest in country A as it offers higher interest rates. Similarly, for investors in country B, it is much more desirable to invest in country A. The investors in country B will then resort to selling their currency in order to obtain the currency of country A. Result, the exchange rate of the country A will escalate when compared with that of country B. This can be more intricate when the effect of change in exchange rate is taken into consideration from a global perspective. The change in the exchange rate of a third can also cause the relative exchange rate between the country A and B although their relative interest rates remains the same. Real interest rate represents the nominal interest rate in an economy, without the impact of inflation. This relationship is also referred to as the Fisher effect. Another factor which can affect the exchange rate is the prevailing income level in the economy. Whenever the income level rises in a country, the exchange rate for that specific country escalates comparatively. The primary factor which affects the exchange rate movement is the government control and intervention. There are several ways through which government can intervene and regulate the exchange rate. Government can impose foreign exchange barriers in order to monitor and control the exchange rate of its currency. It has also been observed in the international economy that whenever the currency of a country has been facing downturn, the Government steps forwards and implement such controls which are meant to stabilize the currency of the country. In order to understand the ways through which Governments can influence the exchange rate, it is of prime significance to grasp the concepts of different exchange rate system that prevails in the global economy. The exchange rates systems are classified on the basis of controls exercised by the government. In general, the exchange rates are categorized into fixed, freely floating, managed float and pegged. In fixed exchange rate system, the government exercises such controls through which the rate is held constant or is allowed to fluctuate only to predetermined extents. There are several reasons on the basis of which the government would like to adopt such exchange rate system in the economy. The fixed exchange rate system would boost the participation of that particular country in international trade as there would be no apprehension pertaining to the devaluation of the currency. In international market, manufacturing concerns, financial institution and other corporate entities would be protected from the exchange rate risk in fixed exchange rate. The exchange rate risk which can be defined as the loss which arise on the conversion of foreign currency in international foreign exchange market. Fixed exchange rate system would escalate the foreign direct investment of the bank in the international economy. Fixed exchange rate system would be beneficial for the investors who aspire to invest in foreign markets. A country having a fixed exchange rate system will attract more and more foreign investors as they would not be expecting any sort of exchange rate risk in future. A brief analysis of the economic history would bring in the consideration the ‘bretton woods agreement’. In the bretton woods agreement, representative from various countries participated in a conference held at New Hampshire in 1944. It was decided in the agreement that every country would be valued in terms of gold and government would intervene to ensure that the exchange rate of its currency does not fluctuate by more than 1 percent. Freely floating exchange rate system is the total contrast of the fixed exchange rate system. A flexible system, in free floating exchange rate system the exchange rate is determined on the basis of market factors and adopts the position on which the demand and supply comes into equilibrium. The governments were forced to implement the free floating exchange rate system after experiencing the rigidness and inflexibility put forward by the implementation of the fixed exchange rate system. Although the government is involved in regulating the exchange system, the intervention is limited and continuous ministration is not required. One of the most highlighted advantages of implementing such exchange rate is that the country is saved from the fluctuation in inflation rates of the other countries. If country A and B both follows free floating exchange rate system, an increase in the inflation rate in country A will cause the commodities in the country A more expensive, hence the demand for the commodities of country B will increase sharply and thus the demand for the country B’s commodities will cause an upward shift in its exchange rate. In addition to the above mentioned advantages, it has been analyzed at global level that in most cases the economic problems are multiplied by adopting a free floating exchange rate system. Frequent fluctuations in the exchange rate system can have negative consequences for other government objectives. Under the free floating exchange rate system it is possible that the frequent change in the exchange rate system may bring about an environment of uncertainty which is liable to discourage trading activities. In order to cope with the dilemma of adopting a suitable exchange rate system, several countries adopted the ‘managed floating system’ under which the exchange rate of the company is allowed to float freely but at the same time the government can intervene and regulate it on the basis of prudence. The managed floating exchange rate system is criticized globally as the system is likely to result in the advantage of one country at the expense of the other. In pegged floating exchange rate system the currency of a country is pegged to another currency and the currency is allowed to move in line with that other currency. Most countries try to link their currencies with a stable currency such as USD or Euro so that resultantly their currency remains stabilize. The pegged floating system has been criticized internationally as it is often observed that under dire economic situation foreign investors and multinational would divest their holdings in the local projects in order to save them from deteriorating. The divestment of investment would result in the exchange of the local currency with the currency to which it was pegged against, thus resulting in a downward pressure on the local currency. Governments all around the world actively monitor the trend of their currency in order to make sure that it remains stabilize and consequently the economy. It is, in most cases, the responsibility of the central banks to intervene in the foreign exchange market in order to control the value of the currency. There are several reasons due to which the central bank would intervene in the foreign exchange market, such as to actively counter the commotion in the exchange rate movement or to maintain and implement implicit and productive exchange rate regulations. The intervention by the central government can be categorized into two aspects which are direct and indirect intervention. In direct intervention, the central bank, on direct order by the government of the country, may resort to selling its local currency with that of the foreign currency, if it wishes to put a downward pressure of its currency. In the contrasting situation, the government might start an operation in which it starts to exchange its local currency for the foreign. In order to achieve the desire value of the currency, it is mandatory to have effective coordination among all the central banks. For effective intervention, it is imperative that the central bank must have an adequate foreign exchange reserve as inadequate foreign exchange reserves would not be able to exert effective pressure on the determinants of the exchange rate. With the passage of time and the implementation of improved exchange rate policies, the total international foreign reserves has significantly increased in the last few decades. The following table illustrates the increased in the total international foreign exchange reserves [2] The direct intervention by the government can further be classified as non-sterilized and the sterilized intervention. The non-sterilized intervention can be defined as when the central bank, in order to exert a pressure on its currency (either upward or downward) disregards the quantum of money supply in the economy. In sterilized intervention, the central bank simultaneously intervenes in the treasury security market in order to offset the corresponding increase or decrease in the money supply. Speculation and intervention by the central banks are go side by side. Speculators in the foreign exchange markets actively and vigilantly monitor the foreign exchange market so as they know beforehand about the future actions of the government, and thus can derive benefits from selling or buying the currency. Central banks cannot participate in the direct intervention without the collaboration of the commercial banks in the economy. But in order to save the apprehensions and baseless forecasts, the central bank tries to keep its operations confidential. As discussed earlier, there are several factors responsible for the determination of the spot exchange rate of a currency. The central bank, by altering and monitoring these characteristics of the economy, participate in indirect intervention. Mostly indirect intervention by the government takes place by altering the prevailing interest rate in the economy. When the country is facing downward pressure on its local currency, the government resorts to increase the interest rate in the economy so that it becomes more lucrative for the investors to invest in the local markets rather than investing abroad. Though affective for stabilizing the interest rate in the short term, this strategy will downgrade the ability of the borrowers as they will not be able to obtain funds from the local financial institutions and thus the economy will suffer. The government can also exercise indirect intervention to regulate the exchange rate in the economy. Implementation of controls such as restricting the exchange of currency, prohibiting the local investors to participate in the international trade or making the procedure unnecessarily tedious and laborious, are some of the methods of indirect interventions. The government intervention for regulating the exchange rate can be utilized as a policy tool for devising a prudent monitory and fiscal policy. If a country’s exchange rate is stable it fosters consumer buying commodities from other countries of the world. Resultantly, the domestic competition is intensified and the consumers are benefited eventually. Contrastingly, the effect of real exchange rate undervaluation casts negative impacts on the economy, in the long run. In developing countries with per capita income below $2,500, real undervaluation has a positive contemporaneous effect on growth but a negative lagged effect. In developing countries with per capita income lower than $6,000 and higher than $2,500, real undervaluation has an insignificant contemporaneous effect and a negative lagged effect on growth [2] Following table illustrates the Impact of 50% Real Undervaluation on Real GDP per Capita Growth per Annum Impact of 50% Real Undervaluation on Exports to GDP Ratio per Annum The following illustration further clarifies the impact of Government actions on exchange rate Keeping in consideration the globalization and the ever increasing importance of the international trade, the policy makers and the government are now focused devising such exchange rate policies which not only reap benefits for the economy of the country, but elevate the global economic scenario as well. References [1] Jeff Madura. International Financial Management. 9th Edition [2] D Bastourre “Why countries accumulate foreign reserves? A dynamic panel approach” aaep.org. AAEP, .nd. Web 14 Feb. 2010. [3] Mona Haddad “Can real exchange rate undervaluation boost exports and growth in developing countries? Yes, but not for long” voxeu.org. Vox – research based policy analysis and commentary from leading economists, n.d. Web. 15 Feb. 2010. Read More