Financial Management at Zeal - Case Study Example

Zeal Case Study According to our calculations of the exchange rate by purchasing power parity theory, the actual exchange rate should be GP33.6 for $1. The old exchange rate of GP20 for $1 should fall to this level to attain its real value. The rate has already fallen to GP38 for $1. The markets have over anticipated the fall and the peso should not fall any more. It should now rise to attain the new exchange rate of GP33.6 for $1. The calculations of the new exchange rate according to PPP theory are shown below. The consumer prices used in the calculations are taken from the Table2. According to Gustav Cassel, the purchasing power parity is the appropriate level at which the foreign exchange rate should be set. The rate is measured by calculating the relative departures or deviations of price levels from a chosen base period in which the balance of payments of the concerned countries had been in equilibrium. If countries X and Y were in reasonable adjustment in time period 0, then these countries should choose an exchange rate in time period 1 (R1) which reflects the changes in their prices between time period 0 and time period 1. So, the formula is: R1 : R0( Px1/ Px0) . (Py1/ Py0) Here, R0 = GP20 Px1 = 180 Px0 = 120 Py1 = 140 Py0 = 125 R1 = 20 x (180/120) x (140/125) R1 = GP33.6 The inflation rate has risen by 5% in US from 1993 to 1995, while it has risen by 12% in Zeal during the same period. Taking these rates into account and calculating at the old exchange rates of GP20 for $1, we calculate the new rate of exchange at GP33.6 for $1. The peso is not likely to fall any further. It has overadjusted. The rate would finally be set near the above calculated level. 2. The peso float could have been forecast due to a number of reasons. First, the exchange rate that was set and maintained by the Zeal authorities was clearly overvalued. The purchasing parity theory of exchange rates predicted a rate of GP33.6 for $1, while it was being pegged at the rate of GP20 for $1. Second, the balance of payments was running in deficit for a number of years as can be seen in Table1. The current account deficit was constantly increasing over the years and it was being funded by capital flows from abroad, putting pressure on the currency to depreciate. Thirdly, Inflation was consistently rising and was at 12% in 1995. The money supply was rising at a greater rate than the price level, again placing peso under pressure. Fourth, Zeal central bank was continuously losing international reserves in an attempt to hold the exchange rate. Fifth, the country had to borrow capital to fill the gap in balance of payments. And lastly, a sustainability of a particular level of current account deficit depends on how the capital flows are used and if the country has the appropriate debt servicing capability. A large and persistent current account deficit in the balance of payments of Zeal shows the employment of unsustainable macroeconomic policies. The exchange rate would have finally fallen victim to those policies. So, from the above reasons we can say that the peso float could have been anticipated. (Beenhakker, 2000) 3. Many wealthy individuals of the country have shifted their money out of the country through the dollarization of their assets. This is indicated from the unilateral transfers shown in Table1. The table indicates that the trade balance deficit has been increasing since 1973 and currently it stands at a very high $400,000,000.00. The current account deficit has similarly been increasing constantly over the years to reach $387 million. The international reserves have also been depleting as the current account deficit is increasing. There are still positive figures in unilateral transfers. The transfers have increased from a very minuscule $1 million in 1973 to reach $13 million in 1995. From 1973 to 1993 there was any increase of $6 million in unilateral transfers overall. But in the two years from 1993 to 1995 the country has seen an increase in unilateral transfers to the extent of $6 million. This increase has been seen within two years from 1993 to 1995. Unilateral transfers are a component of autonomous capital flows. They are independent of the current balance of payments situation. They are the result of private firms or persons having capital transactions conducted with the foreigners. They're also regarded as planned capital movements which emerge from the decisions of individuals, firms or the government to engage in capital transactions with the rest of the world. In this case, the transfers may indicate that many wealthy individuals may be selling their assets to foreigners to convert their wealth into dollars. So we can deduce that many wealthy individuals may be expecting devaluation and in this anticipation they are moving their funds outside the country, to safeguard their wealth from being reduced due to any weakness in the currency of Zeal. 4. The current picture gives the indication that investors may be able to take advantage of the opportunity for covered interest arbitrage. This can be explained below: The study indicates that for 1995 the difference between the U.S. dollar interest rate and the Zeal peso interest rate ranged up to 9 per cent in favor of the peso, but the forward discount rate for the peso ranged up to 20 per cent. This indicates that there is a premium on the forward rate in USA. And the interest rate in U.S. is 9% lower than in Zeal. The interest rate differential thus is 9%. The premium forward rate for the US is, thus, 20%. If the spot rate is GP20 for $1.00, then the forward rate in U.S. should be 20.09. The interest rate in Zeal is, say, 10%, so GB20 would become GB 20.5 in three months, and $1.00 placed in U.S. would become $1.01 in the U.S., which equals GB 20.2 at the spot rate. If the forward rate was equal to spot rate and there is no premium, then it would be disadvantageous for any investor to place funds in U.S., but as there is a premium, so it is added. The premium is 20% per annum, and therefore the forward rate would be 20.20, and GP100 invested in U.S. would give a higher return than that invested in Zeal. So the opportunity for interest arbitrage would be there in this situation. If hedging against current risk is also added, then the investor would derive covered interest arbitrage. He can sell peso forward at the going forward rate for the dollar. Any changes in exchange rate during the three months would be of no consequence to him. 5. Four options are available to the Zeal government for dealing with its balance of payments problems. There are two ways in which a deficit can be reduced. This can be done through recourse to expenditure-reducing or expenditure-switching policies. The use of external measures, including tariffs, quotas and exchange controls, is known as "expenditure-switching policies," since they switch national expenditure away from imports and towards the corresponding goods being produced within the country, that is, domestic goods. These policies work by changing relative prices. The main form, that these policies take, is devaluation or revaluation of the currency. Devaluation can have an inflationary impact on an economy and it also affects income distribution. There is a redistribution of income from the labor class to the non labor class. The factors of production employed in the export and import competing sectors benefit from devaluation. The other set of policies that are available for reducing the balance of payments deficit are known as expenditure-reducing policies. These policies may be divided into two categories: monetary policy and fiscal policy. These involve a reduction in aggregate demand through deflation of the domestic economy through a rise in interest rates and a reduction in money supply, or an increase in taxes and decrease in government spending. The third method for removing balance of payments deficit is the use of international liquidity to fill the foreign exchange gap with the official reserved assets. The central bank provides official liquidity and acts as a lender of last resort. As long as the country has enough reserves there is no real need to correct the balance of payments deficit. In the case of balance of payments deficit the country should not have access to official international liquidity. The country can take internal or external measures to resolve its balance of payments problem. The fourth option is devaluation. This has the effect of reducing imports and increasing exports through a change in price levels. It automatically results in improvement in balance of payments. Devaluation also has the effect of redistributing income through reducing the real wealth of import consumers and increasing those of exporters. These are the main options which are available to a country to cure its balance of payments problem. (Beenhakker, 2000) Certain other options are also available to the government to reduce the deficit in capital account. It can do this by taking the number of measures. The short term measures would include increasing the reserve requirements for banks on foreign or all transactions, or imposing limitations on the open foreign exchange positions of foreign institutions. It may set limits on foreign borrowing on a certain set of classes of liabilities of public borrowers. In the short term, it can also increase taxes on short-term foreign borrowing, and increase restrictions on foreign ownership of certain short term assets. It can restrict speculative transactions as well. In the long run, it will help if it liberalizes the external and domestic trade, and promotes domestic saving. It should also promote a positive investment climate and minimal restrictions on the foreign ownership. A tighter fiscal policy and are relaxed monetary policy will help in the long run. There should also be good regulation and enforcement of financial and capital markets. Free capital movement and easy availability of information from rating agencies, elimination of government financial guarantees and lastly, the encouraging of private hedging markets, would add to solving the balance of payments problem. (Beenhakker, 2000) 6. A change in foreign exchange rates exposes a business which has operations in the devaluating country. This is known as foreign exchange exposure. This exposure may be through transaction exposure, operating exposure and accounting exposure. The transaction exposure involves exchange rate changes that cut the value of the company's outstanding financial obligations, which were incurred before the change in exchange rate, but will not be settled till after the change in the rate of exchange. In essence, it means that there are changes in cash flows from existing contractual obligations. In case of operating exposure, there is a change in the present value of the firm mainly as a result of a change in the future operating cash flows of the firm caused by the unexpected change in exchange rates. This may be because of the change in future costs, prices or amount of sales due to the change in exchange rate. Accounting exposure relates to the accounting related changes in the owner's equity which occurs due to the need to "translate" the foreign currency financial statements of its foreign subsidiaries or affiliates into a single reporting currency, to prepare for worldwide consolidated statements." This is also known as translation exposure. In the case of GPC, the company faces all the three kinds of exposures. They can manage their currency exposure through hedging. Hedging will protect the owner from the expected future loss. It can reduce some of the variance in the value of its expected cash flows which may occur due to the change in exchange rates. There are two benefits in resorting to hedging. One is that it reduces the risk in future cash flows which helps increase GPC's planning capability and ensures that the cash flows will be above the necessary minimum at any point, and hence financial distress will be avoided. The second advantage is that will lead to a management's competitive advantage over an individual stockholder in holding the knowledge of the actual currency risk of GPC. There is, however, a disadvantage also in the sense that a large amount of resources are used up in this process. 7. The IMF has, over a period of time, developed as a lender of the last resort for the emerging economies. It arranges a large amount of capital at very concessional rates for the countries which are still developing. This helps them in relieving their external debt servicing burden, and helps them tide over the current financial difficulties. This is very helpful for the emerging economies, as the main problem for them is the need for capital in order to push economic growth in the country. There are certain repercussions to this strategy by the IMF. It results in indiscriminate borrowing and lending activity and creates a moral hazard problem. (Makin, 2000) It actually subsidizes those borrowers who cannot arrange capital in the short term. It may result in an underestimation of the risks associated with default. In the case of Zeal, IMF provided the capital which was needed to finance the balance payments deficit. Everybody was so sure that the IMF would provide financial assistance anytime there is a problem encountered in the balance of payments, that they did not take the foreign exchange rate risk seriously. Hence, everybody including GPC were caught off guard when devaluation of the peso took place. Despite the fact that Zeal was one of the emerging economies and its banking and financial systems were very fragile, IMF provided a $200 million loan to the Zeal government. This gave the investors and the treasurers and bankers the false assurance that the Peso would not be devalued. The IMF should therefore try to ensure that the funds that it provides are employed to increase the productive capacity of the country or produce value which will increase the foreign exchange reserves of the country. So, the suggestion that IMF should continue to restructure every aspect of emerging market countries so as to achieve the best economic practices, is good. This will result in a reduction in indiscriminate borrowing by the countries and bring accountability among the countries. References Beenhakker, Henri L. Global Economy and International Financing.Westport, CT, USA: Greenwood Publishing Group, Incorporated, 2000. p 84-86. Makin, A. J. Global Finance and the Macroeconomy. New York, NY USA: Palgrave Publishers, 2000. p 172. Sodersten, Bo. (1980). "International Economics." MacMillan. 2nd Edition. Shapiro, A. "Multinational Financial Management." 8th edition. Read More