Exchange Rates of the Countries - Essay Example

Name: Course: Course code: Tutor: Date: Introduction Every country has a freedom to choose the kind of exchange rate that suits to its needs as provided by Article IV of the 2nd Amendments to the Articles of Agreement of international Monitory Fund. The choice of an exchange rate system by any country affects the way that country conducts its local and foreign operations For several countries, the choice of the proper exchange rate has never been an easy task especially if they were only faced with the classical dichotomy of fixed and floating rates. It has been seen that some countries having floating exchange rates have regularly intervened in the foreign exchange market in order to stabilize their rates, while others that have fixed exchange rates avail themselves leaves their exchange rates to be determined by the market forces. In this situation, such countries are affected by arrangements adopted by various countries. As a matter of fact, there are some problems in defining whether the currency of a given country id floating or fixed. For example, countries that use European currency are referred to fixed and floating apart from such factors as inflation and interest rates, exchange rates is one of the critical determinants of the relative economic health of a country. It plays a critical role in the level of trade of a country, which is also paramount to a free market economy in the world. As a result of this, exchange rates and what determines them becomes the most critical subject under study by several scholars in the current economy. Exchange rates affects the bigger and smaller business portfolios therefore its worth to study the reasons behind the determinants of exchange rates Overview on the determinants of exchange rates Before examining what determines the exchange rates, it is good to sketch out the movements of exchange rates and how they affect the trading relationship between one country and the others. A higher currency makes the export of a given country to be relatively expensive and the imports become cheaper in foreign markets. On the other hand, a lower currency makes a country’s exports to be much cheaper and its imports become relatively expensive. In most cases, a higher exchange rate lowers a country’s balance of trade whereas a lower exchange rate increases a country’s balance of trade. When it comes to size, Forex market is one of the largest markets irrespective of its counter market. Interbank market is the largest market for currencies with forward contracts and trade spots. The market can be regarded as efficient with enough breadth, resilience and debt. The following are some basic theories underlying the exchange rates 1. The law of One Price- In competitive market that has no transport costs and other entry barriers, similar products sold in various countries must have similar prices when the prices are expressed in terms of their similar currency. Parity in purchasing power: Since inflation pushes prices to go up in one country than other countries, the exchange rate will certainly change to show the changes in comparative buying power of both countries 2. Effects of Interest Rates- if capital is allowed to flow freely, the exchange rates are stabilized at a point where equality is achieved. The Fisher Effect: nominal interest rate (r) of a particular country is determined by the real interest rates R and rate of inflation r as shown below (1 + r) = (1 + R) (1 + i) International Fisher Effect: the sport rate has to change in same amount in the opposite direction to the difference in interest rates in two countries S1 - S2 ----------- X 100 = i2 - i1 S2 Where: S1 = spot rate using indirect quotes at beginning of the period; S2 = spot rate using indirect quotes at the end of the period; i = respective nominal interest rates for country 1 and 2. Although the above principle seeks to explain the changes in the exchange rates, the assumptions in both theories are rarely recognized therefore the two theories cannot be directly applied The forces of demand and supply determine the exchange rates. Several factors affect these which in turn affect the interest rates The business environment: positive market indications such as market size, government policy and competitive advantages etc. increase the demand of the currency and more organizations could wish to invest there. Such investment motives comprises of business motive and for risk diversification motives. Foreign direct investments take the advantage of economies of scale and comparative advantage whereas portfolio investment is majorly done for the purposes of risk diversification Stock Market: The key stock indices have some relationship with the currency rates where the Dow has been having some greatest influence on the dollar. There has been a positive correlation between the index and the dollar since mid-1990s as foreign investors continue to buy US equities. Indices are affected by three major forces 1. Corporate earnings, actual and forecast 2. Interest rates expectation and 3. International considerations. Therefore, such factors find their way through the local currency Political factors: almost all exchange rates are vulnerable to political instability and expectations regarding to the new party to come into power. Coalitions in such countries such as Germany, France, Italy and India pose a threat exchange rate. Let us take a good example of Russia where its political instability became a red flag to EUR/USD as a result of Germany directing its investments to Russia Political Factors: All exchange rates are susceptible to political instability and anticipations about the new ruling party. A threat to coalition governments in France, India, Germany or Italy will certainly affect the exchange rate. For example, Political or financial instability in Russia is also a red flag for EUR/USD, because of the substantial amount of Germany investment directed to Russia. Economic Data: Economic data items like unemployment rate, payrolls, and average hourly earnings), PPI, CPI, GDP, industrial production, productivity, consumer confidence, international trade, etc. also affects the exchange rate fluctuations (Lane). Having confidence in the currency also determines the exchange rates. Decisions are made based on future considerations on what might affect the currency where any adverse opinions may have an effect of contagion Most observers have concluded currency devaluations must be avoided by all means because panics have resulted to currency devaluations. Others are of the opinion that it is not devaluation but instead the protection of the exchange rate after the crisis that lead to financial terror. The devaluation preceding the exhaustion of reserves in most cases gives an alarm to the market to the depletion of reserves, a situation which may not fully seem to various participants in the market before the occurrence of devaluation. Owners start to change their money into foreign exchange in anticipation of devaluation, and assume that the central bank will defend the exchange rate by buying money and selling dollars. Therefore a panic can unfold as a result of creditors believing there devaluation will occur. In the previous years, panic have been triggered by the following events When it is discovered that the reserves are getting depleted and it is less than it was expected Unanticipated devaluation mostly in part for its role in providing an alarm in relation to exhaustion of reserve Contagion from nearby countries, in a case of perceived vulnerability (overvalued currency, low reserves, high short-term debt). Influence from the government: government may decide to reduce the money in circulation within the country, increase the interest rates and encourage the demand of the local currency. In some other cases the government may decide to buy or sell forex so as to maintain stability or to offer support to its exporters and importers (MacDonald). Productivity of an economy- increase in the productivity of an economy has some impacts on the exchange rate. This is majorly felt if there are some increases in the traded sector. According to the resent study carried by Federal serve Bank of New York, it is seen that for over 30 years productivity has changed and there has been changing and the dollar/euro real exchange rate have been moved Factors determining the exchange rate Economic rate Any change in economic can be explained by the income effect. Any increase in income causes more demand of imported goods and services due to the increase in disposable income of the entire population. The increase in imports pushes a country’s supply of money and the depreciation in its value. This can be explained by the graph below showing the relationship between changes in the growth of GDP and the exchange rate between two countries Source: Own research (2016) Its been seen that the growth in GDP is very important in explaining the depreciation for those countries with inflation rate less than 30% Inflation rate Theoritically, the exchange rate has to reflect the trends in productivity and inflation. Any increase in price level leads to depreciation of a country’s currecncy since more expensive products in the local market encourages consumers to import the products from the foreign markets therefore increasing the supply of currency Picture 2: the relationship between the exchange rate and inflation rate Source: Own research (2016) From the above picture, it can be deduced that there has never been a clear relationship between changes in exchange rate and inflation rate. It can also be seen that inflation rate in 2009 was relatively high by 3.7 points. During this period, the currency depreciated by 23% confirming the theoretical relationship. Therefore, it can be stated that increase in inflation leads to depreciation in exchange rate. Nonetheless, such reasoning shows some long term relationship. Short term factors such as speculations and carry trade plays a critical role Interest rates Every country that maintains high interest rates usually attracts huge short-term capital flows where the currency of that country will depreciate. Increase in interest rates due to global crisis within a given country pushes investors to invest in other emerging markets therefore depreciating the country’s currency (Lane). For instance, in 2010, a country like Poland had its zloty increasing but could not be justified by its change in its interest rates Picture 2: The picture below shows the relationship between the interest rates and exchange rates Source: Own research (2016) Government deficit Huge government deficit of any given country increases the chances of the government borrowing in the money market. In most instances, foreign investors and banks together with local banks are the main creditors of the government who buy treasury bills and bonds to finance the budget deficit. High borrowing increases the inflow of the foreign currency into the domestic market which in turn increases the demand of the local currency. The relationship between the exchange rate and government deficit is complex and multidimensional and should be properly analyzed. In order to reduce inflation, there has to be fixed exchange rate so as to restrict not only the domestic credit but also the rate in the increase in interest rates which might increase the public debt. Source: Own research (2016) The picture above shows the difference between a country’s government deficit and the euro area between 2000 and 2013. During the period of 2001-2002, 2006-2007, 2008-2009 and 2010 and 2011, there was depreciation of the currency Balance of payment A country’s floating exchange rate on the international market is determined by the demand and supply of its currency. A country’s demand for a currency results from the net exports whereas supply of currency is as a result of net in foreign investments. Several researches have shown that international trade has contributed much on the exchange levels especially for those countries that import low-processed goods. The ever increasing demand for raw materials has led to the increase in prices in global markets. This enhances the ability to export more thus increasing the appreciation of the value of the domestic currency (Boykorayev). Picture 5: The relationship between balance of payment and the exchange rate Source: Own research (2016) From the picture above, it can be seen that there has been fluctuations in both balance of payments and exchange rates due to different expectations. From the trends shown in the picture, it can be summed up that exchange rate can be influenced by other factors Data analysis The following variables were used for the period 2009- 2015 − EUR/PLN (Y) – annual average exchange rate, − GDP (X1) - GDP growth rate, − HICP (X2) - the difference between inflation − IR (X3) - interest rates − CA (X4) - current account balance (% GDP), − FA (X5) - financial account balance such as portfolio investments, direct foreign investments, and other investments comprising currency speculation, % GDP). − Deficit (X6) - government deficits In order to ascertain factors determining the exchange rates, linear regression model was used and two stage least method was applied so as to estimate linear regression equation Y = ß0 + ß1X1 + ß2X2 + ß3X3 + ß4X4 + ß5X5 + ß6X6 +ê Where ê is the residual term comprising of other factors that were never used in the model such as non-economic factors like political factors Results 2%. The regression equation for this study is Y = 4,471 + 0,043 (GDP) + 0,084 (HICP) - 0,056 (IR) + 3,751 (CA) – 9,016 (FI) – 0,058 (Deficit) + ê Where R2 = 62, 3%, estimated standard error is 25, Variable Coefficient ß Standard deviation Significance GDP 0,043 0,098 0,675 HICP 0,084 0,074 0,296 IR -0,056 0,069 0,443 CA 3,751 9,500 0,707 FA -9,016 7,539 0,277 Deficit -0,058 0,114 0,627 Source: Own research 2016 R2, which was the coefficient of determination, made up 62.3% meaning that the model was not perfectly fitted. It shows that only 2/3 of the variation in the exchange rate between 2009 and 2015 can be best explained by the model. Fluctuations was a result of GDP, Interest rates current account balance and government deficit. It can be seen that only 37.7% of the variation was as a result of other factors not put into consideration. From the obtained results, it is confirmed that faster economic growth and increase in price level caused the depreciation of the interest rates. The in the current account deficit and financial surplus together with increase in interest rates majorly led to appreciation of interest rates. Nonetheless, from the analysis of this model, it can be deduced that the model is only a simplified picture of the reality, which is marred with lots of errors therefore results should be treated with caution Conclusion As it can be seen, exchange rates and what determines them becomes the most critical subject under study by several scholars in the current economy thus studies relating to the relationship between the exchange rates and what factors determines them has never been conclusive From the analysis it can be deduced that inflation rate and financial account balance have been the major determinant factors of exchange rate. It can also be seen that an increase in a country’s financial account surplus leads to the increase of the currency of a country; a rise in a country’s inflation rate affects has some negative effects and may reduce the country’s currency value Increase in interest rates leads to the appreciation of a currency since it lures the investors into a country. Another important factor that determines the exchange rate is the government deficit, whereas the current account and economic growth have less effect on the exchange rate. Based on the research, it is evident that fiscal and monitory policies have a role to play in determining the exchange rate changes. It is therefore recommended that the two policies have to be harmonized so as to provide an effective link between them and other policies such as trade and investment policies There has to be effective and smooth running of both monitory and fiscal policies so as to minimize inflation and stir up economic growth Works Cited Boykorayev, B. Factors that determine nominal exchange rates and empirical evidence of cross-sectional analysis. Aarhus School of Business, 2008. Ejaz, R.A., & Abbas, A., & Saeed, A.R. " Relationship between Exchange Rate and Budgetary Deficit: Empirical Evidence from Pakistan, ." Pakistan Journal of Applied Sciencies (2002): 56-77. Lane, P. "What Determines the Nominal Exchange Rate? Some Cross-Sectional Evidence,." The Canadian Journal of Economics (2009): 30-37. Lyons, R. The Microstructure Approach to Exchange Rates. Cambridge: Mass.: MIT, 2011. MacDonald, R. "Exchange Rate Behaviour: Are Fundamentals Important?, ." “Economic Journal (2009 ): 23-34. Read More