Exchange rates determination and the effects

By | June 23, 2013

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1.        Exchange rates determination and the effects

 

Despite the fact that the United States, England are still in recession, Japan still in recovery mode and China experiencing a slower worrying growth rate, explain why US dollar, the Sterling pound, the Yen and the Renminbi are so strong. Compare your explanation with the standard theoretical factors which determine exchange rates. What measures have these countries implemented to offset the adverse effects of too strong an exchange rate? (10 marks) (Approx. 1,300 words)

 

1.1    Exchange rates determination

 

In my understanding, a strong currency in term of high exchange rate against other international currencies does not necessarily come with strong economic growth, or in the other words, a slower economic growth would not equal to a weak economy because exchange rate is determined by a number of factors. On one hand, there could be outflow of capital from countries suffering debt crisis and other markets which seek a safer place, and they tend to flow into large markets like US and China. Therefore the stronger demand of these currencies would result in the strong currencies in these several countries; on the other hand, exchange rate of currencies could be used to compensate for the differences in prices of goods, therefore when the exchanges rate could be use to reflect the price differences rather than economic performance and thus we could say that strong currency could be possible even during the economic recession because there is a need to settle the price differences.

 

Now let us review two major theories explaining the rationality of the exchange rate determination: PPP and Monetary and Portfolio Approach. The first approach of Exchange rates determination is Purchasing Power Parity (PPP) which is primarily based on the “Law of One Price”. It is a flow model of the balance of payment. This law lays down that exchange rate of currencies have to compensate for the differences in prices of goods. Monetary and Portfolio Approach is an approach in which the prices of various domestic and foreign assets are decided. The agent is given a portfolio choice of various assets. The instruments, which are either money or bonds, have an expected return that could be invested. This investment opportunity determines the exchange rate (economywatch.com 2009).

 

By reviewing these two major theories explaining the rationality of the exchange rate determination, we can see that my personal understanding of the strong US dollar, the Sterling pound, the Yen and the Renminbi is in accordance with Purchasing Power Parity (PPP) approach and also the Monetary and Portfolio Approach because on one hand, exchange rate reflects the price differences and also it reflects the market demand for the currency shaped by the demand of various domestic and foreign assets, and it is in line with my explanation that outflow of capital from countries suffering from national debt crisis has result in the increased demand of currency in other major economies.

 

1.2    Measures adopted by countries to offset the adverse effects of strong currencies

 

Although having a strong currency seems to be a benefit for any economy, there are certain disadvantages which need to be realized in the process of global trading. One of the main disadvantages of having a strong currency is the increase in export prices which can sometimes make such exports unaffordable to importers of other countries who use their own local currency. Thus, countries with strong currencies may see a decline in the number of buyers as the currency becomes stronger and the buyers become less able to make a profit on what they import in their own setting (Siribaddana 2011). Therefore, countries with strong currencies tend to adopt policies to offset the adverse effects of the strong currencies mainly with the expect to maintain the advantages in the international trade. A particular and typical example happens in China. It is believed that China has laid the foundation to allow for a stronger yuan. Its currency watchdog, China’s State Administration of Foreign Exchange (SAFE), has been preparing China. Some of the more recent developments include the use of the yuan in international agreements; also, yuan denominated debt is being issued in Hong Kong (merkfunds.com 2010). Therefore, we can see that the Chinese government has been using the opportunity of a strong yuan currency to prepare to release the Chinese currency as an international currency which paves a better way for the country’s economic development in the long run. In addition, the policy in place in China for the past decade is designed to encourage tech transfer from abroad and force foreign companies to transfer their R&D operations to China in exchange for access to China’s large volume markets. And this policy is enhanced by the government with the strengthening of the Chinese Renminbi in the recent years. China’s growing R&D capabilities and its large domestic market are strong attractions for many companies, either independently or in partnership with Chinese companies or research institutes. Many multinational companies have already done this, including IBM, Intel, Samsung, and a number of pharmaceutical companies (rdmag.com 2010). In case of United States, the government print out more money to offset the bad effects of the strong USD. For example, the US Federal Reserve, or the Fed, in Q2 of 2010 had embarked on further policy measures aimed at supporting the US economic recovery and coaxing inflation back to the level that Fed policymakers consider consistent with healthy economic growth. The Fed eased monetary conditions by purchasing longer-term US Treasury securities, amounting to some US$600 billion by mid-2011 (mas.gov.sg 2010). This measure also reduced the effects of a strong USD.

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