Exchange Rate and Economy, Essay Example

In a floating exchange rate system, the factors that affect the exchange rates of currencies include inflation rate, interest rates, current account balance, public debt, balance of payment, political stability, and economic performance. Inflation has a negative relationship with a particular country’s currency value i.e. low inflation rates usually lead to currency appreciation because low inflation rate increases the average purchasing power of the citizens. Interest rate has a positive relationship with a country’s currency value because higher interest rates attract investment from international investors in search of higher returns. As a result, the higher demand for local currency also leads to currency appreciation (Investopedia, 2010).

The current account balance also has a positive relationship with a country’s currency value. A positive current account balance leads to currency appreciation and a negative current account balance results in currency depreciation because the country is forced to borrow from international lenders to finance excess imports. As a result, it has to increase demand for foreign currency, resulting in a negative impact on its own currency value. The level of public debt has a negative relationship with a country’s currency value. An increase in public debt is usually accompanied by a rise in demand for goods and services by the government as well which leads to inflation. Inflation decreases the real returns on lending, making the country an unattractive investment destination to international investors. The lower demand for local currency, thus, leads to currency depreciation (Investopedia, 2010).

Balance of payment has a positive relationship with currency value because positive balance of payment means exports exceed imports. The higher level of exports means greater demand for the country’s currency, resulting in currency appreciation and vice versa. Indian Rupee weakened earlier this year due to continuous drop in exports (Rodrigues, 2012). Political stability also has a positive relationship with a country’s currency value because stable political systems reduce the risk and uncertainty for international investors, thus, boosting international investment in the country. Similarly, strong economic performance also makes countries attractive investment destinations, resulting in higher currency values relative to other currencies (Investopedia, 2010). This is why developed countries in the world usually enjoy high currency values as compared to developing countries. Indian Rupee rose slightly on the expectations that Indian Prime Minister Dr. Manmohan Singh’s measures to increase foreign direct investment were resulting in capital inflows into the country (Rodrigues, 2012).

Countries closely monitor the values of their respective currencies because currency values have significant economic consequences. A low currency value improves the country’s balance of payment because foreign buyers increase the demand for country’s exports. Thus, low currency values prove beneficial in terms of international trade. Similarly, low currency value also helps the national economy grow because higher demand for exports also means higher economic activity within the country. Unemployment rate may also drop as companies increase demand for labor. But a low currency value may also lead to inflation. First of all, higher economic activity will lead to higher demand for raw materials and demand has a positive relationship with price. Higher demand for labor may also push up the wage levels, leaving an average consumer with more money to spend on goods and services. Thus, higher spending by both the businesses and the consumers will put an upward pressure on the general price level.

Some countries in European Union such as Spain, Greece, and Portugal serve as good examples of the close relationship between exchange rates and economic growth. Being members of the European Union, Spain, Greece, and Portugal can do almost nothing to bring Euro’s value down against other currencies. This limits their ability to deal with the financial crisis they are faced with because high value of Euro doesn’t reflect the individual economic circumstances in these countries. In addition, high Euro value also negatively affects their efforts to boost exports.

As already noted, the currency exchange rates have significant impact on national economic activity and even the inflation level. High currency values hurt the economy by making exports expensive for foreigners. At the same time, demand for imports increases because imports become cheaper for domestic consumers to buy as compared to local products. Thus, the competitiveness of domestic companies is negatively hurt and their profitability declines. There are several international examples that demonstrate the importance of currency values to national economies. Actions by the national governments to ensure low currency values often subject them to accusations of unfair currency manipulation by other countries.

Earlier this year, Brazilian President Dilma Rousseff complaint that economic policies such as low interest rates by developed nations including the U.S. were hurting developing and emerging nations like Brazil. This is because low interest rates in the U.S. were forcing investors to look for higher returns elsewhere and countries like Brazil seemed attractive investment destinations. As a result, higher demand for currencies of emerging economies was resulting in currency appreciation in those countries, putting domestic exporters at a disadvantage. Not surprisingly, Brazilian economy grew at a rate of only 2.7 percent in 2011 as compared to 7.5 percent just a year earlier.

Even Japanese Government has decided to take action to protect the competitiveness of its companies. When the U.S. dollar weakened against Japanese Yen due to Fed’s actions, the Japanese Government also eased its monitory policy and some still expect further intervention by the Japanese Government to stall upward climb of the yen (Beattie & Ross, 2012). Even U.K’s top banker. is concerned about the potential of currency wars by countries to seek competitive advantage in international trade. Bank of England’s Governor Mervyn King believes many countries will try to bring their currency values down in 2013 to compensate for slow growth at home (Hilsenrath, 2012).

The companies have several options to minimize the negative impact of exchange rate fluctuations on their business. One strategy may be to move the production facilities to another country with a lower currency value as Ryuji Usuda of Kyouwa, a manufacturer of factory automation equipment, did by moving production line from Japan to Vietnam (Fackler, 2012). Another option is forward currency contract or option in which the company may lock-in the local currency against a specific foreign currency (Schoenberger, 2011).

One of the most effective solutions though it may not be for everyone is to build products in the same country where they are intended to be sold, as is done by global conglomerate Colgate-Palmolive Co. (Hamilton, 1995). Such strategy doesn’t entirely protect the companies from the consequences of exchange rate fluctuations as subsidiaries profits have to be converted to the currency of the home country but this strategy does help maintain levels of economic activity.

Having international operations also provide flexibility to the companies against exchange rate fluctuations as Spectra Energy Corporation demonstrates. The company is based in Houston but has almost half of its assets and employees in Canada. The company supports operations in both countries using locally-obtained debt. In case of Canadian Dollar’s appreciation, the company’s interest expense in U.S. Dollars increases but do does its income from Canadian operations. As a result, the company largely neutralized the impact of exchange rate fluctuations on its operations. Even though Spectra has a subsidiary in Canada to take advantage of this strategy, other companies can pursue the strategy by issuing debt in the currency of the international country where they do business (Schoenberger C. R., 2012).

Currency exchange rates have significant impact on national economy and this impact will only grow over time due to globalization as companies increasingly seek growth opportunities in international markets. Luckily, there are several strategies available to them including forward contracts and options, diversification of international operations, moving production facilities to countries with historically low currency values, and issuing debt in foreign currencies.

References

Beattie, A., & Ross, A. (2012, October 3). International trade: A fragile armistice. Retrieved December 20, 2012, from http://www.ft.com/intl/cms/s/0/49dd4646-0d47-11e2-97a1-00144feabdc0.html#axzz2FdZFMinS

Fackler, M. (2012, July 31). Strong Yen Is Dividing Generations in Japan. Retrieved December 20, 2012, from http://www.nytimes.com/2012/08/02/world/asia/strong-yen-is-reinforced-by-japans-generation-gap.html?pagewanted=all&_r=0

Hamilton, M. M. (1995, April 9). Companies Do Little To Protect Themselves From Currency Risks. Retrieved December 20, 2012, from http://articles.orlandosentinel.com/1995-04-09/business/9504070374_1_hedge-against-currency-currency-risks-currency-fluctuations

Hilsenrath, J. (2012, December 10). U.K.’s Top Banker Sees Currency Risk. Retrieved December 20, 2012, from http://online.wsj.com/article/SB10001424127887324024004578171761669892682.html

Investopedia. (2010, July 23). 6 Factors That Influence Exchange Rates. Retrieved December 20, 2012, from http://www.investopedia.com/articles/basics/04/050704.asp#axzz2FdYeaZ00

Lyons, J., & Barkley, T. (2012, April 9). Brazil Leader Slams U.S. Money Policy. Retrieved December 20, 2012, from http://online.wsj.com/article/SB10001424052702303772904577334073710653532.html

Rodrigues, J. (2012, October 1). India Rupee Gains on Speculation Policy Changes Boosting Inflows. Retrieved December 20, 2012, from http://www.bloomberg.com/news/2012-10-01/indian-rupee-declines-on-concern-global-slowdown-hurting-exports.html

Schoenberger, C. (2011, March 1). Exposed! Retrieved December 20, 2012, from http://online.wsj.com/article/SB10001424052970203731004576045680094212132.html

Schoenberger, C. R. (2012, February 27). A New Tool in the Hedge Shed. Retrieved December 20, 2012, from http://online.wsj.com/article/SB10001424052970203806504577178561832236028.html