Implications for an Economy of a Rising Exchange Rate - Essay Example

?Implications for an Economy of a Rising Exchange Rate Introduction This paper attempts to examine the implications for an economy of a rising foreign exchange rate. Foreign exchange rate is defined as the value of a specific currency compared to that of another currency. There are two types of foreign exchange rate, the spot exchange, and the term forward exchange rate. The first is defined as the rate that is currently applicable, while the latter is defined as the rate that is currently quoted and used for trading. Foreign exchange rates are determined by either a fixed rate, or a floating rate regime. A fixed rate regime of foreign exchange means that the value of the currency against a foreign currency is determined by the government through its central bank. A floating rate regime determines the value of the currency based on the dictates of the market, hence, through supply and demand principles. The private sector largely determines the appropriate exchange rate in a floating rate regime. Foreign exchange is among the three frequently used indicators to assess the health of an economy. The other two indicators are the interest rate and the inflation rate. However, it is said that foreign exchange plays a vital role in the country’s level of trade, which is critical to most free market economy in the world. Such importance has made its role in the economy critical, and with its impact, it has thus became the “most watched, analyzed, and governmentally manipulated economic measure”. Implications of a rising foreign exchange rate Exchange rates are affected by a confluence of a host of economic factors. These factors would contribute to exchange rate fluctuations, which in turn would impact either positively or negatively, on the economy. These factors are said to include inflation, interest rates, current accounts deficit, public debt, terms of trade, and political stability and economic performance. In general, what are the factors that contribute to a rising foreign exchange rate? In a regime of a free float, a rising foreign exchange rate would become possible given the following scenarios: 1. Higher interest rates in home country than abroad, 2. Lower rates of inflation, 3. Domestic trade surplus relative to other country, 4. A large, consistent government deficit, crowding out domestic borrowing, 5. A strong domestic financial market. 6. strong domestic economy relative to weaker foreign economies, 7. No record of default on government debts, 8. Sound monetary policy aimed at price stability, and 9. Political or military unrest in other countries. A combination of the above conditions will give rise to a stronger currency. Some of them may be construed as a sign of good economic housekeeping. But who directly benefits from a strong currency, and who will eventually lose out if a strong currency prevails over a longer period of time? How does a rising foreign exchange rate, then, make its impact on the economy? Foreign exchange rate would move in two directions. It moves either up or down (an appreciating or a depreciating currency). In either direction, however, it impacts the economy with some sectors being positively affected, and some sectors being negatively affected. It is therefore a question of balancing or mitigating its impact by government regulators in order to as much as possible keep all stakeholders happy. A rising foreign exchange rate, as stated, primarily affects a country’s exports by making them more expensive for other countries to buy. They will become more expensive to importing countries and are therefore less competitive compared to other countries. Economies whose growth is generally export-led and are relying mainly on income from exporting goods and services will be highly affected by a continuously appreciating local currency. It is the exporting sector of the economy who bears the brunt of an appreciating currency, where their produce have become less competitive in the global market relative to other similar commodities from other countries. Thus, a continuously rising foreign exchange rate will reduce the flow of goods going out of the country, and will have implications on the balance of trade of that country. According to Valentino Piana of the Economics Web Institute (2001), “a high and rising exchange rate tends to depress exports, to boost imports, and to deteriorate the trade balance, as far as these variables respond to price stimuli”. But aside from the impact of a rising currency on exports, Piana also reported other implications to the economy and the consumers. One of these is that consumers find foreign goods cheaper so the consumption composition will change. These mean that budget-conscious consumers will now have the option to buy imported products which will now turn out to be cheaper because of a stronger domestic currency. Importers will flood the market with foreign goods as consumers will now demand cheaper substitutes for locally made products. This tendency will then impact negatively on local manufacturers as demand for their products will eventually drop. Moreover, Piano reiterated that firms will also have the tendency to alter their production cost composition by purchasing intermediate goods abroad which will now prove to be cheaper given an appreciating local currency. Such decision will help firms produce goods at a lower cost, enabling them to sell finished goods at a competitive price. Local manufacturers, on the other hand, will be negatively affected by a strong currency if their products have low import contents, and where they have to compete with similar products available in foreign markets. Local manufacturers who cater only to domestic markets, and have not prepared themselves for foreign competition, will eventually lose its viability in a rising foreign exchange regime. Some firms may eventually have to go bankrupt if they will not be able to competitively compete with imported products. Such implications will tend to affect small local enterprises creating a more insidious and oftentimes unmeasured and not quantified effect on the social or political aspect of the economy as it directly impacts on community life of people. A strong currency will allow the locals to travel abroad as foreign vacations will be cheaper. On the other hand, foreigners will find it a bit expensive to travel for vacation in a country whose currency is strong and is continuously appreciating. Other implication of a rising currency is that it helps check inflation and keep it at a low level. It will also afford domestic investors to buy foreign stocks or bonds at a lower rate. Foreign investors, however, may find it difficult to provide capital to the local economy in case of foreign borrowings as a strong currency will affect their desired rates of return for their investments. Some Asian economies are good showcases of the implications of a strong currency to the economy. Singapore, for example, is an export oriented economy with strong private sector-led growth, market-oriented dynamism, and strong capitalist economic fundamentals. The Singaporean economy is highly responsive to global financial developments, as it is ruled by a regime of open and free market principles. Recently, it has allowed for a stronger, steadily appreciating Singapore dollar. How did Singapore use a stronger currency to its advantage? Singapore’s quasi central bank, the Monetary Authority of Singapore, has long encouraged for a stronger currency policy for the tiny island state economy. This strategy is aimed at promoting Singapore’s development as a financial center by attracting funds, while inducing low inflation. A stronger currency has therefore helped the economy from avoiding the bad effects of an inflationary regime caused by high foreign reserves which the economy has successfully accumulated. An analysis of recent foreign exchange rates over time would show how the Monetary Authority has kept the Singapore dollar from fluctuation, maintaining some stability in the exchange rate. As Singapore is an exporting country, it seemed ironic then that it strategically maintains a strong currency to support its economy. By adopting a strong Singapore dollar against other foreign currencies, its export commodities would then look costly compared to other foreign goods. Singapore has realized this implication to the economy, but her economic managers have a different approach in their economic strategies. They have adopted the policy of promoting export not by means of a short-term prices but by long-term quality. A stronger currency also supported a “high wage industrial strategy” which complements the overall business strategy to promote exports. By having a stronger currency, it has attracted foreign talents to work in Singapore, further contributing to the international success of that island city-state in Southeast Asia. The Philippine economy is another case where the implications of a rising foreign exchange are shown. The Philippine economy is largely agricultural, with exports mainly based on non-traditional agricultural crops such as bananas, pineapples, and mangoes produced by large, multi-national companies. Another exportable product from the Philippines is its human resources, where a large number sends back remittances worth about US$2 billion, keeping the economy afloat amidst global economic recession. The figure below would indicate that the Philippine economy has foreign exchange rates which is appreciating, largely buoyed by the seasonal remittances from migrant workers. In the Philippine economy, a stronger Philippine peso will always impact on its exporters, but will primarily have its effect on the locally-based exporters, as opposed to the multi-national companies. Multi-nationals have at their disposals hedging instruments that protect them from currency fluctuations. Local exporters composed of small to medium enterprises are the ones bearing the brunt of a less competitive pricing for their exports brought about by a stronger peso. It has always been reported that during a regime of strong Philippine currency, factories of exported commodities such as furniture, apparel, semi-conductors, and electronic parts are always shutting down due to slower demand for their products. These exporters are always complaining of detrimental effects on their business whenever there is a prolonged regime of a strong peso. Another implication of a stronger currency in Philippine economy, which is basically consumer-led, is it discourages local manufacturers from putting up factories to produce goods. With cheaper alternatives from importation, budget-conscious consumers will favor imported products, aside from the local’s penchant for consumer items with foreign brands. This therefore hinders the creation of employment for an ever expanding workforce, keeping the wealth creation abilities of the economy limited. With a large migrant workers population sending remittances to the country, the Philippine economy has been keep afloat with foreign remittances even bigger than foreign investments it receives. A stronger peso, however, has not been favored by the families of the migrant workers, simply because they receive fewer pesos per dollar sent to them from abroad. Another export oriented economy which will have a direct impact on a rising foreign exchange is Thailand. Just like the Philippines, Thailand has a large agri-based export industry that will be impacted heavily by a stronger Thai baht. However, due to high interest rates prevailing in the country, foreign capital has been flowing to Bangkok, thus pushing the baht to appreciate. An appreciating baht has made importation cheaper, thus a surge of imports over exports has affected Thailand’s balance of trade. The graphs below would show the correlation between an appreciating currency and its effect on the country’s balance of trade. When the Thai baht started appreciating in June 2010, the country started to record unfavorable balance of trade. Thailand is aware of this and the implications it brought to its numerous small and medium scale exporting enterprises. To mitigate its effect to these smaller enterprises, the government has introduced measures in support to those who are hard-hit by a stronger currency. On the other hand, a stronger currency has also impacted positively on the Thai economy. Economic managers in Thailand have used the opportunity presented by a strong Thai baht to tame the inflation brought about by the influx of foreign capital. Just like Singapore, it was able to curb inflationary effects brought about by offshore capital using a regime of strengthening local currency. As Thailand also has a large manufacturing sector using imported materials, it saw an opportunity to develop its local market with a rising currency. It redirected its manufacturers to developing the domestic market, and encouraged factories to acquire new machineries and replace old plants to boost productivity. This can be efficiently done at a lower cost given a stronger Thai baht to finance their capital equipment acquisition. Conclusion A rising foreign exchange rate may be a double-edge sword. On one hand it is an indicator of good economic housekeeping. As a parameter, it says that your economy is healthy with sound economic fundamentals. It keeps inflation in abeyance. It signals some form of stability. It does have an economic benefit to have a regime of an appreciating currency. Singapore demonstrated that a strong currency has benefited its economy. On the other hand, an economy with a large export industry will generally suffer from uncompetitive pricing of its export products in a regime of strong currency. An economy with a large tourism sector will find fewer tourists visiting the country. Stronger currency likewise encourages importation, to the detriment of the development of domestic manufacturing sector. The Philippines seemed to have generally suffered from a stronger currency. With the exception of economies adopting a fixed rate foreign exchange, currency appreciation or depreciation will be a daily fact of life in a free and open economy. Thus, economic managers will have to play the role of a referee, balancing the effect of a fluctuating exchange rate to the economy. A rising foreign exchange has its good and bad effects, and governments must determine who benefits the most, and who suffers, from a regime of a rising currency. 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[Online] Available at: http://www.investopedia.com/articles/basics/04/050704.asp#axzz1fbFn75Bk [Accessed on 04 December 2011] Read More