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EllerEMBACurrencyDev aluationsinEmergingM arkets

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Information about EllerEMBACurrencyDev aluationsinEmergingM arkets
Business-Finance

Published on April 16, 2008

Author: Malden

Source: authorstream.com

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CURRENCY DEVALUATIONS IN EMERGING MARKETS:  CURRENCY DEVALUATIONS IN EMERGING MARKETS This class explores::  Why do currency crises occur? What factors would be useful to know? Why are currency crises so difficult to predict? This class explores: Q. Why do currency crises occur? :  Q. Why do currency crises occur? Currency crises occur when a fixed (or managed ) exchange rate mechanism is abandoned under duress. Under a floating FX rate system, the exchange rate decline is expected & a necessary component of the adjustment mechanism. A myriad of factors can cause currency crises to occur, i.e. economic, political, corruption, etc., however some data requires greater attention and is more objectively analyzed than other information. Let us focus on the four major economic variables monitored closely by the IMF: 1) Current Account deficits 2) Foreign Currency Reserves 3) The Real Exchange Rate 4) The Fiscal Deficit 1) Current Account deficits:  1) Current Account deficits Reported as a % of GDP. Why not list it as an absolute number? A large current account means that a country must either: a) Attract capital from abroad to gain access to the foreign currency it needs to cover the Current Account deficit or b) Draw down its stock of FX Reserves 1) Current Account deficits:  1) Current Account deficits Q. What level of Current Account deficit can be sustained? A. Typically, 1-3% of GDP can easily be financed by attracting FDI ( Foreign Direct Investment is considered a less risky source of capital ) or incoming portfolio flows ( more risky as is easily reversible ) Current Account deficits > 5% of GDP are in the danger zone 1) Current Account deficits:  1) Current Account deficits Whether a Current Account deficit can be sustained is also dependent upon: a) Whether a country is using imports to build productive capacity that will permit it to earn foreign currency in the future OR b) Whether a country is merely importing consumption goods The combination of a fixed/pegged exchange rate and sustained Current Account deficits is a highly watched indicator, though some countries in those situations have managed to avert a currency crisis 2) Foreign Currency Reserves:  2) Foreign Currency Reserves Two Foreign Currency Reserve measurements are commonly used a) % of GDP (focus is on a country’s buffer against capital shifts) b) Months of imports covered ( focus is on the size of Foreign Currency Reserves required for net import flows) A high level of Foreign Currency Reserves provides a buffer against devaluation This buffer should be greater if: a) The country has a significantly large short term foreign currency debt level and/or b) The country has experienced volatile capital flows 2) Foreign Currency Reserves:  2) Foreign Currency Reserves When faced with a persistent Current Account deficit, the Central Bank can either: a) Draw down its Foreign Currency Reserves This process causes no domestic economic dislocation, however this course of action is limited by the extent of the country’s Foreign Currency Reserves OR b) Attract foreign investment (FDI or Portfolio capital inflows) This course of action, ie. raising domestic interest rates, tax breaks for subsidiaries of MNC’s, etc. often encounters domestic opposition 3) The Real Exchange Rate:  3) The Real Exchange Rate Q. What is the difference between a “Nominal” exchange rate & a “Real” exchange rate? Nominal FX rate = The relative price of two currencies (this is visible to market participants daily) Real FX rate = The relative price of two identical baskets of goods in the two countries Q. What do real exchange rates tell us? It is the nominal FX rate adjusted for the relative inflation rates between the two countries Measures international competitiveness Sees the relative movements in prices after adjusting for exchange rate movements 3) The Real Exchange Rate:  3) The Real Exchange Rate Two Examples: 1) Let’s assume inflation in the US rises by 6%, while in Mexico it increases by only 4% (a 2% differential) However simultaneously, the US$ depreciates 3% versus the MXP. Thus US competitiveness has improved by 1% This is a real depreciation of the US$ against the MXP 2) Let’s assume inflation in Mexico rises by 10%, while in the US it increases by only 3% (a 7% differential) However simultaneously, the Mexican Peso depreciates 5% versus the US$. Thus Mexican competitiveness has decreased by 2% This is a real appreciation of the Mexican Peso against the US$ 3) The Real Exchange Rate:  3) The Real Exchange Rate Conclusion: a) If a country’s inflation rate differential vis-a-vis another currency > its nominal depreciation against that currency: then that currency is experiencing a real appreciation vis-a-vis the other currency b) If a country’s inflation rate differential vis-a-vis another currency < its nominal depreciation against that currency: then that currency is experiencing a real depreciation vis-a-vis the other currency 3) The Real Exchange Rate:  3) The Real Exchange Rate Q. Why does an increase in the real exchange rate create currency devaluation pressures? A. It hurts all firms that are exposed to foreign competition. Exporters suffer, because their costs are higher when measured in terms of foreign currency Firms facing import competition are hurt, because foreign producers are under no pressure to increase prices with domestic inflation 3) The Real Exchange Rate:  3) The Real Exchange Rate The impact of an increase in the Real Exchange Rate depends to a great degree on the Trade to GDP ratio An appreciation of the Real Exchange Rate of a country with a high Trade to GDP ratio is particularly worrisome Why? Because exports are not competitive in world markets, and imports capture a greater market share in the domestic market 4) The Fiscal Deficit:  4) The Fiscal Deficit This link’s (though impacting the firms Current Account) connection with currency crises is not clear cut If a country has a high domestic saving’s rate, then the fiscal deficit can be financed with local savings, ie. there is no need to borrow foreign currency funds from overseas, and thus there is no pressure on the FX rate. If a country has a low domestic saving’s rate, then typically Governments finance the budget deficit by easing monetary policy (ie. printing money), and that puts pressure on the FX rate. Q. Why are currency crises so difficult to predict?:  Unfortunately, no single indicator or combination of indicators, works accurately on every occasion or situation Global market watchers (IMF, World Bank, Private investors, etc.) understand the significance of the variables and their interplay that puts pressure on the exchange rate. However, the timing of market forces that force a country towards a currency crisis is not easily predicted. In many cases, the decision and timing to abandon a fixed exchange rate is a political one Q. Why are currency crises so difficult to predict? Q. What other factors would be useful to know?:  This list is formidable! 1) Timing of parliamentary elections/majority of Ruling party, opposition strength 2) Impact of current economic conditions on various segments of society 3) Level of corruption 4) Extent of capital flight 5) The black market FX rate vs. Central Bank FX rate Q. What other factors would be useful to know? DIFFERENT TYPES OF FLOATING & FIXED FX RATE SYSTEMS:  a) FLOATING FX RATES - CLEAN (PURE) FLOAT: Market demand & supply solely determine the equilibrium FX rate, namely zero government intervention - MANAGED (DIRTY) FLOAT: Though the FX rate is floating, Government authorities occasionally intervene to: Influence the direction Alter the rate of change in the currency value DIFFERENT TYPES OF FLOATING & FIXED FX RATE SYSTEMS b) FIXED FX RATES:  FACE THREE ON-GOING DILEMMAS: Q1. TO WHAT DOES THE GOVERNMENT FIX THE VALUE OF ITS CURRENCY? A1. A variety of possibilities exist: - Gold - Some other currency ( e.g. US$, Euro, FF ) - Some composite basket ( e.g. SDR ) b) FIXED FX RATES Q2. WHEN, HOW OFTEN, & BY HOW MUCH, SHOULD THE COUNTRY CHANGE THE VALUE OF ITS FIXED RATE?:  A2. THE ABILITY TO MOVE / ALTER A FIXED FX RATE HAS INTRODUCED THE WORD “PEG” - ADJUSTABLE PEG: The FX rate is adjusted when the country is faced with a fundamental disequilibrium in its international position - CRAWLING PEG: An anticipatory solution via a continual scheduled change in the pegged rate usually tracks some internal indicator such as: - Domestic inflation versus pegged currency inflation rate - Domestic money supply versus pegged country money supply - Level of international reserve holdings Q2. WHEN, HOW OFTEN, & BY HOW MUCH, SHOULD THE COUNTRY CHANGE THE VALUE OF ITS FIXED RATE? Q3. SHOULD THE GOVERNMENT DEFEND ITS FIXED RATE AGAINST MARKET PRESSURES TUGGING TOWARDS AN APPRECIATION / DEPRECIATION OF ITS CURRENCY?:  Q3. SHOULD THE GOVERNMENT DEFEND ITS FIXED RATE AGAINST MARKET PRESSURES TUGGING TOWARDS AN APPRECIATION / DEPRECIATION OF ITS CURRENCY? A3. The Government can defend its FX rate in the following ways: 1. FX intervention 2. FX controls 3. Monetary policy 4. Undertake macro-economic policy reforms ( e.g. expand export programs, reduce government spending ) OR The Government can succumb to market forces! Q. WHERE DOES A CENTRAL BANK OBTAIN US$ TO UNDERTAKE FX INTERVENTION?:  Q. WHERE DOES A CENTRAL BANK OBTAIN US$ TO UNDERTAKE FX INTERVENTION? A. It cannot just create US$! It can however: - Use its own international reserve holdings - Obtain US$ from the Federal Reserve, i.e. Aid package - Access global capital markets & do a sovereign bond offering - Borrow US$ via pre-established “swap lines” Q. WHAT DOMESTIC MONETARY ACTIONS DO CENTRAL BANKS ENGAGE IN? CAN THESE ACTIONS IMPACT FX MARKETS?:  Q. WHAT DOMESTIC MONETARY ACTIONS DO CENTRAL BANKS ENGAGE IN? CAN THESE ACTIONS IMPACT FX MARKETS? Central banks control the money supply of the domestic economy They engage in “Open Market” operations which involve an exchange of currency for monetary assets Example: A sale of US$ Treasury Bills in the NY Money markets, results in a reduction of US$ in circulation, & thus leads to a reduction in the US money supply ( & vice versa ) Q. WHAT ARE THE COMPONENTS OF A CURRENCY’S OFFICIAL RESERVE ASSETS?:  A. Typical components include: 1. Its own holdings of FX assets (in credible assets, i.e. currencies other than its own) 2. The country’s Reserve position with the IMF 3. The country’s holding’s of Special Drawing Rights (SDR’s) 4. Gold holdings 5. Proceeds from the sale of state assets Q. WHAT ARE THE COMPONENTS OF A CURRENCY’S OFFICIAL RESERVE ASSETS? Q. WHAT IS STERILIZED FX INTERVENTION?:  Q. WHAT IS STERILIZED FX INTERVENTION? A. When the reduction in the monetary base is offset by the Central bank’s action in the Money Market, namely via Open market operations This forestalls any adjustment that would have occurred through the monetary mechanism, i.e. the effect of the loss of FX reserves on the money stock Q. WHAT IS UNSTERILIZED FX INTERVENTION?:  The support of the domestic currency by the Central Bank in the Foreign Exchange Market leads to a macro adjustment via a contraction of the country’s domestic money supply This enables the country to support its exchange rate at the Fixed target level via the rising interest rate This rising domestic interest rate functions to strengthen the currency however it also leads to a domestic economic slowdown Result: The Central bank can choose to target the level of its exchange rate, or the level of its interest rate, but cannot do both independently. Thus frequently the defense of a Fixed exchange rate system results in a loss of an independent monetary policy Q. WHAT IS UNSTERILIZED FX INTERVENTION? Q. WHY DO GOVERNMENTS STERILIZE?:  A. They sterilize when they want to: Hold the FX rate away from its true market equilibrium value and…… SIMULTANEOUSLY: …….want to prevent the automatic adjustment mechanism from impacting the domestic money supply Q. WHAT ARE THE LONG RUN EFFECTS OF STERILIZATION? A. It is unlikely to be effective, as it implies a chronic disequilibrium in the country’s Balance of Payments ( BOP ) Q. WHY DO GOVERNMENTS STERILIZE? STERILIZED FX INTERVENTION (CONTD.):  STERILIZED FX INTERVENTION (CONTD.) ASSETS HELD BY A CENTRAL BANK ARE: MB = INT. RES. + DC ……………………………………..(1) AND BOP = CHANGE IN INT.RES……………………………(2) GLOSSARY: MB = MONETARY BASE INT. RES. = INTERNATIONAL RESERVES (CENTRAL BANKS HOLDINGS OF CLAIMS AGAINST THE REST OF THE WORLD) DC = DOMESTIC CREDIT (CENTRAL BANKS HOLDINGS OF CLAIMS AGAINST ITS OWN GOVERNMENT) STERILIZED FX INTERVENTION (CONTD.):  STERILIZED FX INTERVENTION (CONTD.) When a country runs a BOP deficit, then the country’s Central Bank is essentially buying its own currency & selling International Reserves See Equations (1) & (2) together In a BOP deficit situation, the country experiences a fall in International Reserves, if the DC is unchanged, then the MB falls by an identical amount Key Point: THE BOP DEFICIT AFFECTS INT. RES. WHICH AFFECTS THE MB Q. WHAT IS THE CENTRAL BANK DOING VIA STERILIZATION? A. It is expanding DC at the same rate as the International Reserves outflow, thus preventing a contraction of the MB i.e. If the change in DC = change in International Reserves, then the change in MB = 0 Q. A COUNTRY WITH A BOP DEFICIT DECIDES TO DEFEND ITS FIXED FX RATE BY UNDERTAKING UNSTERILIZED FX INTERVENTION. WHAT IMMEDIATE IMPACT WILL THIS HAVE ON THE DOMESTIC ECONOMY?:  A. As the Central Bank buys the domestic currency (versus the foreign currency), it reduces the country’s monetary base & thus its money supply. This results in higher interest rates. Rising interest rates lead to: - Reduced interest sensitive spending - Lower aggregate demand - Falling real GDP/National Income - Rising unemployment Q. A COUNTRY WITH A BOP DEFICIT DECIDES TO DEFEND ITS FIXED FX RATE BY UNDERTAKING UNSTERILIZED FX INTERVENTION. WHAT IMMEDIATE IMPACT WILL THIS HAVE ON THE DOMESTIC ECONOMY? Q. A LATIN AMERICAN COUNTRY HAS THE COMBINATION OF HIGH INFLATION & A FLOATING FX RATE. WHAT OPTIONS DOES IT HAVE, & DOES THAT INCLUDE MOVING TO A FIXED FX RATE?:  A. IN THE SHORT RUN: The Government must tighten monetary policy, i.e. raise interest rates: Aggregate demand shall be reduced Weaker demand will put downward pressure on the inflation rate IN THE LONG RUN: The solution is to reduce the growth in the Money Supply, i.e. The underlying cause of inflation Q. A LATIN AMERICAN COUNTRY HAS THE COMBINATION OF HIGH INFLATION & A FLOATING FX RATE. WHAT OPTIONS DOES IT HAVE, & DOES THAT INCLUDE MOVING TO A FIXED FX RATE? Q. A LATIN AMERICAN COUNTRY HAS THE COMBINATION OF HIGH INFLATION & A FLOATING FX RATE. WHAT OPTIONS DOES IT HAVE, & DOES THAT INCLUDE MOVING TO A FIXED FX RATE?:  Adoption of a fixed FX rate may help because: 1. It is evidence of the Government’s willingness to accept the discipline required for the efficient functioning of a Fixed FX rate system 2. Unsterilized FX intervention to combat a weakening currency (due to high inflation) will force a tighter monetary policy Q. A LATIN AMERICAN COUNTRY HAS THE COMBINATION OF HIGH INFLATION & A FLOATING FX RATE. WHAT OPTIONS DOES IT HAVE, & DOES THAT INCLUDE MOVING TO A FIXED FX RATE? Q. A LATIN AMERICAN COUNTRY HAS THE COMBINATION OF HIGH INFLATION & A FLOATING FX RATE. WHAT OPTIONS DOES IT HAVE, & DOES THAT INCLUDE MOVING TO A FIXED FX RATE?:  3. The expectation of market participants that inflation fighting is a Central Bank priority, contributes to actual inflation declining. Why? Expectations hypothesis 4. The stability given to the local currency prices of imported goods by the fixed FX rate Steady import prices contribute to reducing the country’s inflation rate as well as putting competitive pricing pressure on competing domestic products Q. A LATIN AMERICAN COUNTRY HAS THE COMBINATION OF HIGH INFLATION & A FLOATING FX RATE. WHAT OPTIONS DOES IT HAVE, & DOES THAT INCLUDE MOVING TO A FIXED FX RATE? PRO’S & CON’S OF ADOPTING A: 1) FLOATING FX RATE SYSTEM 2) FIXED FX RATE SYSTEM:  1a) PRO’S OF A FLOATING FX RATE SYSTEM: 1. Crisis avoidance How? As FX rates undertake necessary adjustments and large BOP deficits & surpluses can be avoided Only the FX rate needs to adjust to correct this imbalance, i.e. no loss in FX Reserves or Government intervention is required Policy adjustment delays by decision makers can be avoided PRO’S & CON’S OF ADOPTING A: 1) FLOATING FX RATE SYSTEM 2) FIXED FX RATE SYSTEM 1a) PROS OF A FLOATING FX RATE SYSTEM::  1a) PROS OF A FLOATING FX RATE SYSTEM: 2. Monetary independence Each country can pursue an independent monetary policy & thus determine its own inflation rate A country’s response to domestic unemployment: Increase the money supply Results in declining interest rates Domestic currency is less attractive & depreciates This leads to an export boom & lower domestic unemployment A country’s response to domestic overheating: Decrease the money supply Results in rising interest rates Domestic currency is more attractive & appreciates This leads to an import boom & higher domestic unemployment 1a) PROS OF A FLOATING FX RATE SYSTEM::  3. Consistency with capital mobility 4. Clearly identifies the comparative advantage / disadvantage of a country in various commodities when the equilibrium FX rate is translated into domestic prices Namely, a Floating FX rate is more likely to give accurate price signals for the allocation of resources Example: An overvalued FX rate may result in Exports / Imports in which the country in reality has a comparative disadvantage Governments are prevented from setting Fixed FX rates that may benefit particular sectors of the domestic economy 1a) PROS OF A FLOATING FX RATE SYSTEM: 1b) CON’S OF A FLOATING EXCHANGE RATE SYSTEM:  1. Discipline imposed by fixed FX rate systems on monetary policy is missing 2. Disturbing speculative volatility 3. Damage to international trade & investment 4. Lack of coordination in economic policy, e.g. countries may engage in competitive devaluations 5. Myth of greater autonomy 1b) CON’S OF A FLOATING EXCHANGE RATE SYSTEM 2a) PRO’S OF A FIXED FX RATE SYSTEM:  1. Price discipline Fixed FX rates impose price discipline by preventing Central Banks from engaging in an expansionary / inflationary monetary policies Empirical evidence shows that Central Banks circumvent this discipline, though the initial purpose was to gain credibility 2. Reduced volatility & uncertainty Lessens impacts on pricing decisions, facilitates trade and investment flows, & reduces hedging costs 3. Prevention of exchange crises: This reason is suspect when we see recent experience! 2a) PRO’S OF A FIXED FX RATE SYSTEM 2b) CON’S OF A FIXED FX RATE SYSTEM:  1. Incompatible with open, integrated, international capital markets, eg. A rising real exchange rate hurts domestic producers as rising local costs makes exports less competitive in world markets 2. Offers a target to speculators, even if prudent economic policies are followed, ie. provides speculators with a one-way bet. 2b) CON’S OF A FIXED FX RATE SYSTEM

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