Exchange Rate
This chapter studied the process of determining exchange rates under a floating exchange rate system. We saw that in the absence of government intervention, exchange rates respond to the forces of supply and demand, which in turn are dependent on relative inflation rates, interest rates, and GDP growth rates. Monetary policy is crucial here. If the central bank expands the money supply at a faster rate than the growth in money demand, the purchasing power of money declines both at home (inflation ) and abroad (currency depreciation). In addition, the healthier the economy is, the stronger the currency is likely to be. Exchange rates also are crucially affected by expectations of future currency changes, which depend on forecasts of future economic and political conditions. In order to achieve certain economic or political objectives, governments often intervene in the currency markets to affect the exchange rates. Although the mechanics of such interventions vary, the general purpose of each variant is basically the same: to increase the market demand for one currency by increasing the market supply of another. Alternatively, the government can control the exchange rate directly by setting a price for its currency and then restricting access to the foreign exchange market. A critical factor that helps explain the volatility of exchange rates is that with a fiat money, there is no anchor to a currency’s value, nothing around which beliefs can coalesce. In this situation, in which people are unsure of what to expect, any new piece of information can dramatically alter their beliefs. Thus, if the underlying domestic economic policies are unstable, exchange rates will be volatile as traders react to new information.
Question: Describe how these three typical transactions should affect present and future exchange rates?:
a) Seagram imports a year supply of French francs is due immediately:
b) Korean Airlines buys five Boeing 747s. As part of the deal, Boeing arranges a loan to KAL the purchase amount from the U.S. Export-Import Bank. The loan is to be paid back over the next seven years with a two- year grace period.
Capital flight from Latin America
Between 1974 and 1982, Argentina borrowed $32.6 billion. Estimates of the level of the level capital of flight from Argentina over the same period range from $15 billion to more than $27billion . This estimates would mean that capital flight amounted two between one-half and four-fifth of the entire inflow of foreign capital to Argentina. For Venezuela the inflow was $27 billion over the same period, with capital flight estimated at between $12billion and $20billion. The inflow for Mexico was $79 billion between 1979 and 1984, the outflow has been estimated at between $26billlion and $54billlion for the same period. Other debtor countries, such as Nigeria and Philippines, have also had large capital outflows. As conditions in many of these countries worsened, capital flight continued. As of the end of 1988, just prior to the end of the Latin American debt crisis, Morgan Guaranty estimated that Latin Americans held $243billion in assets abroad, far exceeding the amount of loans to the region held by U.S banks. And this excludes assets taken abroad before 1977.
Capital flight occurs for several reasons, most of which have to do with inappropriate economic policies, government regulations, controls, and taxes that lower the return on domestic investments. In countries in which inflation is high and domestic inflation hedging is difficult or impossible, investors may hedge by shifting their savings to foreign currencies deemed less likely to depreciate. The may also make the shift when domestic interest rates are artificially held down by their governments or when they expect a devaluation of an overvalued currency. Yet another reason for capital flight could be increases in a countries external debt. Such an increase may signal the probability of a fiscal crises and , therefore , induce capital flight.
India is one country in which capital flight was unusually large when economy was still shackled by socialistic ideologies and high amount of external debt. As the Indian economy engaged in a liberalization and started attracting non debt inflows such as FDI, capital flight was reversed.
Perhaps the most powerful motive for capital flight is political risk. In unstable political regimes( and some stable ones), wealth is not secure from the government seizure, especially when changes in regime occurs. Savings, may be shifted overseas to protect them. For example, the citizens of Hong Kong, which was turned over to communist China on July 1, 1997, responded to the anticipated change in regime by sending large sums of money abroad in advance.
Common sense dictates that if nations own citizens do not trust the government, then investment there is unsafe. After all, residents presumable have a better feel for conditions and government intentions than do outsiders. Thus, when analyzing investment or lending opportunities, multinational firms and international banks must bear in mind the apparent unwillingness of the nations citizens to invest and lend in their own country.
What is the needed to halt capital flight are tough –minded economic policies –the kind of policies that make investors want to put their money to work instead of taking it out. As we shall see in the next section, this policies include cutting budget deficits and taxes., removing barriers to investment by foreigners, selling of state owned enterprises, allowing for freer trade, and avoiding currency overvaluations that virtually invite people to ship their money elsewhere before the official exchange rates fall. Starting around 1990, such policies began to be employed in much of Latin America, with predictable results.
Culture- Often overlooked is the role of culture, but it is culture that shapes the behavior that determines economic outcomes. As with individuals, so with nations. As Banfield pointed out, societies that are presents oriented, thereby attaching “no value to work, sacrifice, self-improvement”, will likely remain poor despite substantial amounts of aid. Conversely, cultures that adopt the values and practices of a modern industrial society, including free market, meritocracy, pragmatism, the rule of law, an orientation toward the future, and emphasis on education, and an interest in science and technology , are more likely to succeed.
