Exchange Rate as Important Measure of Economic Development - Case Study Example

? INTERNATIONAL ECONOMICS AND FINANCE Exchange Rates Introduction Exchange rate is one of the important measures of economic development of a country. Exchange rate of a country is governed by several factors. Increase in value of local currency makes country’s exports expensive in the global markets which will affect exports. Imports become cheaper under expensive local currency. The combined effect will affect balance of payments position negatively. The increase in demand for external currencies due to increase in imports coupled with decrease in export earnings leads to current account deficit. The exchange rate of the local currency comes down due to interplay of demand and supply. The floating exchange rate system based on demand and supply is a self-adjusting mechanism in market economy. But, stability in exchange rate is very important for the growth of the economy. Therefore, the central bank of a country exercises its monetary authority to ensure that the local currency is traded around the desired or target exchange rate. The central bank closely monitors movements of exchange rate of the country’s currency. It will intervene in the market by resorting to open market purchase or sale of currencies to maintain stability or for influencing the exchange rate of the local currency in relation to foreign currencies. Spanjers (2009, p. 10) stated “As the expectation of stable exchange rates tends to promote trade and thus welfare, the monetary authority of each country commits itself to exchange rate targets.” Central bank also in its liquidity management through monetary policies influences money supply in the country with a view to regulate interest rates and keep inflation under control. Money supply in a country will also influence the behaviour of exchange rates. The interest rates and inflation are closely linked to the behaviour of the exchange rate. Gold standard system In Bretton Woods Conference in 1914 the participant countries have agreed to adopt gold standard system which envisaged economic discipline among the nations. But, it could not succeed in achieving the objectives mainly due to currency devaluation spree post-World War-I by the countries to maintain or improve their exports. While devaluation strategy was adopted to make the countries’ products competitive in the world market, in order to make the local products more competitive locally, they also introduced trade restrictions which made the imports costlier. These measures taken by the governments for protecting their national economies had severe impact on the international trade. To stem this tide in international economy, International Monetary Fund was created in Bretton Woods in 1944 with the aim of preserving global monetary order. The exchange rates of the currencies fixed in relation to US Dollar or gold could not work smoothly for a long period. Defending these fixed exchange rates has become increasingly difficult due to several factors. Under the fixed exchange rate regime the country has to continuously monitor the system and impose several restrictions on transactions involving foreign exchange. These restrictions are likely to encourage black market operations in foreign exchange. The question of devaluation of the currency for a country with fragile economy is the greatest cause for concern. The countries’ current account imbalances caused failure of the system because under consistent deficit in current account a currency cannot be kept artificially at a higher exchange rate. Stability in Floating exchange rates and economy The stability factor, being the major concern relating to exchange rates, could not be addressed in floating exchange rate system based on demand and supply for currencies as well. The process of self adjustment expected to come into play is affected by several factors. For example, when a currency becomes weak, the imports become costlier and exports more profitable and the volume of exports is expected to increase. The increased demand for local currency due to exports and decreased demand for foreign currencies due to decrease in imports make the local currency to appreciate and find its equilibrium at a higher level. Also, decrease in demand for imported products will increase the demand for local products. The increase in demand reactivates economic activity. New production facilities established to meet this additional demand will lead to employment generation. This could attract foreign direct investments in the country. Multiplier effect caused in this process leads to stability in economy. Continued inflow of FDIs will strengthen the currency further. However, this mechanism is affected due to various factors such as trade restrictions, currency speculative activities, weak central banking system and poor management of economy by the developing and the underdeveloped countries. Krugman (2002) stated “Under the "floating" exchange rates we have had since 1973, exchange rates are determined by people buying and selling currencies in the foreign-exchange markets. The instability of floating rates has surprised and disappointed many economists and businessmen, who had not expected them to create so much uncertainty.” Many third world countries need external support in overcoming their trade imbalances. Actually, the countries are only bailed out from a crisis, and the external supports are not meaningful in eliminating the causes. Purchasing Power Parity Friedman and Schwartz (1982, p.626) stated “If the "law of one price" were perfectly satisfied, the purchasing-power-parity exchange rate would equal the market rate. In fact, it does not do so but fluctuates around the market rate. Before the early 1930s, the purchasing-power-parity rate stayed within plus or minus 10 percent of the market rate—a reasonable approximation to the law of one price. After the early 1930s, the variation was much wider, ranging from 10 percent below to 60 percent above.” Inflation is an important economic variable in determining the value of currency. The currency of a country with nominal inflation rate appreciates over years. It is also important to note that higher inflation is linked to higher interest rate as well. Therefore, though exchange rate is an important indicator of the economy, for the purpose of comparing the strengths of different economies it cannot be relied upon. GDPs of the different countries for this purpose could be related to a common currency like US Dollar at PPP of the respective countries for determining the exchange value. Terms of trade between two countries indicates the trade relationship in terms of imports and exports between the countries. The imports that could be made by exports to the other country will show the relative position of a country in international trade. This can be calculated by total volume of exports to a country as a percentage of the volume of total imports from that country. For example China’s exports to US can meet 384.31 % of its imports from the US. China's Trade with the United States, 2011 ($ billion) US exports to China 103.9 US imports from China 399.3 Source: The US – China Business Council (2013) Exchange rate is an important determinant in varying the effects of this relationship. For example, an increase in value of the local currency makes exports costlier in the international markets. Therefore, the equilibrium in the terms of trade is disturbed due to increase or decrease in exchange rates of the local currency. Gregorio and Wolf (1994, p. 10) found that “both terms of trade fluctuations and differential productivity growth across sectors are highly significant determinants of real exchange rate movements as well as important factors behind changes in changes in the relative price of nontradables.” Forward exchange rates Few decades back actual exports and imports were the prime drivers of the foreign exchange markets. Though the macroeconomic fundamentals are the guiding factors in the long run, the influence of other factors on exchange rates in the short term cannot be ignored. Predictions based on fundamental factors such as GDP growth, employment growth, fiscal and monetary policies would be hazardous in short term. There are several forces at interplay in the markets which include speculation in foreign exchange markets, flow of capital across the nations, repatriation of money by people to their country of origin, movement of funds in capital markets, international loans and interest and repayments thereon. The demand and supply position in relation to various currencies are dynamic and can result in to violent fluctuations based on several factors including war, natural disasters and political instability. It is generally believed that the forward exchange rates reflect the likely movement of exchange rates in the future. But, the forward premium is not the reliable indicator of expected exchange rates in the future. Here again, demand and supply is the important determinant for premium which could be influenced by several factors. Forward contracts are used to hedge the risk involved in foreign exchange. But, volatility in foreign exchange market is mostly associated with decrease in trade. The forward markets for smaller currencies are either non-existent or have very limited time horizon for the contracts. Krugman (1979, p. 311) observed “A Government can peg the exchange value of its currency in a variety of ways. In a country with highly developed financial markets it can use open-market operations, intervention in the forward exchange market, and direct operations in foreign assets to defend an exchange parity.” Interest rates The monetary policies of the central banks aim at keeping the inflation under control and regulating the interest rates by exercising controls over supply of money. The exchange rate of a currency is closely linked to the interest rates and inflation. Therefore, the monetary policies of the country will have impact on the exchange rates. Apart from these monetary policies, the central bank can also engage in open market operations to maintain exchange parity. Increase in interest rates can attract foreign investments which create demand for the local currency, if it is expected that the inflation will remain unchanged. Current account deficits and external debt Hale (2013) stated “The 1999 introduction of the euro set the stage for current account imbalances in some euro-area countries. A common currency reduced trade costs, thereby boosting overall trade volume…As Figure 2 shows this produced surpluses in Germany and widened current account deficits in Greece, Italy, Ireland, Portugal, and Spain (GIIPS), especially Spain.” Source: Hale (2013) It could be observed that in the case of GIIPS current account balances have been continuously negative for a prolonged period. These governments are not in a position to intervene effectively in the economic process without external assistance since continued poor performance in current account balances have already sapped their strength. Generally, current account deficits accumulated over years coupled with external debts accumulated to meet the foreign exchange requirements depress the exchange rate of a country’s currency to a precarious level. When the terms of trade enjoyed by a country deteriorates consistently due to export prices increasing at a faster pace than the import prices or vice versa, the country is forced to go for external debt. Comparative advantage of a country in the international trade depends upon the nature of products and services traded. Repayment of debt along with the interest would cripple the economy since the local currency undergone depreciation substantially over years. Flight of capital out of the country would add fuel to the economic crisis. The revival of economy under such a situation would be painful and prolonged. Failure in debt service by a country leads to sovereign debt crises. Reinhart and Rogoff (2010, p. 25) observed “Banking crises most often either precede or coincide with sovereign debt crises … in which the government takes on massive debts from the private banks, thus undermining its own solvency.” IMF needs to tighten the surveillance standards to identify the warning signals in international monetary order for taking effective steps in earlier stages to avoid crisis like South East Asian countries crisis in 1990s or the current European financial crisis, in the future. Strategies for future global economic development The international financial institutions and the governments of various countries are working towards financial inclusion of the economically weaker sections of the society. It is also important to ensure that the poor countries do enjoy the fruits of technological and economic developments achieved by the world. Many underdeveloped countries need to import goods and services to catch up with the rest of the world in economic development. Most of these countries depend upon natural resources such as coffee, cocoa, rubber and mineral ores for their export earnings. However, unfavourable terms of trade, exploitation by the companies, corruption by the government officials and politicians hamper growth of international trade. Countries in various Asian and African regions have common social and cultural background. However, bilateral trades among these nations are insignificant due to political differences, border disputes, insurgencies and trade restrictions. Bilateral trade among these nations will ensure stability in exchange rates in these regions and narrow down the imbalances. It is important to note that growth in bilateral trade in Euro zone after introduction of common currency ‘Euro’ has been remarkable. Conclusion The International Monetary Fund, which is responsible for world monetary order should take initiatives to improve the balance of payments position and stability in exchange rates in third world countries. Foreign direct investments aiming export of value added products from these countries by setting up production facilities should be encouraged. Integration of the economies of the third world countries into the international trade is important for sustainable world economic growth and stability in exchange rates. The causes underlying the current account deficits and imbalances in the world monetary system should be tackled through negotiations and dialogues with a view to ensure stability in exchange rates for an orderly economic growth of the nations. References Hale, G., 2013. Balance of Payments in the European Periphery, FRBSF Economic Letter, Federal Reserve Bank of San Francisco. [online] Available at: [Accessed 6 April 2013]. Friedman, M. and Schwartz, A. J., 1982. Monetary Trends in the United States and United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867-1975, University of Chicago Press. Gregorio, J. D. and Wolf, H. C., 1994. Terms of Trade, Productivity, and the Real Exchange Rate, Working Paper 4807, National Bureau of Economic Research, Cambridge. Krugman, P., 1979. Journal of Money, Credit and Banking, Vol. 11, No. 3. (Aug., 1979), pp. 311-325. Journal of Money, Credit and Banking, Vol. 11, No. 3. (Aug., 1979), pp. 311-325. Krugman, P., 2002. Exchange Rates, Library of Economics Liberty. [online] Available at: [Accessed 6 April 2013]. Reinhart, C. M. and Rogoff, K. S., 2010. From Financial Crash to Debt Crisis, Working Paper 15795, National Bureau of Economic Research, Cambridge, March 2010. Spanjers, W., 2009. Monetary Policy, Trade and Convergence: The Case of Transition Economies, LIT Verlag, Berlin. The US – China Business Council, 2013. US-China Trade Statistics and China's World Trade Statistics, US-China Trade Statistics and China's World Trade Statistics. [online] Available at: [Accessed 6 April 2013]. Read More