Emerging Economies and Floating Exchange Rates - Literature review Example

Topic: Lecturer: Presentation: Introduction Emerging market economies are those economies which are rapidly developing and lie between developed and developing countries. Major emerging market economies include: Argentina, Brazil, Chile, China, Columbia, Hungary, Hong Kong SAR, Russia, South Africa, Thailand and Mexico among others (Bank for International Settlements (BIS), 2009, 15). Most of these economies adopt a floating exchange rate although they exercise some control or intervention in exchange rates to control capital flows. Healthy economies according to the monetarists are those whose monetary authorities or government are better able to control their monetary policy or money supply in the economy. This is because money matters in the economy especially if it is mismanaged as it impacts on income, output and prices. However, Keynesians differ and would rather go for fiscal measures in controlling the economy. Capital flows is one component of money in the economy and which matters most for monetary policy, management of liquidity and financial stability. They determine how an economy performs against other economies in the world. To control these capital flows, an effective exchange rate regime is essential especially for emerging market economies which depend heavily on capital inflows and these can destabilize the domestic market conditions if not well managed. During pre-WWI world currencies were pegged on gold standard which was abandoned after the war. However, in post-WWII, the Bretton Wood conference imposed capital account restrictions hence fixing exchange rates until 1973 when a generalized floating of major currencies occurred and which continues to dominate to date. In this essay, I will argue that emerging market economies with floating exchange rate are better able to deal with problems associated with sudden capital inflows or outflows. This is supported by empirical evidence which also show failure in fixed exchange rate to accomplish the same (BIS, 2009; Weber & Towbin, 2011). Moreover the Mundell-Fleming logic posits that “fixed exchange rates are preferable where nominal disturbances dominate and flexible exchange rates where real disturbances dominate” (Weber & Towbin, 2011). Moreover, floating eases the monetary policy for other uses such as inflation targeting and control of interest rates for sound domestic financial system. The paper will be divided into sections. First section will be definition of concepts used. Secondly, a brief history of exchange rate regimes. Thirdly, capital flows will be discussed. Fourthly, the functioning of floating exchange rate in controlling capital flows will be discussed and lastly, a brief summary. Definition of Concepts Definition of concepts is very crucial in helping to understand the problem under study. Money is used as a medium of exchange, unit of account, and store of value. The demand and supply of money in the market determines the effectiveness of the economy hence the preoccupation of the monetary authorities in controlling its supply. The Federal Reserve Bank Board (2015) defines money supply as “a group of safe assets that households and businesses can use to make payments or to hold as short-term investments.” It is the amount of money in circulation at any given time in an economy and is mostly regulated by the central bank or Federal Reserve Banks of various countries. It is measured by use of monetary base, M1 and M2 whereby the base is the sum of currency in circulation plus reserve balance, M1 is currency held by public and transaction deposits at depository institutions and M2 is M1 plus savings deposits and retail money market mutual fund shares. However, different economies adopt different measures. It affects price level, inflation, exchange rates and business cycle hence the continued reliance on monetary policy to control inflation (Friedman, 1987). The monetary policy which refers to “any policy related to supply of money” (Labonte & Makinen, 2006, 1) aims at price stabilization, economic growth, interest rate stabilization, controlling unemployment, and stabilizing foreign exchange and financial markets. In doing this it employs different strategies such as inflation targeting, and exchange rate targeting. Inflation refers to overall level of prices and it is not good for the economy as it leads to capital flight, discourages investments and erodes savings. As such, stabilizing prices through inflation targeting is vital. The reason behind use of monetary policy is that “money matters” given current financial system with flexible exchange rates and high degree of capital mobility. Inflation targeting is defined by International monetary fund as “the public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets” (IMF, 2015). Each country’s monetary authority’s sets inflation target depending on its economic conditions and this is regulated mostly by use of interest rates or other monetary tools. For example, Australia Reserve Bank sets its target at 2-3%, Bank of England 2%, and Bank of Canada 2%.When inflation is above target, interest rates are raised and when it is below target, they are lowered to stimulate the economy thus raising prices. Monetary policy concentrates on interest rates as they are the channel through which money supply is transmitted to real economy (Labonte & Makinen, 2006). Exchange rate is the rate at which one currency exchanges for another in the foreign exchange (forex) market or “the value of one country’s currency in terms of another currency” (O’Sullivan & Steven, 2003, 458). Strengthening of the domestic currency against the foreign currency is regarded as appreciation while weakening of domestic currency or strengthening of foreign currency is depreciation. Appreciation makes exports expensive and imports cheaper thus stabilising balance of trade (BOT). The role of monetary authorities is to set an exchange rate regime that is appropriate for its economic conditions. Some countries use fixed rate regimes while others adopt floating exchange rate regimes. Fixed regimes is whereby government intervenes in currency market to ensure exchange rate stays close to exchange rate target whereas floating exchange regime is whereby exchange rate is determined by market forces of currency demand and supply (tutor2u, 2015). The history of exchange rate regimes dates back to pre-World War 1 (1870-1914) and it is the primary concern for emerging market economies and secondary concern for OECD countries such as the UK. During this time, currency was pegged on a gold standard; that is, fixed exchange rate to gold ounces (Mehmet, 2008). It was then abandoned during WWI. It was again revived after WWII by the Bretton Wood institutions such as the IMF. This was in order to promote foreign trade and ensure economic stability. These institutions fixed the exchange rate against U.S dollar which was in turn pegged against gold at US$ 35 per ounce. The U.S could not withstand such monetary pressures hence it adopted floating system in 1971 and other economies followed suit. This has been the favourite of many economies since then. However, there are different exchange regimes under the fixed and floating systems as it is not possible to maintain a pure exchange regime system. These include: managed floating, free floating, pegged regimes, and semi-fixed, (Mehmet, 2008, 181; tutor2u, 2015). On free floating regime, value of currency is determined by market demand and supply in foreign exchange market with no pre-determined official target by government. However, it is rare to exist since governments often intervene (tutor2u, 2015). Managed floating is just like free floating regime but with government controls to manage value of currency. A semi-fixed regime is characterised by setting of specific targets and currency allowed to fluctuate between permitted bands. Fully-fixed regime employs a single fixed exchange rate without any fluctuations allowed. For example, the UK had fixed regime from 1944-1972, managed floating from 1972-1990, semi-fixed from 1990-1992 and thereafter floating (tutor2u, 2015). Same case applies to Australia with currency pegged to sterling and US dollar from 1931 to 1974, crawling pegs in 1976, and floating regime from 1983 onwards (Weber & Towbin, 2011, 43). Examples of emerging economies with floating exchange rate include: Brazil, Colombia, Hungary, India and South Africa. Those with free floating include: Australia, Canada, Mexico (Calvo & Reinhart, 2002; Levy-Yeyati & Sturzenegger, 2005). The advantage of pegging currencies is economic stability hence encouraging foreign investments (BIS, 2009). Since exchange rate is fixed, the investors are able to predict the value of their investments as opposed to when these rates fluctuate. This also helps to reduce inflation due to reduced speculation and also to generate demand. However, the peg is not easy to maintain in the long-run especially during crisis as evidenced by the Asian crisis of 1997. Research (Weber & Towbin, 2011) indicates that fixed regimes are suitable for economies with homogenous imports and high degree of foreign currency debt. Empirical evidence (Ghosh et al.1997) revealed that output volatility is lower in flexible regimes while inflation volatility is higher. The flexible regimes thus insulate better from shocks to world output and world real interest rates. This is because exchange rate can adjust and stabilise demand for domestic goods through expenditure switching. The advantage of floating is that it results in automatic adjustment for countries with large balance of payment deficit (Tutor2u, 2015). These deficits cause large outflow of currency hence depreciating local currency. This in turn leads to the decline in price of exports and increased price of imports in domestic market. As such, it helps reduce deficits in BOT. It also enables the government to concentrate on other monetary measures such as interest rates and open market operations hence fleeing monetary policy; no concentration of monetary policy on fixing and maintaining exchange rates. The conduct of monetary policy is influenced by capital flows especially in a globalised world with free movement of capital among countries. Capital inflows represent non-resident purchases of domestic assets while capital outflows refer to resident purchase of foreign assets .The foreign direct investments (FDI) are capital inflows and thus an important component of money supply in the economy which needs to be managed especially for emerging market economies to avoid huge BOT deficits. These capital flows especially inflows are very volatile hence can have a great impact on domestic financial institutions of emerging economies. Empirical evidence (BIS 2009: cited in Broto et al 2008) shows that macroeconomic soundness; that is, higher GDP per capita and ratio of reserves to imports, and lower inflation decreases volatility of FDI. The development of domestic financial system was also negatively correlated with volatility. This calls for a floating exchange regime which is self-correcting. If the demand for local currency is low, it loses value making imports to become more expensive. This in turn stimulates demand for local goods and services leading to high output and employment in the economy. The floating exchange rate regimes were adopted by these nations in the wake of financial crisis that hit Mexico in 1994, Asia and Russia in 1997 due to failure of pegged rates to correct the situation and desire to hold more forex reserves (BIS, 2009, 10; Mehmet, 2008). Interest rates were being used to support exchange rate peg hence undermining monetary control leading to their failure. These crises were a result of huge capital inflows into the EMEs without strong banking systems and developed capital markets. However, floating enabled them to regain control of domestic monetary conditions by enhancing effectiveness of monetary policy. For example, while Mexico was forced to devalue its peso by 30%, Australia was not much affected as it was already floating and applying inflation targeting; instead the shock was borne by the exchange rate leading to dollar depreciation of about 20% (BIS, 2009, 43). Moreover, the Reserve Bank does not have to keep sterilising volatile capital flows and also large capital flows and exchange rate changes are not hindrances to conduct of monetary policy. BIS (2009, 15) indicates that by 2006, total holdings of foreign assets by major EMEs was $6.7 trillion and $8.4 trillion due to reserve accumulation. There are various factors that affect regime choices such as optimum currency area (OCA), optimal stabilisation policy, monetary policy credibility, and currency crisis, political and institutional variables. Researchers (Calvo & Reinhart, 2002; Gosh et al. 1997) also found that there is a difference between de jure (what countries say) and de facto (what countries do) exchange rate regimes. This according to Calvo and Reinhart (2002) is due to fear of floating. They fear floating due to their small variations in nominal exchange rate while at the same time having bigger shocks, interest rates and reserve movements. Unexpected depreciation can thus have great impact on domestic financial stability, but as Weber and Towbin (2011, 1) found out, “flexible regimes can insulate output better from real shocks (world output and real interest) because exchange rates can adjust and stabilise demand for domestic goods through expenditure switching.” Some of OCA variables that affect regime choice according to these studies are size of economy, trade openness, degree of economic development and geographical concentration of trade (Mehmet, 2008). Inflation, terms of trade and foreign exchange reserves also affect choice. For example, empirical studies (Mehmet, 2008: cited in Edwards, 1996; Von & Zhou, 2005) showed that economic development (GDP per capita) is significantly correlated with floating regimes and so is inflation and size of economy although not significantly related. This may help to explain why emerging economies prefer flexible regimes due to their large size. Conclusion Emerging market economies are faced with huge capital flows especially in form of inflows and if they do not have a sound domestic financial system and developed capital markets, they are prone to external shocks and other risks. This is especially so if they adopt a fixed exchange regime as it undermines monetary control thus making it unable to deal with such shocks. A floating regime on the other hand, as evidenced by the case of Australia during the financial crisis of 1990s is able to absorb the shock and save domestic economy from destabilisation. This is because the shocks are borne by the exchange rate hence do not compromise the monetary policy. Moreover, floating exchange rates are self-correcting due to market demand and supply pressures leading to financial stability. The implication of this is that emerging market economies should ensure optimal response to large and volatile capital flows by developing sound macroeconomic policies, appropriate levels of reserves and a flexible exchange rate regime. References Bank for International Settlements. (2009), Capital flows and emerging market economies, Report submitted by working group established by the Committee on the global financial system, CGFS Papers, No 33. Calvo, G and Reinhart, C. (2002). Fear of floating, Quarterly Journal of economics, 117 (2), 379–408. Friedman, M. (1987), Quantity theory of money, Palgrave: a dictionary of economics. Ghosh, A.R., Gulde, A.-M., Ostry, J. and Wolf, H. (1997), Does the nominal exchange rate matter?, NBER Working Paper, No: 5874. IMF. (2015), Inflation targeting holding the line, Available at:http://www.imf.org[Accessed 15 Feb 2015] Labonte, M and Makinen, G. (2006), Monetary policy and price stability, New York: Nova. Levy-Yeyati, E., and Sturzenegger, F. (2005), Classifying exchange rate regimes: deeds vs. words, European Economic Review, 49 (6), 1603-1635. Mehmet, G. (2008), The determinants of exchange rate regimes in emerging market economies, International Conference on Emerging Economic Issues in a Globalizing World, Izmir. O’Sullivan, A and Steven, M.S. (2003), Economic principles in action, New Jersey: Upper Saddle River. Tutor2u. (2015), Fixed and floating exchange rates. Available at:http://tutor2u.net/economics/content/topics/exchaangerates/fixed-floating.htm[Accessed 15 Feb 2015]. Weber, S and Towbin, P.( 2011), Limits of floating exchange rate: the role of foreign currency debt and import structure, IMF Working Paper, No. 11. Read More