Theories on Currency Crisis - Essay Example

Currency crisis. There is no universal definition of the currency crisis. Currency crisis happens when the value of the currency changes to the extent that it can no longer serve as a medium for exchange and store of value. During the period of currency crisis, major investors try to reduce their assets in the currency or get rid of it altogether and thus exacerbating devaluation process. There are several theories on currency crisis. One should however distinguish several models of currency crisis. 1)   Speculative attack model. According to this model currency crisis is caused by the attacks on the currency by speculators. These attacks in turn entail the depletion of international reserves and changing of the exchange rates. The cornerstone of these attacks is a poor monetary policy of the government (the gap between monetary policy and fixed exchange rate). According to Krugman, the prerequisite for the currency crisis is the budget deficit that in turn is financed by the credits; this process may entail the depletion of the reserves of the currency (reserves of the currency to which a national one is pegged). If the domestic interest rate equals foreign interest rate, than the supply of the money caused by the expansion will be more than the demand on the national currency. The surplus of the domestic currency on the market leads to the increased demand on the foreign currency. In order to satisfy demand on the foreign currency, the national bank has to sell the reserves of the foreign currency. Once the reserves have been depleted, the national bank will have to abandon its fixed exchange rates policy as it will have no sufficient reserves to sustain it(Crznar, Currency crisis: theory and practice with application to Croatia). Certainly as several decades have passed since the formulation of this model by Paul Krugman it has been readjusted to reflect current trends and realities, however in view of many critics this theory has one important flaw: contention that a government could be a passive observer on the market and will do little or nothing at all to remedy monetary and fiscal problems of the country. Usually the government could readjust its monetary and fiscal policy to the exchange rate regime it maintains. Second generation model. In view of the crisis of European Monetary System in 1992, new theories of causes of currency crisis have been developed. According to this model, the government maintains fixed exchange rate regime as long as it deems necessary to do so( it might do it to decrease inflation or to establish more predictable environment for its importers and exporters. However, the government will certainly jettison fixed exchange rate policy, if there are reasonable grounds to believe that it will lead to negative impacts in the economy. The proponents of this theory attributed the ultimate failure of the European Exchange Rate Mechanism to the negative impacts of the increase in interest rates in order to prevent the speculative attacks during the period of high unemployment. The final decision whether to maintain or abandon fixed exchange rate policy depends on macroeconomic situation in the country rather than some automatic forces as in the first theory. Once the government decides to abandon its fixed exchange regime, if its maintaining is harmful for the economy (for instance if there is a high unemployment), it could devaluate the currency; this step might correspond with actual expectations of investors and lead to the currency crisis. In both of these theories sound macroeconomic and fiscal policies can prevent the currency crisis. 2- International institutional system and the problem of moving developing countries to sustainable growth. Current world include many institutional systems, which are destined to increase the cooperation between the states and enhance the development of different countries. The most notable of these institutional organizations are UN, WTO, and IMF. All of the organizations mentioned try in one way or another to assist in the reformation of the economies of less developed countries and increased the level of living of people in those countries by active participation of more developed nations in trade process or financial organizations. However, the power in all of these organizations mentioned is concentrated in the hands of more developed countries. One country in the Security Council of the United Nations, that comprises five nations, may veto any decision accepted by other states (Kirton, Seven power summit as new security institution). This type of the system was devised in post war period, more than 50 years have passed and certainly current structure of these organizations does not reflect modern world. Many developing countries fear that they are being underrepresented in these vital originations and demand more representations in most important institutional bodies of the world. However, in my opinion the developing countries need not just more representations in these organizations but more direct investment that will help them to increase their growth rate and consequently the standards of living of their people. Private investors are driven by market rather than institutional factors. Certainly, these institutions might help less developed countries in the fighting against corruption, reforming tax systems and employment laws, which are prerequisites for the successful business of international investors. So far major investments in the developing countries have been in two forms: mergers and acquisitions (M&A) and Greenfield investments. M&A comprises acquisition of the companies or privatization of the public sector enterprises. Greenfiled investments are investments in the subsidiaries that represent one of the parts of the company (Multinational enterprises). However lack of human capital, high rate of illiteracy and absence of basic schooling might inhibit the development and attraction of FDI. Most of the developing countries should also facilitate the technological transfers and improve HRD programs. Moreover , most of the developing countries are export dependent and rely on the fluctuations of the prices on raw materials, as these fluctuations are unstable and the prices on the majority of the raw materials are decreasing thus the developing countries can not rely on this source as substantial financial resource of their income . In order however to understand the persisting growth problems of the less developed nations one should study current growth theories. There are several growth theories that should be considered in order to understand persisting growth problems of less developed nations. According to Solow growth theory the balanced growth is achieved only on condition that labor force, capital stock and the output would grow at the same rate. (John.B.Taylor, p.75). Many developing countries experience substantial growth in their labor force, without corresponding growth in their capital stock. Another theory-endogenous growth theory (John.B.Taylor, p.80) emphasizes the technology as one of the most important factors in the growth of different economies. According to this theory the increase in technology depends on several factors, such as availability of labor that can produce high technology, the expenditures on the production of the technology and current technologies. Many developing countries suffer from the lack of high-skilled and educated people, who can produce the technology as well as from the dearth of the capital that can be used in the production of the technology; most of the existing technologies in developing countries are too old and worn out. As the technology, according to this theory is without the diminishing return, additional technological innovations will result in increased growth; as developing countries do not have sufficient capabilities for this, their growth can be impeded for the reasons mentioned. 3) The difference between free trade and fair trade. Free trade is a process of trading goods and services among the nations without or with minimal trade barriers, wherever fair trade is process of trading that matches moral principles of justice. Free trade supposes free movement of goods and services; protectionism is widely viewed as an impediment to free trade process (Jeffrey Eisenberg, Point-CounterpointFree Trade Versus Fair Trade). However, developed nations often use protectionism by subsiding different types of industry (agriculture is one of the most heavily subsidized one), intervening in the markets of high technology, accepting one-trade agreement at etc. New developing countries may also protect their industries to develop their national economies. Nevertheless, the largest institutional of the free trade –World Trade Organization-WTO tries to reduce trade barriers and levels of protectionism in the trade among the countries. Supporters of the free trade content that free trade, without protectionism benefit the countries because it helps to reduce the cost of productions (as imported goods and services are cheaper), and this leads to the reduced cost of living. According to the studies conducted by WTO, protectionism of agriculture increases the cost of food in developed nations from $ 1500 per year for family of four in EU up to 3 billion $ ( for the sugar in the United States). The same trend is visible in other manufacturing industries, such as textile and manufacturing of the cars. However, the benefits of free trade do not confine to the manufacturing industries alone, the liberalization and free trade also make services cheaper- according to the WTO it reduces the price on the phone calls from 2% up till 4% both in developing and developed nations (Free trade cuts the costs of living, WTO). Whereas free trade strives to build the trade process without trade barriers, fair trade tries to reduce unfairness in trade between developed nations and developing countries. According to the proponents of fair trade practice there should be more fair relationship between the consumers in developed countries and the suppliers of raw materials in lesser developed ones. Most of the goals and aims of free trade and fair trade movement are similar; however fair trade supporters reject current form of free trade as unfair and injurious to developing countries. They content that modern methods of the trade make less developed countries dependant on more developed ones and deplete the resources of developing nations that entails in turn the slowing down of the growth. The fact that developing countries produce raw materials and their economies are largely exposed to the fluctuations of the prices on raw materials augment the situation and it leads to further impoverishment of the less developed countries. The prices on the raw materials are too low to compensate for the labor of the workers and can not provide them with sufficient financial resources to meet their ends. The fair price thus is one of the most important cornerstones of fair trade practice; according to fair trade organization fair price is established through negotiations and should include the fundamental principles of fair payment for work (About fair trade, key principles of fair trade, IFAT). However, as many critics of fair trade policy contend, the word “fair” is vague and highly partial to define. Even if the fair price is agreed upon it is not possible to make a final judgment whether the price is fairer when it is higher or when it is lower? If it is higher, then fewer workers would be employed, however they would be better of. If the price is lower than more workers would be employed, though their standards of living would be lower (Eisenberg, Point-Counterpoint Free Trade Versus Fair Trade). Unless these questions can be answered, it will not be possible to implement the theory of fair policy in practice. 4). Main types of international capital flows and the major determinants of these flows. International Capital Flows –“Financial flows of credit and ownership claims between countries. Flows of physical capital goods are typically treated as ordinary trade flows, not capital flows, in the balance of payments accounts” (Thomas A.Pugel, Glossary). There are several types of international capital flows, such as Foreign Portfolio Debt Investment, Foreign Portfolio Equity investment and FDI( Foreign Direct Investment). There are many trusts in developed countries that were established to covert no marketable assets into the securities that can be traded in the market. Such non-marketable assets as real estate mortgages are included in the trusts mentioned that in turn sell these securities to national and foreign investors. Foreign investment in the mortgage securities of the country are foreign debt investment portfolio (Ralph Kozlow, Exploring the Borderline between Direct Investment and Other Types of Investment: the U.S. Treatment). The level of FDPI depends on the mortgage rate as well as such factors as interest rate, the current trend in the security market and other factors. Foreign Portfolio Equity Investment (FPEI) is the process of purchasing of the small amount of the shares of the company.” By definition, foreign portfolio equity investment is distinguished from FDI by the degree of management control that foreign investors exercise in a company. Portfolio equity investors usually provide only financial capital without any involvement in a company’s management, and typically have a shorter-term investment horizon than direct investors”(World Investment Report 1997:Transnational Corporations, Market Structure and Competition Policy). As, one can see from definition a foreign investor in this case is not able to exercise a direct control over the management of the company. The level of Foreign Portfolio Equity Investment depends largely on macroeconomic and microcosmic factors alike. Investors are mostly interested in the possibility of capital formation of the company. Such factors, as economic indicators of the company, the level of professionalism and education of its workforce as well as the possibility for the research and development, access to the credits and possibilities for the innovations in the sector play important part in the decisions on Foreign Portfolio Equity Investment. “Foreign direct investment reflects the objective of obtaining a lasting interest by a resident entity in one economy (‘‘direct investor’’) in an entity resident in an economy other than that of the investor (‘‘direct investment enterprise’’). The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence on the management of the enterprise.” (OECD BENCHMARK DEFINITION OF FOREIGN DIRECT INVESTMENT, p.7) Several factors influence the decisions of foreign investors. These factors ultimately determine the level of foreign investment in the country. 1)    The size of the market of the national country (two major indicators are taken into account-GDP per capita as well as the strength of the middle class). The market is also evaluated on its potentiality to growth, the former factor is especially important for the less developing countries that should achieve high growth rates in order to attract investments. 2)    The participation of the country in different trade agreements or regional international organizations. This factor is taken into account because it might increase the demand on the products and services that investor provides, as more potential buyers have access to the market. . 3)    The availability of the pool of highly-skilled and well-educated workforce. However, this factor is widely considered by investors only in conjunction with wage-adjusted labor productivity. The workforce should not only be well-educated and experienced but should be productive as well 4) Such factors as well-developed infrastructure, stability of the tax system, strong legal system, stable and predictable political conditions as well level of corruption and bureaucracy influence the ability of the country to attract investments. Infrastructure includes such factors as the availability of good roads, electricity, clean water and telecommunications; tax system is quite important, and according to some experts tax incentives do not play critical role in the decision of the investors: stable political system must provide investors with free and transparent legal procedures in order to be effective; legal system should be well-developed, stable and predictable, the government should not attempt to change the regime in which most of the investors operate. 5). Differences in national business systems and how this creates barriers to international business activities. Current global economy represents many countries of all continents. They have different social, cultural, religious and political traditions. These traditions sometimes might impede and sometimes might facilitate trade and business activities between the countries. If for instance, some major Western company decides to establish its outfit in such country as Japan, it will have to take into account several social and cultural factors such as group consciousness of the labor force (where most of Japan’s workers regard their work collective as one of the most important groups of people in their life and can abandon some selfish interest for the sake of their group).It should also accept the fact that vital decisions are frequently taken only after the consultation with all workers, that seniority is frequently associated with management and mostly senior people are promoted to managerial posts. The companies should understand that on understanding of the social factors depends the successful development of their business. Cultural differences play very important part as well, and despite the fact that many Asian societies have many similarities, they have many differences as well. Differences between India and Pakistan , between Japan and China, between Middle Eastern and Mediterranean countries are quite sharp and should be examined more thoroughly by the companies before their start some ventures and expand to the new markets. From the export of food up to the trade in CD and video tapes social factors and elements should be taken into account. In many cases national feelings and distrust to the foreigners can lead to strained business relationship between the countries. Such feelings might still persist in different degrees in such countries as China and Russia, but they are receding and will, bound to recede in the decades to come. Political traditions, such as difference between parliamentary democracy and authoritarian regimes also influence business activities. On the whole, investors and international business might prefer more stable but open authoritarian regime rather than unstable democratic one (China have more investments than many countries in Eastern Europe). On the other hand, level of corruption in authoritarian regime may be higher and may impede the relationship between business companies of the countries. Works Cited. John.B.TAYLOR. Macroeconomics, W.W.Norton 1997. CampbellR, McConnel, Macroeconomics, McGraw Hill Book 1987. Eiteman DAVID K, Multinational Business Finance, 1995. Dolan Edwin G, Basic Economics, 1980. Ivo Crznar, Currency crisis: theory and practice with application to Croatia, Available form Hearing on Official Dollarization in Emerging-Market Countries Prepared Testimony of the Honorable Lawrence H. Summers Deputy Secretary United States Treasury, Available from http://banking.senate.gov/99_04hrg/042299/summers.htm. Kirton, Seven power summit as new security institution Available from Koji Miyamoto, OECD DEVELOPMENT CENTRE Working Paper No. 211(Formerly Technical Paper No. 211) HUMAN CAPITAL FORMATION AND FOREIGN DIRECT INVESTMENTIN DEVELOPING COUNTRIES 2003. Available from Jeffrey Eisenberg, Point-CounterpointFree Trade Versus Fair Trade Available from Anup Shah, Protectionism: evil; Economic Liberalization: good — an oversimplification, Available from Free trade cuts the costs of living Available from About fair trade, key principles of fair trade Available from Economic glossary, Available from Ralph Kozlow Exploring the Borderline Between Direct Investment and Other Types of Investment: The U.S. Treatment U.S. Bureau of Economic Analysis, Available from FOREIGN DIRECT INVESTMENT IN EMERGING MARKET COUNTRIES Report of the Working Group of the Capital Markets Consultative Group September 2003. OECD BENCHMARK DEFINITION OF FOREIGN DIRECT INVESTMENT, ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT, 1999. World Investment Report 1997: Transnational Corporations, Market Structure and Competition Policy, Available from < www.unctad.org/Templates/Download. asp?docid=714&lang=1&intItemID=2575 > Read More