Analysis of The Domino Effect - Article Example

Through increased exports, the current account deficit tends to correct itself and bridge the gap. However, what has been observed that in the real world is something different. It has been observed that currencies of the countries with large deficits have witnessed great appreciation in the value over the period of time. The apparent reason for this appreciation in currency is the fact that the emergence of new emerging market economies like India, China, Brazil, South Africa, etc have witnessed a marked decrease in the overall risk profile of developing countries.

This coupled with increased interest rates saw the strong inflow of speculative capital into those countries which increased the overall attraction for the currencies of the countries having large current account deficits. The increase in the interest rates has been attributed mainly as the most important factor which attracts foreign investors and hence increases the overall attractiveness of the currency and helps stimulate its appreciation in the foreign exchange market despite country running a large current account deficit.

The author further cited the examples of some countries like New Zealand, Australia, Britain, and Iceland, which despite their large and persistent current deficits tend to have higher gains in their currencies. Theoretically, it has been argued that there is a relationship between the two variables however, empirical studies have proved it otherwise as there is very weak or no relationship between the two variables. These trends in current account financing, however, seems to be reversing because of the current financial turmoil in the markets.

The article further went on to discuss that the same relationship, however, does not persist over the sustained period of time and foreign capital inflows tend to dry up thus forcing current account deficits too much higher spreads. Further, the trends seem to hold when foreign investors investing in countries with high current account deficits tend to be more risk-averse. A slight change in the overall risk appetite of the foreign investors may reverse the relationship and with increased current account deficit, inflationary pressures may further damage the trust of international investors hence virtually reverse the process of current account deficit financing through high-interest rates.

The above graph shows the relationship between the Current Account Deficit (CAD) and the growth in currency in Australian Markets. This graph very clearly indicates that the relationship between current account deficit and the currency appreciation and shows that as the CAD accumulated so does the exchange rate. Another important characteristic that is depicted in the above graph is the rise of bank credit with the rise in CAD and exchange rates. The higher inflows of foreign investment finally seem to be ending up in the form of local bank deposits.

It is also important to mention that the article discussed the effect of foreign investments from two perspectives. First is a foreign direct investment which is believed to have a less volatile nature and fluctuate less with current account deficit, therefore, it has a lesser correlation with the exchange rates. However, the speculative portion of foreign investment, the so-called speculative capital, tends to show a relationship with the exchange rates and current account deficit.