Banking and Finance - Literature review Example

Banking and Finance Name Course Tutor Date Banking and Finance Factors influences exchange rate movements and strategies adopted by the Reserve Bank of Australia in the foreign exchange market An economic state of a country is increasingly more complicated and dynamic topic in its level and mobility. Chen & Kenneth (2002) claim that besides the factors like inflation and interest rate, the exchange rate is also a major critical determinant of a nation's relative degree of economic status. Exchange rate is an integral part in a states’ trade level that is vital to most each free market economy across the globe. Hence, exchange rates are one the most observed evaluated and governmentally controlled economic measures (Chen & Kenneth, 2002). However, exchange rates concerns on a smaller degree too: they influence the real profits of an investor's undertaking. Exchange rate movements affect a country’s trading relations with its trading partners. When a currency goes high the nation’s exports become expensive whilst imports become cheaper in oversee markets. An increase in exchange rate lowers the nation’s balance of trade whilst a decrease in the exchange rate increases it. Based on this concept, the key concern of this paper is to outline and explain various factors which can influence exchange rate movements. The paper will also describe and assess the strategies implemented by the Reserve Bank of Australia in the foreign exchange market comparing it with those of the US. To contextualize this discussion in relation to factors that influence exchange rate movement we can first define exchange rate movements. Qfinance Dictionary (2013) defines the term exchange rate movements as the variations in the value of different currencies that may cause losses to businesses which export and import goods and also to investors. Several factors influences exchange rates and each of them are associated with the trading relations between two countries (Edwards, 2000). It should be noted that exchange rates are comparative, and are stated as a relationship of the currencies of two nations. Some of the key forces that influence exchange rate movements include differentials in inflation, interest rates differentials, deficits in current-account, public debt, terms of trade and political stability and economic performance among others. While inflation differential may appear normal phenomenon to the economy it actually impacts on the exchange rate of currencies between countries (Chen & Kenneth, 2002). As a universal rule, a nation with a constantly low level of inflation rate demonstrates an increasing currency value, because its purchasing power rises in relation to other currencies. In the last half of the 20th century, the nations with lower inflation consisting of Japan, Switzerland and Germany, whilst the U.S. and Canada attained low inflation just later. Those nations experiencing higher inflation normally observe their currency depreciate with regard to the currencies of the partners. This event is also normally followed by higher interest rates. The variation (differential) in interest rate existing between comparable currencies is a major concept of evaluating financial stability. Interest rates, exchange rates and inflations are all extremely interrelated. Bergen (2010) claim that by influencing the interest rates, central banks put forth manipulation over both exchange rates and inflation, and fluctuating interest rates influence currency values and inflation. High interest rates provide lenders in a market a high return in relation to other nations. Thus, higher interest rates exert a pull on foreign capital and make the exchange rate to increase. The effect of high interest rates is eased, though, if inflation in the nation is higher compared with others, or if extra elements work to compel down the currency. The opposite relations exist for reducing interest rates - to be precise, low interest rates normally tend to reduce exchange rates (Bergen, 2010). The dynamics of government debt sometimes cause major impact on the exchange rate. Nations will always involve in large-scale deficit funding to reimburse public sector developments and governmental financing. Whilst these activities stimulate the economy at the domestic level, countries with huge public debts and deficits are usually unattractive to foreign investors (Chen & Kenneth, 2002). This is because a huge debt promotes inflation, and if inflation goes higher, the debt could be serviced and eventually paid off with inexpensive real dollars in later days. The most undoing is that the government might print money to pay for part of a huge debt, but raising the supply of money certainly results to inflation. If the state is cannot be able pay for its deficit be domestic means, that is by trading its domestic bonds, raising the supply of money, then it ought to raise the securities supply for to foreigners, thus reducing their prices (Bergen, 2010). Finally, a hefty debt could be worrying to foreign markets if the foreigners think the nation risks defaulting on their obligations. Outsiders could be less willing to buy securities denominated in that particular currency if the threat of defaulting on them is likely. Therefore, the debt rating of a country is a critical determinant of exchange rate. Value of currency can be influenced by terms of trade. Bergen (2010) says that the ratio comparing the relationship between export prices and import prices, on the basis of trade is interrelated to the balance of payments and the current accounts. If the charges on a nation's exports increases by a greater margin compared to the imports, on the context of trade have positively recovered. Rising the terms of trade demonstrates big demand for the export for that country. Bergen (2010) says that, as a result, leads to increasing proceeds from exports, which offers high demand for the nation's currency thus increases the value of the currency. If the charges on the exports go up by a smaller margin compared to that of the imports, the value of the currency will go down with regard to its trading allies. Economic performance of the nation is major investors will assess before making an entry to do business of invest. Investors from foreign countries inevitably look for stable nations with solid economic performance in a bid to invest their money. A country having such positive characteristics will attract investment funds than those countries identified to be economic and political risk (Edwards, 2000). Political uproar, for instance, may result to loss of assurance on a currency and a shift of assets to the currencies of stable nations. Bergen (2010) argues that the currency’s exchange rate in which a case bears the range of its investments influences that portfolio's actual proceeds. A falling exchange rate apparently lowers the purchasing power of capital gains and revenue obtained from all returns. Whilst exchange rates movement are influenced by several complex factors which frequently make even the most knowledgeable economists stunned, investors must still have some knowledge of the way exchange rates and currency value is an integral part of the level of return on particular investments. For a government, in particular Australia to operate appropriately it must create a situation where its currency for the economy to grow and compete with other developed countries. To create this stability of the currency for the economic affluence and wellbeing of the citizens of Australia, the Reserve Bank of Australia uses various strategies to achieve this. Since exchange rate is comparable factor, this essay compares these strategies with ones adopted by another developed country, in particular, the US. Some the strategies used includes sterilized intervention, Spot and Forward Markets for Intervention, the Options Market and Intervention and Indirect Intervention strategy. Fluctuations in the international financial system, alongside latest experience with floating and fixed exchange rates, have led to a reconsideration of the exchange rate strategies for developed economies (Fischer, 2001, p.16). The realization of a currency union in part of Europe has been perceived by many as proving the path forth in the ongoing integration course of developed countries like Australia. Fischer (2001, p.9) maintains that in this practice, financial system is one of the major influencing factor of the efficiency and health of the country’s economy. It is impossible to have a contemporary, dynamic economy; like the economy of Australia without a sound and an effective financial system. As a result, Reserve Bank of Australia which is a financial system becomes a major player in the stability of system to restore confidence in the Australian currency. The Reserve Bank of Australia sometimes uses sterilized intervention if they need to control the Australian Dollars (AUD) value with no the liquidity impacts on the interest rates and money supply (RBA, 2013). Sterilized intervention sometime known as neutralization of the intervention of Reserve Bank of Australia in the foreign exchange market is realized by purchases of Cost Good Sold or taking offsetting sales. When the Reserve Bank of Australia is trading (buying) Australian Dollars it would trade (buy) Cost Good Sold and lower (increase) the money supply and liquidity thus sterilizing its interventions in the foreign exchange market and the effects on the interest rates and money supply. Other developed countries like the US consider this strategy as controversial concept and a more orthodox tool in the forex market (Craig & Humpage, 2001). Financial institutions in various countries are made to intervene now and then in the forex markets to attempt to stabilize the exchange rate. Craig & Humpage (2001) postulate that the moment Federal Reserve sells or sells currencies in support of foreign central banks, the aggregate rate of bank reserves usually do not change, therefore sterilization intervention is not required. Spot and Forward Markets for Intervention is key strategy used by the RBA to influence and stabilize its currency exchange rate. In forex exchange there are two major categories of transaction that is spot and forward (Dominguez, 2003, p.32). A concurrence to sell or buy a currency at the present exchange rate is called a spot transaction. Spot transaction is usually settled two within days. On the other hand in forward transactions, traders consent to buy and sell particular currencies which they will settle no less than three days, at set exchange rates (Edwards, 2000). Forward market transactions are frequently applied by Reserve Bank of Australia to lower the risk of exchange rate. Apart from spot market, it also could be conducted in a forward market. Since the forward cost is related to the spot cost by means of interest parity covered, the forward market intervention can manipulate spot exchange rate. Forward Markets for Intervention -the sale purchase of foreign exchange meant to be delivered in future have the benefit since they do not need direct cash outlay (Dominguez, 2003, p.31). Reverse bank of Australia use this strategy if they expect that the intervention method will be short-lived and can be reversed. The United State federal reserve do not use this process stating that is it passive because it cause no clear impact on the side of forex market reserves (Bjorksten, 2001). RBA sometimes use spot and forward markets concept at the same time. This transaction is called a currency swap, although RBA rarely use it because it has little impact on the forex market. RBA also uses options market strategy for exchange rate intervention. Generally, the option contract states the cost for buying and selling an asset, known as the exercise or strike price. When Reserve Bank of Australia is seeking to check devaluation or depreciation of its currency it sells put options on the local currency or calls options on their partner’s currency (RBA, 2013). The Reserve Bank of Australia often try to circumvent its position by taking a strong position on the weak foreign currency contributing to the descending pressure on its value. This agreement results to similar kind of financial risk for Reserve Bank of Australia because the currency is undervalued just like the direct purchase would done on the weak exchange in either spot or forward market (RBA, 2013). Similar to Spot and Forward Markets for Intervention, the method do not, however, need the Reserve Bank of Australia to directly spend forex reserves. Actually, the strategy creates revenues on the sales of that option. Lastly Reserve Bank of Australia use indirect intervention strategy to raise its domestic currency value. This can in a bid an effort to raise interest rates, in order to attract a foreign demand for its domestic currency to purchase securities with higher returns (Edwards, 2000). Just like Australia the Federal Reserve bank of New York also uses this approach to stabilize the exchange rate, though they have to keep watch on it every time. Australia is a developed economy that has benefited from a high level of integration into international financial markets. Policies on inflation and intervention in foreign exchange market have until now proved efficient in sustaining price stability and steered clear of currency challenges, and appear to offer proper incentives to the country’s private sector to hedge the risk of foreign currency. Nevertheless, transformations to the thinking with reference to best exchange rate regimes have proved substantial in current years. The Reserve Bank of Australia is keen on the developments of foreign exchange in comparison to other developed economy. The question of adjusting Australia’s exchange rate strategy has emerged not due to any apprehensions regarding prone to the risk of predicament, but because of discontent over a slow growth performance in relation to the US. These interventions always aim at stabilizing the forex market; unfortunately, several researches have shown that intervention may not level the exchange rate movement. References Bergen VJ. (2010). 6 Factors That Influence Exchange Rates. Retrieved from http://www.investopedia.com/articles/basics/04/050704.asp Bjorksten, N. (2001). The current state of New Zealand monetary union research. Reserve Bank of New Zealand Bulletin, 64(4), p. 23-90. Chen, Y. & Kenneth, R. (2002). “Commodity currencies and empirical exchange rate puzzles”, IMF Working Paper, WP/02/27. Craig, B., & Humpage, OF. (2001). Sterilized Intervention, Non sterilized Intervention, and Monetary Policy. Federal Reserve Bank of Cleveland Working Paper. No. 01-10 Dominguez, KM. (2003). The market microstructure of central bank intervention. Journal of International Economics. Vol. 59. pp. 25-45. Edwards, S. (2000). Exchange Rate Regimes, Capital Flows and Crisis Prevention. NBER (December). Fischer, S. (2001). Exchange rate regimes: is the bipolar view correct?” Journal of Economic Perspectives. 15, 2 (Spring), pp 3-24. Frankel, Jeffrey and Andrew Reserve Bank of Australia. (2013). About Monetary Policy. Retrieved 28th July 2013 from http://www.rba.gov.au/monetary-policy/about.html Qfinance Dictionary. 2013. Exchange Rate Movements. Retrieved 28th July 2013 from http://www.qfinance.com/dictionary/exchange-rate-movements Read More