Are Fixed Exchange Rates Compatible with Free Capital Flows - Assignment Example

Are fixed exchange rates compatible with free capital flows? Discuss. Introduction: The options of identifying best exchange rate for an economy aredependent on several variables. The three parameters on which a highest return is determined are a) free capital flow b) fixed exchange rate, and c) an individual monetary policy. (Pilbeam, 2006) For getting highest returns countries can maintain any two policies and this is termed as the “impossible trinity”. In case a country has a fixed exchange rate and a free capital flow, it cannot have an independent monetary policy. Argentina has followed this policy between 1991 and 2002. Again in case of China, the country has a fixed exchange rate and allows central bank to respond to domestic inflations but the capital market flows are kept under control. In case of US, Britain and China have an independent monetary policy and capital flows but the exchange rate cannot be kept at a fixed level. (Carbaugh, 2008, p.465; Grey, n.d., p.34) The impact on the emerging economies on 1990’s with onset of liberalization had similar effects. A high level of interest rates and a pegged exchange rate lured foreign investment in Latin America, east of Asia and Russia. The result was very optimistic with stock market booming and financing of countries deficit accounts. However, during recent years there was a reversal in the situations. Subsequently massive volume of wealth was flown out of the country. The economies were compelled to get rid of the pegged exchange rate system and float their currencies. In some cases like Brazil and Russia financial imbalances worsened the situations. Even a small change in foreign capital index result in a large swing in capital inflow and result the economy enter the vicious circle. This paper aims to understand the relationship between exchange rate, currency crisis and capital flows. The lesson’s learned during 90’s from emerging economies like Mexico, East Asia, Brazil and Russia. This article is segregated into following four segments. (Edward, 2001, pp.1-3) I. Lessons learned on exchange rates from 1990 crisis. II. Based on economic scenario the exchange rate to be opted. III. Working out a correct exchange System. IV. The economies of China– A study. I. Lessons learned from crisis of 1990s The economic analysts had to rethink their views on exchange rate policies. In order to prevent the same in future country should opt for freely floating exchange system. A fixed exchange rate limits the scope of macroeconomic activity in a country. Unlike, the flexible exchange rate system no combinations of GDP and interest rates are available. So, the economies had lesser options to combat inflationary fluctuations. Though Mexico had a painful experience in 1990s, analyst had still supported the pegged or quasi pegged rates. The 5 East Asian countries that gradually entered into crisis in 1997 had pegged exchange rates with US dollar. This system was working well as dollar was a weak currency into international currency market. On 1997 the position of dollar strengthened causing the Asian economy to combat a crisis. In Russia and Brazil the public sector accounts were not manageable. Three years post crisis the normal deficit was 7.4% GDP. Furthermore the lack of leadership during the privatization process, the red tape corruption made international investors more skeptical. The East Asian nations also had similar problems. While Malaysia, Indonesia and Thailand suffered from an overestimated exchange value. On the other hand Korea and Philippians had a underestimated exchange value. (Edward, 2001, pp.10-15 ) II. Based on economic scenario the exchange rate to be opted As per the “impossible trinity’ Countries can have combination of only two policies in case a country has independent monetary policy and free capital flow it cannot have a pegged exchange rate. The easy way to have an understanding of this is by a specific example. The US has flexible exchange rates along with an independent monetary policy and free capital inflow. This means the US government can curb the inflation in the country by adjusting the interest rate relative to the foreign interest rates. By increasing the interest rate in the country the demand for dollar can be significantly changed compared to other currencies. On the other hand China has a fixed value of its currency against dollar and allows a free capital flow. However, Hong Kong is not empowered to change in monetary policies to stimulate the internal economy. Based on the economic scenario the country should opt for particular exchange rates. Following are some examples sited to have a better understanding: Size of the economy- In case trade is a major portion of a country’s GDP, then cost of currency fluctuations can have a bigger impact on the economy of that country. This means a open economy of a small country should opt for a pegged exchange rate. Inflationary Implications-In case country has higher problems related to inflation. It is advisable to have a flexible exchange rate. So, that the government will have an access on the monetary policy and curb inflation significantly. Labor Market wage- In case a country has a rigid wage structure; the requirement of flexible exchange rate is required. This will help the monetary policy to be restructured as per required shocks. Developing Economy- For developing economy a small change in the foreign exchange can cause a big swing in the market conditions. So, a freely floating rate is not advisable. Central Bank’s reputation- A country with a week policymaking body should go for a pegged exchange rate. Capital Mobilization Rate – In case country is open and has a lot of inflow from international market, it is desirable to have a flexible exchange rate. (Carbaugh, 2008, pp.465-466) III. Working out a correct exchange rate System As per a recent work publication of World Bank, one of the most acceptable ways to work out real exchange rate is by a single equation based on time series. The following set of steps requires to be followed. Time series equations are used to derive a real exchange rate equation. These have fundamentals segregated into both permanent and temporary components. The permanent component is included in the estimated portion of time series. Finally, the calculated rate of exchange is compared with the actual rate. Deviation between these two helps to identify the exchange rate over or under estimation. The first model was released in 1996 six months before the start of Asian crisis. This model declared that the currency of Indonesia, Philippians and Thailand was overvalued. On 2000, JP Morgan coined his real exchange theory. He incorporated the role of monetary implications as a short run variable. IMF to indicate these kinds of effects uses a general equilibrium simulation. In a recent study, Deutsche Bank has used these kinds of variables to indicate the development rates in Latin America. As per this model the current account of a country is determined by GDP, inflation and demand of liability. In case country has a current account deficit in order to have long run equilibrium real exchange rate requires depreciating. The Goldman Sachs, JP Morgan and Deutsche Bank models have indicated the overvalued real exchange rate in the long run for Latin American and East Asian economies. This is also more pronounced in pegged and fixed economy and not in a floating economy. (Edward, 2001, pp.10-15) IV. Economies of China – A study China’s entry into World trade organization in 2001 has resulted in further growth in the economy. The GDP of China has increased a phenomenal amount of 9.5%. This has resulted in huge capital inflow resulting in a boom in the economy. Along with bells of celebration there is cause of concern also. There are signs of inflation and overheating of economy. The Chinese currency is set in competition with other trading partners like Japan and US. The central bank of China has shown a diversion from moving into a flexible exchange system. They have imposed restriction on some capital outflows. To succumb to competition of influx of huge foreign capital China should invest on banking infrastructure. Post Liberalization, China has immerged from economic isolation in an era of economic growth. Leaving aside the concepts of import substitution, China has embraced the outward facing economy. This has resulted in a growth to a boom of $ 1.2Trillion in 2004.Market openness has resulted in a source of attracting foreign investment. The net foreign investment on was $61 billion- making China one of the recipient of world’s largest investments. With Liberalization of her capital account China has faced challenges as third world countries across the world. The challenges were in fields of maintaining an enhanced capital flow subject to domestic price and inflation stability. In past few years China has experienced a massive credit boom with red-hot inflation. Also China is facing a huge criticism from her trading partner US and Japan for maintaining of an artificially low pegged rate of her currency value. The issue of “hot money” is the main cause for Chinese authorities now and requires to be redressed. In 2002-03 China had experienced a boom in monetary growth. As a result the domestic credit increased resulting in an investment in steel, real estate, automobile and cement industries. This resulted in an increase of inflation @ 28% and a massive deterioration of quality of assets. The present banking sector requirement may also end with quality issues if not properly addressed. The official foreign exchange reserve for China has gone up by more than $ 200 billion in 2004.This result is owing to surplus in BOP at a pegged rate of exchange. However, there was a subsequent rise in inflation. To maintain the liquidity and hence to curb inflation the central bank indulged in buying of the trade surplus created due to foreign capital inflow. The effectiveness of China’s policy of free capital inflows is questioned by the problems of “hot money issues. However following are some steps taken by the central bank to curb inflation in the country. (1) Central government to impose ceiling in the value of foreign exchange that can be held by an individual. (2)Encouraging Chinese firms to invest in foreign bonds. (3) Encourage domestic firms to invest in foreign countries. The government raises capital by means of equity, bonds and bank loan. Based on requirements the portfolio mix is done by banking system. Whereas for equity dividends needs to be paid for bonds fixed interest requires to be paid and for bank loan a variable interest rate is charged. (Valdez, 2008,p.85) With China having embraced an open market economy, gradual shift to flexible exchange rate will be a better idea to handle the pressure of domestic challenges and external shocks that might hit the economy in near future. Implementation of flexible exchange rate will enable China to reap the benefits of liberalization and cross border inflow of capital. (Hu, n.d., pp.1-10) Conclusion: As with an on set of liberalization countries are facing enhanced inflow of foreign capital but pegged exchange rate is causing a hurdle in the maintenance of growth and development. Tightening of policies by Central Government may cause a temporary solution but not a permanent cure for the economy. Implementation of flexible exchange rate will help a more free cross border inflow of capital as well will help the country to design her own monetary policies to have better effect on inflation and external shocks. The countries can identify the pain areas and indulge in a corrective action based on that. China, understanding her weakness in the banking sector is, making huge investments to upgrade the banking system. The impact of liberalization has resulted in opening up of economy but with a pegged exchange rate there are tensions of inflations. To have a more compatible capital flow, firstly, countries should shift away from fixed exchange system to a floating system; Second, development of infrastructure is to enhance growth and development and; third, the capital restrictions should be loosened. Such conditions will help countries with fixed exchange system to combat macro economic crisis and usher into era of development and growth. (Edward, 2001, p.10) References: 1. Carbaugh, R, 2008, Business & Economics, New York: Cengage Learning 2. Edward, S. Sep 2001, Exchange Rates Regimes capital flows and crisis prevention”, available at: http://www.anderson.ucla.edu/faculty/sebastian.edwards/woodstock_edwards.pdf (accessed on March 23, 2010) 3. Fred Hu, n.d., Capital Flows, Overheating and the Nominal Exchange rate in China”, available at: 4. http://docs.google.com/viewer?a=v&q=cache:87THcLLDtO8J:www.ciaonet.org/olj/cato/v25n02/v25n02k.pdf+Again+in+case+of+China,+the+country+has+a+fixed+exchange+rate+and+allows+central+bank+to+respond+to+domestic+inflations+but+the+capital+market+flows+are+kept+under+control&hl=en&pid=bl&srcid=ADGEEShpQiKhPBnCyTThJn626NJ0YSsmFueFQBy-IwigUas0zJm0Y1yViiOXo6dA1MwwZuSrlRVxlHrv02dMjHoHd6qwis3C5tbfVnMDDP42jzLJMUkrRTl-jfYWcXom7xInjAGH16DC&sig=AHIEtbS8ah_wdkSlLd2XxHKNDlGNgydhtQ (accessed on March 23, 2010) 5. Grey, D, 2008, Macro financial risk analysis, New York: John Wiley and Sons 6. Pilbeam, K. 2006. International Finance, London: Palgrave Macmillan 7. Valdez, S. 2008, An introduction to Global financial Market, New York: Macmillan Read More