The Balance of Payments for the Zeal and the International Reserves - Case Study Example

Case Study of The Zeal Peso. Question To determine whether the Zeal peso has devalued enough, we need to calculate the expected exchange rate by applying purchasing power parity (PPP). That is by taking into consideration the relative inflation rates between the US and the Zeal over the last 22 years. According to purchasing power parity, price levels should be equal worldwide (Shapiro, 2006: pp 135). This implies that if and are the periodic price-level increases (rates of inflation) for the US and the Zeal, respectively; is the spot exchange rate between the Zeal peso and the US dollar at the beginning of the period and is the spot exchange rate in period t, then (Shapiro, 2006: pp 136) Therefore,0, (Shapiro, 2006: pp 137) From the case, we know that the exchange rate at the beginning was 20ZPG per dollar; the total time from 1973 to 1995 is 22 years. Price levels in the US have moved from 70 to 140 representing 100% inflation while those in the Zeal have moved from 50 to 180 representing 260% inflation. Substituting these figures in equation 2 we get: = 36 ZGP per US dollar This represents 1/36 = $0.027 per Zeal Peso. According to the case report, the peso had devalued to a figure of $0.0263 per peso, which is the same figure predicted using PPP. Assuming that PPP holds true, then we can conclude that the figure $0,0263/ZPG is the best prediction for the Zeal peso spot rate for the last 22 years. (Shapiro, 2006: pp137). Therefore we can conclude here that the currency has devalued enough. However, given that this is the figure for 1995, the figure might be expected to reduce with further increase in inflation by the end of 1996. Question 2 In my opinion, it was possible to forecast the peso float. From an understanding of purchasing power parity it is clear that two currencies can only be in fixed parity if the rates of change of consumer prices in the two countries are equal through time. In so far as the changes in inflation rates in one country are more than the other it will not be possible for fixed parity to be maintained. Thus, the currency values must readjust to reflect the inflation differentials. In the case of the US and the Zeal, one can observe from table 2 that the consumer price index for both countries has been increasing but that for the Zeal witnessed higher increases than that for the United States. As purchasing power parity states, currencies with higher inflation rates should depreciate relative to currencies with lower rates of inflation (Shapiro, 2006). Therefore given that the inflation index for the Zeal was increasing at a rate that was higher than that for the US it should have been possible to forecast the peso float. Question 3. According to Black (2002), foreign exchange reserves or international reserves represent liquid assets held by a country's government or central bank for the purpose of intervening in the foreign exchange market. These include gold or convertible foreign currencies. (Black, 2002). For example in the case of the Zeal this might refer to assets denominated in US dollars rather than the Zeal peso. Foreign exchange reserves can also include balances with international institutions, notably the International Monetary Fund (IMF). (Black, 2002). Looking at table 3, which shows the balance of payments for the Zeal from 1973 to 1995, including the international reserves, we can observe that the international reserves have been decreasing since 1973. The international reserves have dropped from $-45million in 1973 to $-150million. This implies that the country has more liquid liabilities and not assets in foreign currency and therefore less money has been transferred out of the country. Instead, more money has been moved into the country in foreign currency. This is contrary to the assertion in the case that many people transferred money out of the country. Question 4 Bodie et al (2002), Shapiro (2006) state that in a well functioning foreign exchange market, there should be a spot-futures exchange rate relationship that will prevail. If this relationship is violated then it will create opportunities for risk-less or arbitrage profits. This relationship is known as interest rate parity theorem (IRP). (Bodie et al, 1999). This theorem states that the currency of the country with a lower interest rate should sell at a forward premium in terms of the currency of the country with the higher interest rate. (Shapiro, 2006: pp 156). This condition ensures makes sure that the return on a hedged (or "covered") foreign investment will just equal the domestic interest rate on investments of identical risk, thereby eliminating the possibility of making arbitrage profits. (Shapiro, 2006: pp 156). Interest rate parity can be represented by the following equation as stated in Shapiro (2006: pp 160): Where and are the home and foreign interest rates respectively, is the forward exchange rate between the home and foreign currencies. What equation 3 is saying is that high interest rates on a currency are offset by forward discounts and that low interest rates are offset by forward premiums. (Shapiro, 2006: pp 160). This implies that a currency with a high interest rate should sell at forward discount while a currency with a low interest rate should sell at a forward premium. From this perspective therefore, given that the interest rate differential was 9% while the forward discount rate was up to 20% is an indication of the violation of the interest rate parity condition which would ultimately create room for arbitrage profits. Investors might take advantage of this by borrowing from the United States at the low interest rate and investing in the Zeal at the high interest rates. At the end of the period, they would convert their cash flows back to dollars, which will yield higher returns in dollar terms than investing in the United States would provide. Question 5 The Zeal government could deal with its balance of payments by increasing domestic production so as to boost exports. This will enable it to benefit from an appreciating dollar and other appreciating currencies. It can also deal with the situation by increasing its foreign exchange reserves. As earlier stated, foreign exchange reserves refer to liquid assets held by a country's government for the purpose of intervening in the foreign exchange market (Black, 2002). Given that the foreign exchange reserves of the Zeal government have witnessed a constant decrease and at the close of the period under study began decreasing at an increasing rate, we can say that the country had instead maintained a lot of liquid liabilities in foreign currency, which is very dangerous for a depreciating currency. For example, its -150million dollars in international reserves could have been worth just 3,000million ZPG considering an exchange rate of 20ZPG per dollar 22 years ago but given that the current exchange rate is 36ZPG per dollar today, this liability translates into a total ZPG cash outflow of 36 x 150 = 5,400 million ZPG reflecting a foreign exchange loss of 2400 million ZPG. On the other hand if these were liquid assets maintained in US dollars, this could have translated into foreign exchange gain of 2400 million ZPG. The government can deal with the current account deficit and current account balance in the following ways: Currency Depreciation. An overvalued currency acts as a tax on exports and as a subsidy on imports thereby reducing exports and increasing imports. (Shapiro, 2006: pp 196). Since a high valued currency results in a trade deficit, adopting a policy that reduces the value of the currency will help to eliminate the trade deficit. (Shapiro, 2006: pp 196). It is generally believed by policy makers and academic researchers that currency devaluation in a floating rate system can reduce trade deficits. (Shapiro, 2006). This is because devaluation results in a sluggish adjustment of nominal prices, thus translating changes in nominal exchange rates in changes in real (inflation-adjusted) exchange rates. The implication here is that in a situation where the country faces a current account deficit, the deficit will be automatically reduced by a fall in the value of the currency. (Shapiro, 2006). This implies that the Zeal government can effectively deal with its current account deficit by allowing its currency to depreciate against other currencies. However, despite these believes it is also argued by some critics that trade deficits and currency depreciation have no significant relationship and as such currency depreciation cannot eliminate the trade deficit. (Shapiro, 2006). They argue that exchange rate changes and trade balances are influenced by more fundamental factors. (Shapiro, 2006). Having said this, we would now move on to look at another response to the current account deficit which is protectionism. Protectionism Although international trade can be regarded as the major determinant of the growth of the world economy throughout history, almost all countries have often sought to protect either the entire economy, or at least part of it, from the negative impacts of international competition by imposing barriers such as tariffs or government levies on imported goods so as to raise their prices up thereby, encouraging domestic consumers to consume home-made goods. (Cannon, 2001). For example, the Common Agricultural Policy (CAP) adopted in the European Economic Community (EEC) has enabled European Union farmers to become large-scale exporters to the rest of the world. (Cannon, 2001). Protectionism refers to the imposition of tariffs, quotas or other forms of restraint against foreign imports. (Shapiro, 2006). Protectionism has also been defined as the theory or practice of shielding a country's domestic industries from foreign competition by taxing imports. (McKean, 2005; Soanes and Stevenson, 2006). A tariff imposed on imports raises domestic prices so that consumers are worse off. (Cannon, 2001) The government gains tax revenue from the tariff and producers gain from the price increase. (Cannon, 2001). Having discussed what protectionism is, we now turn to table 1 from the case study to take a closer look at the Zeal's current account and its trade balance. One can see that the Zeal has been facing a trade deficit as its goods and services have been negative throughout the period under study. We also observe that the trade deficit has been widening as the figure increased from -30million US dollars to -400million US dollars over the 22-year period. Also the current account has been on a deficit with the figure widening from -29million dollars to -387mllion dollars. It is therefore essential for the Zeal government to adopt some protectionism policies as the ones discussed above so as to encourage domestic consumption and discourage consumption of foreign goods. By so doing it can help boost government revenue as well as increase revenue to domestic producers. This will help to reduce the trade deficit as well as the current account balance, which will in turn improve on the overall balance of payments. Question 6 Given that the GPC's manufacturing facilities in Zeal depend heavily on components from the United States is an indication of serious threats to its profitability, competition and future growth prospects following the devaluation of the ZPG. This is so because both its economic and accounting exposure to currency risk have been increased. The company can work against these threats by carrying out the following: Marketing Management; Production Management; and Financial Management. Marketing Management GPC should design its marketing strategy in such a way that the fluctuations in the Zeal peso provide opportunities for it to gain competitive leverage. (Shapiro, 2006). Its international marketing manager should identify the likely effects of changes in the Zeal peso so as to act on them by adjusting pricing and product policies. GPC should consider the following: Market selection The markets in which GPC sells its products should be its major strategic considerations as well as the relative marketing support to devote to each market. (Shapiro, 2006). Therefore GPC can carry out most of its manufacturing in Zeal while it sells most of the products to the United States. Pricing Strategy. The firm should decide on whether its objective is to maximise market share or profit margins. GPC can benefit from the devaluation of the Zeal in that it can gain a competitive price advantage in the world market thereby increasing its market share or it can increase its prices thereby maintaining market share and increasing profit margins. However, the decision whether to boost market share or profit margins depends on whether the changes in exchange rates are likely to persist or disappear as well as on the cost structure of expanding output, economies of scales, consumer price sensitivity and the likelihood of attracting competition of high unit productivity is obvious. (Shapiro, 2006). The greater the price elasticity of demand - that is the change in demand for a given change in price the greater will be the incentive to hold prices constant and expand sales and revenue as well as market share. (Shapiro, 2006). Also, the existence of significant economies of scale will require GPC to keep its prices constant, increase demand and lower its production cost per unit. (Shapiro, 2006). On the other hand if there are no economies scale, or if the price elasticity of demand is low, then it will be worthwhile for GPC to increase prices so as to boost margins while keeping market share constant. (Shapiro, 2006). Product Strategy GPC can also react to the exchange controls by revising its product strategy. (Shapiro, 2006). Altering product strategy means introducing new products, innovating existing products and altering product line decisions. (Shapiro, 2006). In the case of the Zeal peso devaluation the GPC may introduce new products as it will be able to benefit from competitive price advantage. (Shapiro, 2006). Production Management This is concerned with the sourcing of inputs and the location of plants. (Shapiro, 2006). GPC should consider shifting most of its plants to the Zeal and it should source its inputs locally and not from the US. By so doing it will benefit from low cost manufacturing in Zeal while it will be possible for it to export at higher prices to the US. Financial Management. A firm's liabilities should be structured in such a way that reductions in asset earnings are matched by corresponding decreases in the cost of servicing these liabilities. (Shapiro, 2006). GPC should consider holding maintain most of its liabilities in foreign the zeal while keeping assets in US dollars. By so doing it can reduce its debt servicing expenses in the event of a change in the exchange rate. (Shapiro, 2006). Question 7 The international Monetary Fund (IMF) oversees exchange rate policies in member countries. (Shapiro, 2006: pp 99). Its particular emphasis are in emerging markets and in developing countries that are likely to run into financial difficulties. (Shapiro, 2006: pp 99). According to Shapiro (2006), this organisation has become a lender of last resort to these countries and as such often bails them out each time they are in poor financial health by providing them with credits. However, critics argue that continuous bailing out of careless lenders and imprudent nations by the IMF makes it difficult for governments to change their bad policies and thereby encourage investors to ignore the risks created by these policies. (Shapiro, 2006). Therefore by eliminating the prospects of failure from government and investors, which underlies the market discipline that encourages sound policies-these bailouts amplify the problem of moral hazard and so make imprudent policies to be repeated. (Shapiro, 2006: pp 99). Moral hazard refers to the perverse incentives created for international lenders and borrowers by IMF bailouts. (Shapiro, 2006). Since investors anticipate that the IMF will always bailout these countries, they will continue to provide them with loans and the governments continue to maintain their bad policies. (Shapiro, 2006). Although the IMF grants short-term loans on the condition that these countries change their bad policies so as to allow it achieve self-sustaining economic growth, a review of the evidence suggests that the IMF creates long-term dependency. (Shapiro, 2006). For example, 41 countries have been receiving IMF credit for 10 to 20 years, 32 countries have been borrowing from the IMF for between 20 to 30 years, and 11 countries have been relying on IMF loans for more than 30 years thereby reflecting the inability of the conditions imposed by the IMF to help these countries change their bad economic policies. (Shapiro, 2006: pp 99). From these findings one can therefore conclude that the IMF should not restructure every aspect of emerging markets. These markets should be left to learn from their past errors and therefore avoid policies that run them into poor financial health. This will result in the adoption of policies that will help them achieve best economic practices. BIBLIOGRAPHY Black (2002). Foreign exchange reserves"A Dictionary of Economics. Oxford University Press, Oxford Reference Online. http://www.oxfordreference.com/views/ENTRY.htmlsubview=Main&entry=t19.e1257 Bodie Z., Kane A., Markus A. J. (1999). Investments. Fifth International Edition. McGraw-Hill Irwin. Cannon E. J. (2001). Protectionism.A Dictionary of British History.. Oxford University Press, 2001. Oxford Reference Online http://www.oxfordreference.com/views/ENTRY.htmlsubview=Main&entry=t43.e2808 McKean E. E. (2005). Protectionism .The New Oxford American Dictionary, second edition. Oxford University Press, http://www.oxfordreference.com/views/ENTRY.htmlsubview=Main&entry=t183.e62087 Shapiro A. C. (2006). Multinational Financial Management. Eight Edition. Wiley and Sons, Inc. Soanes C., Stevenson A (2006). Protectionism.The Concise Oxford English Dictionary, Eleventh edition revised . Ed. Oxford University Press, 2006. Oxford Reference Online. http://www.oxfordreference.com/views/ENTRY.htmlsubview=Main&entry=t23.e45325 Read More