Treasury, Foreign Exchange and Financilization - Essay Example

? Treasury, Foreign Exchange and Financialization The US inflation rates from 2002-2007 are as follows: (International Monetary Fund 2002-2007) The inflation rates of countries have been calculated according to the formula: Inflation rate of the country in year1 = (CPI in year 1- CPI of the previous year) / CPI of the previous year where CPI: Consumer Price Index The Purchasing Power Parity between the currencies of the countries and the US dollar have been calculated according to the formula: PPP between country A’s currency with respect to the US dollar = price of a basket of goods in country A/ price of the same basket of goods in the USA = [ initial price (100) + inflation rate of country A] / [ initial price (100) + inflation rate of USA] The inflation rates of country A during 2003-2007 are as follows: (Mathis, Keat & O’Connell 2001) Therefore the Purchasing Power Parity (PPP) exchange rate of country A with respect to the US dollar would be: Year PPP of Country A with respect to US dollar 2003 1.12 2004 1.04 2005 1.03 2006 1.01 2007 0.99 The inflation rates of country B from 2003-2007 are: Year Country B inflation rate 2003 13.7 % 2004 10.9 % 2005 12.6 % 2006 9.7 % 2007 5.5 % (Mathis, Keat, & O’Connell 2001) Therefore, the PPP exchange rate of country B with respect to the US dollar is as follows: The inflation rates for country C from 2003-2007 are: (Mathis, Keat & O’Connell 2001) Therefore the PPP of country C with respect to the US dollar is as follows: Year PPP of country C with respect to US dollar 2003 1.02 2004 1.01 2005 1.01 2006 1.02 2007 1.01 The inflation rates for country D from 2003-2007 are as follows: (Mathis, Keat & O’Connell 2001) Therefore the PPP for country D with respect to the US dollar is: Year PPP of country D with respect to the US dollar 2003 0.99 2004 1.01 2005 0.98 2006 0.98 2007 0.99 Thus, these were the respective inflation rates of the countries A, B, C, D and their purchasing power parities calculated with respect to the US dollar. (b) The Purchasing Power Parity (PPP) Theory states that the exchange rate between the currencies of two countries is in equilibrium when their purchasing power is equivalent in both the countries. Let there be a fixed basket of goods and services and then let us determine the price of this common basket in both the countries. Then the exchange rate between the currencies of the two countries should be equal to the ratio of the price levels of the two nations. PPP theory also states that when a country is subject to inflation i.e. there is a continuous increase in the level of domestic prices of the country, there should be depreciation in the country’s exchange rate in order to restore PPP. (The University of British Columbia 2011) We can see from the data in the case study, that while country A has experienced inflation from 2003-2007, the exchange rate of its currency with respect to the US dollar has depreciated during the same period (except for 2007). Thus, the PPP theory held true for country A. In country B also, as it was experiencing inflation during 2003-2007, the exchange rates of its currency with respect to the US dollar has devalued over the period (except for 2005). Thus the PPP theory held true in the case of country B also. As country C was going through a period of inflation from 2003-2007, the exchange rate between its currency and the US dollar also underwent devaluation during the same period (except for 2005). Thus, for country C also, the PPP theory held good. In the case of country D, as it experienced inflation during 2003-2007, the exchange rate between its own currency and the US dollar remained the same in 2004 but devalued after that during the successive years. Thus the PPP theory also held good for country D. Therefore, the PPP theory held good for all the countries A, B, C, D. (c) The US dollar prime lending rate during 2002-2007 was as follows: Year US dollar lending prime rate 2002 4.67 2003 4.12 2004 4.34 2005 6.19 2006 7.96 2007 8.05 (Board of Governors of the Federal Reserve 2011) The International Fisher Effect (IFE) Theory states that “an estimated change in the current exchange rate between any two currencies is directly proportional to the difference between the two countries’ nominal interest rate at a particular time”. (Maps of the World Finance 2011) The IFE is expressed by the following formula: E = [ ( i1- i2) / (i1 + i2) ] ~ (i1 – i2) where E : percentage change in exchange rate i1: interest rate of the first country i2: interest rate of the second country The Lending Rates of country A from 2002-2007 are as follows: Year Lending Rate of country A (i1) Lending Rate of USA (i2) E (i1~ i2) 2002 62.88 4.67 86.17 58.21 2003 67.08 4.12 88.42 62.96 2004 54.93 4.34 85.35 50.59 2005 55.38 6.19 79.89 49.19 2006 50.81 7.96 72.91 42.85 2007 47.2 8.05 70.85 39.15 Column 4 is found to be proportional to column 5. Thus the exchange rate between the currencies of country A and the US dollar agrees with the IFE. The Lending Rates of country B from 2002-2007 are as follows: Year Lending Rate of country B (i1) Lending Rate of USA (i2) E (i1 ~ i2) 2002 15.71 4.67 54.17 11.04 2003 12.98 4.12 51.81 8.86 2004 11.40 4.34 44.85 7.06 2005 10.68 6.19 26.61 4.49 2006 10.46 7.96 13.57 2.5 2007 9.90 8.05 10.30 1.85 Column 4 is found to be proportional to column 5. Thus the exchange rate between the currencies of country B and the US dollar agrees with the IFE. The Lending Rates of country C from 2002-2007 are as follows: Year Lending Rate of country C (i1) Lending Rate of USA (i2) E (i1 ~ i2) 2002 11.92 4.67 43.70 7.25 2003 11.46 4.12 47.11 7.34 2004 10.92 4.34 43.11 6.58 2005 10.75 6.19 26.91 4.56 2006 11.19 7.96 16.86 3.23 2007 12.50 8.05 21.65 4.45 Column 4 is found to be proportional to column 5. Thus the exchange rate between the currencies of country C and the US dollar agrees with the IFE. The Lending Rates of country D from 2002-2007 are as follows: Year Lending Rate of country D (i1) Lending Rate of USA (i2) E (i1 ~ i2) 2002 5.31 4.67 6.41 0.64 2003 5.31 4.12 12.61 1.19 2004 5.58 4.34 12.5 1.24 2005 5.58 6.19 -5.18 -0.61 2006 6.12 7.96 -13.06 -1.84 2007 6.39 8.05 -11.49 -1.66 Column 4 is found to be proportional to column 5. Thus the exchange rate between the currencies of country D and the US dollar agrees with the IFE. (d) The Theory of relative Purchasing Power Parity (PPP) refers to the inflation rates between countries, i.e. to the rate of change of the price level in the two countries. This theory states that “the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country.” For example, if country X has an inflation rate of 2% and country Y has an inflation rate of 5%, then the currency of country Y will depreciate against the the currency of country X by 3 % every year. This theory holds true specially when there are large differences in the inflation rates of the two countries involved. (The University of British Columbia, 2011) In 2007, country A’s inflation rate was 2.6% while the inflation rate of USA was 2.9%. Thus, the currency of country can be anticipated to appreciate in opposition to the US dollar by 0.3% every year over the next three to five years. In the same year, country B’s inflation rate was 5.5% while the US inflation rate was 2.9%. Therefore, it can be expected that the currency of country B will depreciate against the US dollar by 2.6% every year for the coming three to five years. Again in 2007, the inflation rate of country C was 4.1% while the US inflation rate was recorded at 2.9%. Thus, the currency of country C can be expected to depreciate against the US dollar by 1.2% every year for the next three to five years. Finally, in 2007, the inflation rate in country D was reported at 2.5% while the US inflation rate was 2.9%. Thus, it can be expected that the currency of country D will appreciate against the US dollar by 0.4% every year for the coming three to five years. (2) Financialization as a Possible Cause of Country Crisis There are four main types of crisis that can precipitate in the financial markets and thus have an effect on the economy of a nation. These can be a Currency crisis, a Financial Crisis, a Foreign debt crisis and a Banking Crisis. Currency crisis: When there is a strong devaluation or depreciation in the currency of a country as result of speculative attacks on the value of exchange of that particular currency, a currency crisis precipitates. In this case, the Government of the country is almost compelled to spend large volumes of its international reserves and /or raise the interest rates by a large degree in order to defend its own currency from further depreciating. After World War II, there have been examples of major currency crises in some countries as in the economy of USA in 1971, when the country’s liabilities in foreign dollars had exceeded the gold reserves held by USA. This forced USA to put a hold to convertibility of gold. Financial Crisis: When the financial markets of a country are not able to function properly and effectively, this usually impairs the other economic activities too. This is called a financial crisis. In 2007, a real estate crisis developed in the USA which originated in the sub-prime mortgage market. There were investors around the world who had purchased these sub-prime loans, and thus the financial crisis affected many economies of the world. Foreign Debt Crisis: When a country is unable to service its obligations of foreign debt, it is said to be in a foreign debt crisis. In 1982-84, many of the growing market economies at that time failed to service their respective foreign debt obligations resulting in a major default of foreign debts. This further caused writing-off of bank loans, restructuring of loans and swapping of foreign debts. Banking Crisis: Bank runs or bank failures in the economy usually results in a cessation of the internal convertibility of bank liabilities. Such a state is called a banking crisis. To prevent this from happening, the Government is forced to intervene in the banking market by extending considerable assistance to the banks. In 1980s, due to a sharp increase in the US rate of interest, about one-third of the banks in the economy ran into a failure. (Mathis, Keat, O’Connell 2011) Financialization: The method by which financial institutions, financial markets and financial authorities acquire more influence on the policies and outcomes of the economy, is known as financialization. Under this process, the way in which the economic system operates is transformed both at the micro and macro levels. Financialization increases the importance of the financial sector in relation to the real sector, shifts income to the financial sector from the real sector and increases the inequality of income and leads to stagnation of wages. The economy may also be at the peril of debt deflation and recession due to financialization. (Pallet 2007) Ismail Irtuk in his paper in 2003 presents a debate on the choice between Governance or Financialization regarding the case of Turkey which experienced a financial crisis in 2001. The country was a developing economy and the International Monetary Fund implemented neo-liberal economic reforms in Turkey from the beginning of the 1980s. However, since the process of financial mediation in the country was corrupted, this led to economic instability in the national economy. There have been adverse effects caused in the Turkish economy by financialisation: the bond market of the local government has assumed a pyramidal structure. These damages need to be comprehended and addressed accordingly. Only then, government reforms can bring about a positive impact on the economy. Irtuk further argues in his paper that, the framework of financialization can be implemented successfully in Turkey. Developed countries like the USA and the UK remain interested to utilize capital efficiently and thus search for the norms of optimum management which will ensure this. Washington had extended a governance discourse to Turkey’s case after it was hit by the financial crisis. (Irtuk, 2003) References 1. Gabor D (2010) (De) Finalization and crisis in Eastern Europe Vol 14 (3-4) pp 248-270 2. Irtuk I (2003) Governance or Financialization: the Turkish Case Vol 7 No 4 pp 185-204 3. Kaltenbrunner A (2010) International Financialization and Depreciation: The Brazilian Real in the International Financial Crisis Vol 14 No 3-4 pp 296-323 4. Mathis J.F, Keat P, O’Connell J (2011) Country Risk Analysis and Managing Crisis: Tower Associates 5. Pallet T I (2007) Financialization: What is it and why it matters? The Levy Economics Institute, available at: http://www.levyinstitute.org/pubs/wp_525.pdf (accessed on September 9, 2011) 6. The University of British Columbia (2011) Pacific Exchange Rate Service available at http://fx.sauder.ubc.ca/PPP.html (accessed on September 9, 2011) Read More