The Various Factors Which Can Influence Exchange Rate Movements - Essay Example

Question: Outline and explain the various factors which can influence exchange rate movements. Describe and evaluate the strategies adopted by the Reserve Bank of Australia in the foreign exchange market comparing it with those of another developed country Introduction Movements in the exchange rate of an economy cause changes in other important financial indicators such as interest rates inflation and balance of payments. Since these parameters indicate the general performance of an economy at any given time, and that fluctuation in the exchange rate is a haphazard occurrence, there is need for governments, through their central banks, to intervene in foreign exchange markets. This paper examines strategies that guide the Reserve Bank of Australia (RBA) in its intervention in the foreign exchange markets. It also explores how different factors influence movements in exchange rates. Factors that influence exchange rate movements Movements in the exchange rate depend on the impact of a number of factors such as the level of public debt, the terms of trade, the general level of political stability in a country, overall economic performance, deficits in the current accounts, and differences in the rate of interest and lastly, differences in the rate of inflation (Archer, 2005, p. 43). Also, Johann (2008, p. 5), observes that changes in exchange rates occur in both medium- and long-term. Since exchange rates can be considered as the prices of specific commodities and the currencies, their movement occurs generally in terms of demand and supply of the currencies. In general, movements in exchange rates are determined by models that fall into two broad categories: those that view the movements as a function of macroeconomic fundamentals and those models that ascribe them to short-term dynamics in the market (micro-structures of exchange rates resulting from changes in order flow, market participants and speculation). There is a connection between the macroeconomic fundamentals of a country’s economy and the level of changes in the exchange rates (Horne, 2004, p. 526). The different models of exchange rates that are based on the fundamentals of macroeconomic factors of monetary demand and supply of currencies affect the level of volatility of the exchange rates of the countries involved (Bailliu & King, 2005, p. 4). This happens in several ways. For instance, under conditions of flexible rates, macroeconomic policies of a country determine the market expectations of the nominal exchange rates in the medium-term (Coyle, 2000, p. 23). Also, under conditions of flexible rates, changes in the exchange rates are a result of the level of growth of the domestic economy which is a function of the adopted macroeconomic policies (Sanchez, 2005, p. 5). Under the elasticity flow model of the foreign exchange market (Johann, 2008, p. 8), movements in the exchange rates are determined by the flow of demand and supply of foreign exchange, which themselves are influenced by the forces of demand and supply of imports and exports (Lim, 2003, p. 7). Slight changes in prices trigger exogenous shocks that cause appreciation or depreciation of exchange rates away from the equilibrium level (Horne, 2004, p. 528). The asset market approach to determining exchange rates holds that movements in exchange rates occur as a result of factors that influence the prices of assets as well as market expectations of future rates (Sanchez 2005, p. 7). This explanation is entailed in the monetary model of determining exchange rates which provides clear cut predictions that link the macroeconomic fundamentals of money supply together with its demand in countries with the expected and actual changes in exchange rates (Bailliu & King, 2005, p. 9). Another factor that influences movements in exchange rates is changes in the rates of interest. There is a close relationship between the rates of inflation, interest rates and exchange rates in an economy (Coyle, 2000, p. 24). This relationship is evident in both the nominal interest rate (that quoted by financial institutions) and the real interest rate. Because of this linkage, a number of factors which influence both nominal and real interest rates cause a negative or positive correlation between interest rates and exchange rates (Archer, 2005, p. 45). For instance, shocks resulting from high levels of inflation cause a negative correlation between interest rates and exchange rates (Archer, 2005, p. 46). High inflation leads to depreciation of the local domestic currency in relative to others; leading to high interest rates (Edwards, 2000, p. 17). In the same way, disinflationary policies, while lowering the general level of inflation in an economy, cause a negative relationship between interest rates and exchange rates (Coyle, 2000, p. 26). This is because lower interest rates reduce the relative return to lenders in a country, thus decreasing the exchange rates (Edwards, 2000, p. 19). Another factor that influences movements in exchange rates in an economy is the general level of political stability in a country. Countries having stable political environments with well performing economies tend to attract and sustain both foreign and domestic investment, which in return enhances the stability of the currency and the markets. This reduces the level of volatility of the exchange rates in the economy. However, Lim (2003, p. 4), observes that although there is a positive correlation between political stability (political risk) and movements in exchange rates, the exact effect of political risk on movements in exchange rates of countries remains marginal. The effect of political stability also determines changes in exchange rates by influencing the exchange regime adopted by a country (Edwards, 2000, p. 16; Pailwar, 2010, p. 204). Whereas high political instability increases the cost of abandoning the peg in a country having the pegged exchange rate regime, the choice of an exchange rate regime to be adopted by a country is a factor of an empirical decision-making process (Pailwar, 2010, p. 206). Prospects of investment growth and general enabling environment enhance the level of investment even when the rates of interest are high (Edwards, 2000, p. 15). Lastly, the level of public debt plays an important role in the movements of exchange rates in an economy. In the event of the public debt becoming unsustainable, as a result of government borrowing to sustain consumption expenditure, the economy may get into a debt trap which jeopardises the macro-economic environment (Pailwar 2010, p. 207). Also, poor debt rating increases the rate of inflation, leading to movements in the exchange rates (Edwards,2000, p. 17). Strategies adopted by the Reserve Bank of Australia The need for official intervention in the foreign exchange market is necessitated by the fact that fluctuations between currencies create currency risk which, if not managed, reduces or increases the anticipated income or expenditure in foreign exchange trading (Coyle, 2000, p. 6). For the case of Australia, the fact that the country uses a floating exchange rate system means that the value of the Australian dollar is in constant fluctuation due to the effect of changes in financial conditions in both domestic and foreign markets (Liu, 2007, p. 3). The need for the Reserve Bank of Australia to take intervening measures arises from the fact that many businesses in the country are affected by fluctuations in the exchange rates of the Australian dollar (Liu, 2007, p. 4). The RBA is therefore required to develop an optimal hedging model that can be used to cushion the local economy against currency risk and its possible effects of poor financial indicators. Also, the need for official intervention in the foreign exchange market is due to the following factors: one, the need to influence the level of exchange rates; two, in order to contain the volatility of the exchange rates; three, so as to build reserves as a precautionary move and lastly, in order to influence the speed of currency appreciation or depreciation (Adler & Tovar, 2011, p. 8). One common strategy employed by the Reserve Bank of Australia in its intervention activities in the foreign exchange market is seeking to reduce disorderliness in the market by targeting to return the exchange rate to a level the bank deems appropriate (Becker & Fabbro, 2006, p. 14; Kim & Sheen, 2002, p. 632). In this case, the RBA uses its monetary policy together with long-term purchasing power parity considerations to correct any short-term speculative bubble or surge. This strategy is commonly referred to as leaning against the wind (Adler & Tovar, 2011, p. 8). Also, the RBA may seek to calm the market in its intervention. This may be necessitated by the existence of disorderly conditions resulting from excessive fluctuations, higher volatility, and uncertainty and higher trading (Newman, Potter & Wright, 2011). In such a scenario, the RBA seeks to reduce uncertainty in the market by reducing the level of volatility in the daily changes in exchange rates (Neely 2000, p. 17). It is observed that the bank intervenes in the market when there is a rise that is manageable. On the other hand, on days when there is excessive one-way speculation or highly volatile movements in the exchange rates, the bank avoids intervening in the foreign exchange market (Newman, Potter & Wright 2011). Thirdly, the RBA’s intervention in the foreign exchange market is guided to a small extent by the profit gaining strategy (Becker & Fabbro 2006, p. 19). It is observed that in practice, the actual strategy by the institution is to seek to minimise cumulative losses that are inevitable as a result of pursuing the first two objectives: calming the market and stabilising the exchange rate (Kim & Sheen 2002, p. 637). Since these losses become a binding constraint on the bank, profitability becomes a secondary strategy for its intervention in the market. It is important to note that when taking intervening measures in the market, the bank considers its actions based on the profitability of its previous activities (Kim & Sheen 2002, p. 638). The last strategy employed by the RBA is seeking to correct exchange rate deviations from the implicit targets set by the bank (Neely & Weller, 2013, p. 26). Fluctuations in either the domestic or foreign exchange rate causes widespread changes in the spot exchange rates over a medium-term horizon. Since these changes take a longer time than what is anticipated under normal circumstances, they cause distorting effects which the bank seeks to eliminate by its intervention (Neely 2000, p. 19). Further, it has already been observed that the RBA intervenes in the foreign exchange market with the objective of achieving particular effects in the market. The efficiency of its intervention strategies, however, depends on a number of factors. For instance, the bank employs its discretion in determining the timing and extent of its intervention actions (Liu, 2007, p. 7). As such, the bank uses large transactions which are carried out at the right time when the market is liquid in order to have the desired level of impact Newman, Potter & Wright 2011). Further, the bank has based most of its intervention transactions in the spot market. As such, the bank is able to offset any negative liquidity effects on the local market by use of foreign exchange swaps (Liu, 2007, p. 9). According to Neely (2000, p. 17), the general strategy used by the RBA in intervention in the foreign exchange market is similar to what is employed by the Federal Reserve Bank of New York. For instance, both banks basically employ the same types of intervention which include: the use of both unsterilized intervention (that which changes the monetary base) and the sterilised intervention strategies that do not change the monetary base of the economy (Kim & Sheen, 2002, p. 641). Also, both banks have shown similarity in the manner in which they use spot and forward markets for interventions. Both institutions have used these tools simultaneously and discreetly, with no effects on the foreign exchange reserves data (Neely, 2000, p. 10). It is common for the Federal Bank of New York, just like the RBA, to use currency swaps as a flexible means of sterilising spot interventions in the foreign exchange markets (Archer, 2005, p. 54). Conclusion From the discussion, several conclusions can be drawn. One, it can be seen that the effects of factors such as public debt, terms of trade, political stability in a country, economic performance, and current account deficits influence movements in exchange rates both in the middle- and long-term. Two, since the exchange rate can be viewed as the price of two corresponding currencies, changes in exchange rates therefore occur as a result of demand and supply forces in the market. This implies that changes in exchange rates can be viewed in terms of two models: movements resulting from macroeconomic fundamentals and those resulting from changes in the microstructure of exchange rates. Concerning the strategies employed by the Reserve Bank of Australia in its intervention in the foreign exchange market, it can be seen that several strategies inform the bank’s actions – top among them being calming the market, stabilising market conditions, seeking to minimise losses from its prior activities and maintaining the level of interest rate within the perceived equilibrium level. These strategies and tactics are similar to what the Federal Bank of New York uses in its interventions. References Adler, G. & Tovar, C. E. (2011). Foreign exchange interventions: A shield against appreciation winds? IMF Working Paper Series No. 11/165. Retrieved 10 August 2013, from: http://www.imf.org/external/pubs/ft/wp/2011/wp11165.pdf Archer, D. (2005). Foreign exchange market interventions: Methods and tactics. BIS Papers Series No. 24: 40 – 55. Retrieved 10 August 2013, from: http://www.bis.org/publ/bppdf/bispap24d.pdf Bailliu, J. & King, M., R. (2005). What drives movements in exchange rates? Retrieved 10 August 2013, from: http://faculty.haas.berkeley.edu/lyons/Bailliu_King_what%20drives%20movements.pdf Becker, C. & Fabbro, D. (2006). Limiting foreign exchange exposure through hedging: The Australian experience. Research Discussion Paper 2006 – 09, Reserve Bank of Australia. Retrieved 10 August 2013, from: http://www.rba.gov.au/publications/rdp/2006/pdf/rdp2006-09.pdf Coyle, B. (2000). Foreign exchange markets: Currency risk management. Canterbury: Financial World Publishing. Edwards, S. (2000). The choice of exchange rate regime in developing and middle income countries, in Ito, T. & Krueger, A., O. (eds). Changes in exchange rates in rapidly developing countries: Theory, practice and policy issues. London: University of Chicago Press. Horne, J. (2004). Eight conjectures about exchange rates. Journal of Economic Studies, 31 (6), 524 – 548. Johann, R. (2008). Determinants of an exchange rate: An analysis. Retrieved 9 August 2013, from: http://books.google.co.ke/books?id=GaC7XMjQiFcC&printsec=frontcover&source=gbs_ge_summary_r&cad=0#v=onepage&q&f=false Kim, S. & Sheen, J. (2002). The determinants of foreign exchange intervention by central banks: Evidence from Australia. Journal of International Money and Finance, 21, 619 – 649. Retrieved 10 August 2013, from: http://wwwdocs.fce.unsw.edu.au/banking/seminar/2002/Suk-JoongKim.pdf Lim, J., J. (2003). Political risk and the exchange rate: An exploration with a regime switching model. Retrieved 10 August 2013, from: http://www.jamus.name/research/ipe3.pdf Liu, C. H. (2007). Foreign exchange hedging and profit making strategy using leveraged spot contracts. PhD thesis, Victoria Graduate School of Business. Retrieved 10 August 2013, from: http://vuir.vu.edu.au/1474/1/liu.pdf Neely, C. J. (2000). The practice of central bank intervention: Looking under the hood. Retrieved 10 August 2013, from: http://research.stlouisfed.org/publications/review/01/04/1-10Neely.qxd.pdf Neely, C. J. & Weller, P. A. (2013). Lessons from the evolution of foreign exchange trading strategies. Federal Reserve Bank of St. Louis, Working Paper Series No. 21D. Retrieved 10 August 2013, from: http://research.stlouisfed.org/wp/2011/2011-021.pdf Newman, V., Potter, C. & Wright, M. (2011). ‘Foreign exchange market intervention’ in, Bulletin- December Quarter, 2011, The Reserve Bank of Australia. Retrieved 10 August 2013, from: http://www.rba.gov.au/publications/bulletin/2011/dec/7.html Pailwar, V., K. (2010). Economic environment of business. New Delhi: PHI Learning Private Limited. Sanchez, M. (2005). The link between interest rates and exchange rates. European Central Bank Working Paper Series, No. 548. Retrieved 10 August 2013, from: http://www.ecb.int/pub/pdf/scpwps/ecbwp548.pdf Read More