The Economic Dragons Threatening Our World - Research Paper Example

Running head: Mission Possible: Case Study in International Mission Possible: Case Study in International Finance Abstract This case involves a rich East Asian nation with a pegged currency fixed to the US dollar for ten years, supported by monetary policy of tight capital outward flows and unrestricted inflows. An increasing inflow of foreign capital is exerting an upward pressure on the nation's exchange rate. This is an early-warning sign of a speculative attack on the currency designed to force a revaluation, or a strengthening of the local currency's exchange rate with the dollar. The paper outlines what the nation can do to ward off speculation, minimize the potential for inflation - identified as an economy's worst enemy - and at the same time improve its standing in the world economy. Mission Possible: Case Study in International Finance What problem The first step in finding a solution is to agree on the problem. If there is indeed a problem with the upward pressure that capital inflows are causing on the pegged exchange rate, then we need to address it. If none exists, then why fix what ain't broke Defining the problem is not as simple as it looks, more so since the case details are mum on crucial information like inflation rates, interest rates, balance of trade, our buying power and demographic profile, employment and so on. In the absence of such data, we have to resort to assumptions and predict the worst that can happen. Having foreseen the assumed problems, we proceed to craft elegant solutions that will entrench us in the pantheon of modern-day mandarins adept at slaying the economic dragons threatening our world. Stating the case Offhand our exercise looks easy, but it is not, and this judgment has less to do with the dearth of facts than with the basic givens. "A rich East Asian nation with a pegged currency fixed to the US dollar for ten years, supported by monetary policy of tight capital outward flows and unrestricted inflows, is experiencing an upward pressure on the exchange rate." The question remains: what to do now Deciding on a strategy depends on a clear understanding of the world's monetary system, the role that exchange rates play, how they are determined, and what will happen if we do nothing. As Robert Solomon said (1977, cited in Samuelson, 1992): The world's monetary system is like the traffic lights in a city, taken for granted until it begins to malfunction and to disrupt people's livesA well-functioning monetary system will facilitate international trade and investment and smooth adaptation to change. A monetary system that functions poorly may not only discourage the development of trade and investment among nations but subject their economies to disruptive shocks when necessary adjustments are prevented or delayed (pp. 1, 7). What is the worst that can happen and what should we do to prevent it The World's Monetary System The world's monetary system refers "to the set of policies, institutions, practices, regulations, and mechanisms that determine the rate at which one currency is exchanged for another" (Shapiro, 1996). It is the coordinated way each nation manages its supply of money so that we can buy and sell each other's goods, doing business by exchanging pieces of paper, the value of which we agree on, called money. In the recent past (which in East Asia means less than three hundred years ago), each nation was free to decide how much of its currency to circulate to buy goods. This turned out to be unwise because wantonly printing money and giving it artificial value caused absurd price increases, a phenomenon we know now by a word that sends shivers down central bankers' spines: inflation. Clear and Present Dangers Inflation is just one danger of being at the wrong end of currency speculators bent on attacking exchange rates that, in our case, may cause a revaluation or strengthening of our currency, the Eck (symbol: X). How did we conclude that speculators are after revaluation and not devaluation (or weakening) of the currency The answer lies in our being a rich nation with tight capital outward flows. The best path to be a rich nation (not only in East Asia) is by way of exports that bring in dollars to the economy. Then, measures of tight capital outward flows are a sign of market inefficiency, a strategy normally adopted by developing nations to restrict capital flight (Shapiro, 1996, p. 79). It was useful when our nation was poor, but now that we are rich, it is a chink in our economic armor that speculating warriors can exploit. How Seeing our dollar horde, speculators working under the guise of total integration of the globalised economy, which includes the currency markets, bring in dollars and attack the currency, hoping to bring out profits. The only way they can make money is if we revaluate the currency. Our nation, therefore, faces two dangers from speculators: inflation and forced revaluation. Costs of Revaluating the Eck How do currency speculators affect an economy A currency's price (its exchange rate) in a floating rate system is determined by supply and demand. Looking at the supply and demand curve on the right [A], the equilibrium point e is the price of the currency at which the supply and demand Q of the currency Ecks (or X) are balanced at the exchange rate of 1 Eck per 0.50 US Dollar (USD or $), which is the same as 2 Ecks (X) for each USD. When the dollars flow in, what happens Since investors cannot pay for their purchases in US Dollars, they buy Ecks in the currency market using US Dollars, and then put their Ecks in different investment baskets. With the supply of Ecks the same, the demand curve shifts to the right (increased demand), moving the equilibrium to e' where the price of the Eck is 0.80 USD, or X1.25 per USD. If our currency revaluates from X2.00 per dollar to X1.25, the speculator heads for the exit and buys dollars for X1.25. A $1 million (equivalent to X2 million now) speculative investment becomes $1.6 million (what X2 million can buy, net of interest earnings, after revaluation to X1.25 per USD), lowering our dollar reserves by $600,000 and increasing our money supply by X2 million. Imagine the havoc that speculation in billions of dollars can create. Increasing the money supply will push inflation up, but the story does not end there. We will be left holding a bag of troubles rippling through the whole economy. First, our imports will go up since these will be cheaper by 37 percent. A $100 widget that used to cost X200 at the old exchange rate will now cost only X125, so people may buy more. Second, instead of buying one, people might decide to buy two. Third, such a decision made by a few would not matter much, but if the whole population, or a majority, decides this way, it depletes our savings and, fourth, funds available for investments as loans. Fifth, instead of buying a local widget priced competitively at X190, people may decide to buy an imported one (at X125) that used to cost X200. This may drive local widget companies out of business, causing unemployment and social unrest if and when more local widget-making companies lose out to foreign widget-makers. Sixth, exporters will be adversely affected by a currency appreciation as their dollar income stays the same and gives them less Ecks (a $100 export used to earn X200, but now they get only X125), or they lose foreign buyers as their products become more expensive (a product that used to cost X200 or $100 now costs $160 at the new exchange rate). As inflation rears its ugly head and the money in circulation keeps on rising, borrowings increase as exporters cover their losses and importers borrow to buy more goods, all these driving up interest rates as the demand for loans goes up. Obviously, doing nothing will lead to disaster. The fact that our currency is pegged and capital outflows are restricted means that nothing of the scenario just mentioned may happen, but since our nation's inflows are unrestricted and dollar reserves are sufficiently high, we will attract pesky speculators as honey does to the bee. If we want to get rid of the pests, the best time to do something is now while we are in a position of strength. Taming the Shrew: Tools of the Trade John Maynard Keynes was once traveling in Africa with a Cambridge friend, Walter John Sprott. At one point, they had their shoes polished by the native boys. The economist handed the boys a miserly tip. Sprott suggested a more generous handout, but Keynes firmly declined: "I will not be a part to debasing the currency". (Fadiman et al., 1985) Today's central bankers have more creative ways to avoid debasing the currency than handing out miserly tips to native shoeshine boys. Inflation being the child of a footloose money policy caused by speculation, limiting the supply of money helps avoid moderate inflation from galloping and turning hyper (Samuelson, 1992). How central bankers do it is a fascinating combination of rocket science, knowledge of mass psychology, and perfect command of syntax and grammar to communicate to the public which of three inflation-controlling tools they will use, either singly or in combination. The first tool is to target the growth of money supply, the cash, bank reserves, checking accounts, interest-bearing deposits, and short-term securities circulating in the economy, in effect determining how much money to print, circulate, or keep in bank vaults. Money supply targeting is done when the central bank sells or buys government securities at a certain interest rate (called the federal funds rate). The rate at which they buy is what really matters, because it signals how much reserves the central bank wants to keep in bank vaults. Armed with economic data, the central bank with its monopoly on supplying bank reserves determines how much money it will allow to circulate by making banks comply with the reserve requirement (Economist, 1999). Money supply targeting, achieved through upward or downward adjustments of short-term interest rates, worked well because of the link between money supply growth and future inflation. Through a combination of short- and long-term interest rates and money supply targets, the central bank can help fight the inflationary effects speculative dollar inflow. The second tool in the inflation-fighting arsenal targets inflation directly, which many central banks do. Although it has many advantages like transparency and accountability, success is difficult because targets are based on future, not current, inflation and the long time lag between monetary policy and its effects on the future inflation rate makes it a hit and miss affair (Economist, 1999). We would prefer not to do this. The third tool of monetary policy is setting exchange rate targets (Samuelson, 1992, p. 712). As we are now in a pegged currency exchange system, a variation of the flexible exchange rate mechanism where the currency floats in the market within a small band in a managed manner, we can use this tool to adjust our currency. The question is by how much Managing the Exchange and Interest Rates The dark scenario painted above would result from a drastic revaluation of our currency. Ours being a managed flexible exchange rate system makes our work easier. Technically, a revaluation refers to an increase in the par value of a pegged currency, while devaluation is a decrease in the par value (Shapiro, 1996). The increasing inflow of dollars into the country is exerting an upward pressure to revaluate the Eck. In a managed exchange rate system where the Eck is pegged to the dollar at USD 0.50, we can allow the Eck to be traded within a narrow band, say an arbitrary range of USD 0.48 to 0.52. The exchange rate to the dollar will be allowed to fluctuate from X1.92 to 2.08, a revaluation of plus or minus four percent (4%). Revaluating within a narrow band gives us time to make adjustments. Our exporters will see profits decrease, but since they enjoy large profit margins now (making us rich), it would not pose too much of a danger. However, we should encourage exporters to raise productivity to compete with cheaper imports. A strong banking system and low interest rates should enable exporters to achieve this. This revaluation will not be the last, so we should prepare for the next round by improving export productivity. Another benefit of a narrow-band revaluation is that the price differentials of imports will not be sufficiently attractive to consumers as to change spending patterns. We need to study price elasticities of imports so we can foresee which products place our local manufacturers at a disadvantage when a small price difference may encourage consumers to patronise imported, rather than locally produced, goods. These sectors will be given preference in access to low-interest loans. We also need to study our industrial policy so we can get out of industries where margins are small and start moving into high value-added goods, but this is not the purpose of this paper so we will not address this here. Our move to keep interest rates low will encourage borrowing and discourage speculation if combined with a managed floating exchange rate system. Low interest rates mean low earning potentials for speculators to keep funds in the local currency, while a managed exchange rate limits the potential for earning from currency speculation. Speculative money either stays out or, if already in, moves out. Keeping interest rates low also has the benefit of keeping inflation in check. And if, like other rich East Asian nations, our savings rate is high, we can channel the funds towards other investments like investing in foreign companies, building factories, or improving the quality of education (Economist, 2005b). We can also decouple the currency from the dollar and peg it to a basket of currencies. The choice of currencies and their relative weights will depend on the pattern of our trade, the sources of our foreign direct investments, and the currency composition of our debt (Economist, 2005a). This will minimize our currency's dependence on the dollar and diversify our options in using monetary policy. A managed revaluation of the Eck can be a strong signal to the outside world that many other nations have their interests linked to ours, allowing us some space in negotiating with them. Removing our absolute dependence on the dollar might create shocks to the system, but we can mitigate this by loosening up on our control of currency outflows. An added benefit is our integration into the world economy by our efforts to remove inefficiencies in the outward flow of capital. This has to be done slowly to discourage rapid capital flight, but if we are ready and show the world that we are an attractive place for investments, those funds will come back in the form of foreign direct investments that will be put to productive use. This may also signal more revaluations to come and attract speculative inflows, but with the currency tied to several currencies, our fundamentals stable, our banks on a solid footing, and our industries gaining in confidence in competing globally, we will be ready and more flexible in using all the weapons in our arsenal to shoot down any future attempts to cause economic destabilization. Another worldwide phenomenon we can help address is the issue of low bond yields in our neighbor across the Pacific, which creates problems in the form of market bubbles in debt and real estate (Economist, 2005b). Our exports helped create this phenomenon, so a tiny devaluation may help them if our goods become a bit more expensive and people in developing countries consume less. But if our exporters can live without increasing their prices, we will end up ahead. Lastly, our dollar wealth makes us a target not only for speculators but also for nations who envy us, causing an image problem we can address by making a move the world can interpret positively. By revaluating our currency, we send a political signal that improves our image and makes our nation a worthy partner in the global economy. Recommendations Free and mobile international movements of capital have made even managed exchange rate systems vulnerable to attack (Economist 2005b). Despite our best intentions, speculators exert pressure for us to revaluate to align our currency with the rest of the world. We know that a sudden revaluation can cause inflation, rising interest rates, unemployment, social unrest, decreasing savings, increased consumption, systemic risks, and a recession, troubles that may be too much for us to address. We have to move the East Asian way: slowly but surely. We will move forward, using targets we can predict and control, to minimize the risks and maximize the political benefits of our actions. What should we do First, continue maintaining a managed foreign exchange rate system, pegging our currency to a basket of currencies from our major trade, investment, and credit partners. Including some of our East Asian neighbors will allow us to improve our trade and investment relationships them. Second, we will allow a revaluation of the Eck within a narrow band. If we do this well, we can send a strong signal to the world that we are serious in being part of the global economy and, in return, we can ask for greater recognition of our role in making decisions that affect us all. An added advantage of a managed revaluation is that our exporters will not be radically affected by the stronger currency. Our strong banking system should be able to help exporters in the initial adjustment period to bring down costs and be more competitive. Third, we should liberalise foreign exchange trading to allow banks and other financial institutions to manage the risks that will go with decoupling our currency to the dollar. This will minimize systemic shocks and discourage speculators by slowly easing up on control of dollar outflows. Fourth, we should keep interest rates low to control inflation and discourage currency speculators from parking funds. We will encourage our banks to lend and our people to borrow, so we should prepare them by opening up opportunities for new businesses, purchases of productive assets, and business expansion to put the money to productive uses. Lastly, we will strike a balance among the currencies in our basket when shoring up our foreign reserves. Not only will this reduce the pressure from our rich neighbors across the Pacific to tinker with our exchange rates; this can also help us improve our bargaining position with other nations. Implementing these recommendations will give us the policy space and flexibility we need as a member of the world community. References Economist, The. (1999) Monetary Policy in Finance Briefs (October-December). London: Economist. Economist, The. (2005a) Chinese puzzles. August 13, 2005. London: Economist, p.60. Economist, The. (2005b) The great thrift shift. September 24-30, 2005. London: Economist. Fadiman, C., Speakes, J., Isaacs, A., and Urdang, L. eds. (1985). The Little, Brown Book of Anecdotes. Canada: Little, Brown & Co., p. 330. Samuelson, P. A. and Nordhaus, W. D. (1992). Economics. New York: McGraw-Hill. Shapiro, A. C. (1996) Multinational Financial Management. 5th ed. London: Prentice Hall. Solomon, R. (1977) The International Monetary System, 1945-1976. An Insider's View. New York: Harper & Row, pp. 1 and 7. Read More