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International Economics: Exchange Rate.

Exchange rate manipulation and misalignment was discussed much in the news recently. The primary focus was on China, who was criticized strongly for undervaluing ‘Yuan’. Because of this they had a low cost advantage and also took away the business from the hands of US and other competitors. (Smith, Farr & Gallagher, 2005)..The current account surplus of China was really high which caused the foreign exchange reserves to rise up, because of this Yuan was considered undervalued. This undervaluation of the Chinese currency was considered as the exchange rate misalignment, which was causing much head-ache to China.

The exchange rate equilibrium and the current account balance can be better understood by having an idea about the balance of payment. The balance of payment of a country is the measure of the real monetary transaction of a country with the rest of the countries. This affects the economic policies of the government. Balance of Payments can be either deficit or surplus. With in balance of payments, there are various accounts in which the whole transactions of the country will be categorized.

The accounts include current account, capital account and the financial account. Current account includes all the transactions which give rise to or use national income. These accounts are related to the export and import of goods and services, income and the current transfers are recorded. (Lesson 14: Balance of payments). In the capital account, all the physical assets are recorded and the financial account of the country reflects the investments of the government and also various assets related to the international transactions. The balance in the current account clearly gives a picture whether that particular country has a deficit or surplus balance.

The major components of the current account include goods, services, income and current transfers. The goods include mainly the physical goods, which are transacted either by exports or imports. In current account, export is considered as credit, since the money is flowing into the economy and import is considered a debit, since the money flows out to other countries. The transactions which are recorded from the transactions like transportation, business services, tourism etc are included in the services account.

If money is paid for a service, it is recorded as if an import is made that is the account will be debited, similarly if we receive any money, it is recorded as if an export is made and the amount will be credited. Income is another component of the current account in which the income of the country in the form of salaries, portfolio investments etc. The goods, services and the income component of the current account forms the actual resources of the country and is transferred between the countries for overall economic production. The last component is the current transfers, which include the remittance of the workers who from abroad, which are considered as independent transfers. The scarcity or excess balance in the current account gives an idea about the position of the economy.

The economic theory of a country has several concepts of defining the exchange rate equilibrium by investigating it from different angles. There are mainly six ways to make clear the real misalignment and also various measures taken to settle the equilibrium exchange rate. In the first notion it explains the equilibrium of trade balance which considers the exchange rates under the purchasing power parity theory, in which the price movements will influence the export and import of a country and which in turn will affect the equilibrium value of exchange rates.

Since the flexibility in the exports and imports decides the balance of payment disequilibrium, the domestic price will be equal to the external prices and so the deviation of the exchange rate will be directly related to the relative change in the prices. The second view explains that the equilibrium of the current account which establishes the equilibrium in the exchange rates by price movements.

But the third concept explains the overall equilibrium of balance of payment, which considers both the price and the comparative interest movements. It takes into consideration both the current and the capital account movements. The fourth conception of the exchange rate equilibrium is on the absence of the speculative attacks on the foreign exchange markets. It explains the monetary policy of the government.

Thus the policy of the authority and the cost incurred in such involvement will influence the exchange rate value. The existence of high cost will increase the participation of the speculators and will obtain capital gain on the future value of currency. The fifth model is the absence of a ‘begger thy neighbors’ dispute with other major currencies at an international level. This concept is also concerned about the monetary policy of the government. In a flexible exchange rate regime, competitive devaluation of the money is not possible since it will bring the problem of unemployment. But the quantity of the money in circulation could be increased than the rest of the world, which in turn increases the exchange rates.

The last and the final view of the equilibrium value of exchange rate , which is in the pursuit of the monetary policy rule explains that a sound and credible monetary policy does not encourage the speculators and will correctly define the future rate so that the inflation rate remains constant. The inflation rate not only depends on the monetary policy of the government but also on the international demands of currency. The currency appreciation will decrease the inflation rate and the currency depreciation will increase the inflation rate. (Rosaria Rita, 2002). China’s current account surplus was severely high and was quite shocking. It has reached nearly 11 percent of the GDP.

The main reasons for the current account surplus of china were the undervalued Chinese Yuan, which made the exports of China on a boom and by making the imports cheaper. Chinese government was very much interested to increase its exports as much as possible. The government thought that more exports will bring growth in the export sector and more employment opportunities could be produced.

This would inurn reduce the effects of unemployment due to the decline in the agricultural operations and also due to the privatization. But the point is that the growth of China was tremendous since their exports were cheaper compared to other countries. They have got a comparative advantage in producing goods at a low cost since the elastic supply of labor made the wage rate to remain low. The high expansion of the economy inurn has increased their savings rate also. The Chinese prefer to invest more in the foreign securities and it resulted in surging forex reserves. (Coudert & Couharde, 2005).

The mounting current account surplus has underestimated the currency of China. Another draw back of the undervaluation of Chinese currency is that it contributes to world depression that is the low price of the Chinese products will topple the domestic prices of the importing countries. When the total reserves of the country increases, it will direct to disequilibrium in the exchange rates. (Economics focus: Misleading misalignments, 2007).

Then the central bank of the country will intervene in the money market so as to bring the equilibrium in the exchange rates. This will appreciate the country’s currency. This can be also explained in other words, at the time of devaluation of the currency, there is always an expectation of revaluation in the forward forex market. Due to currency appreciation, the country will face the problem of high inflation. Because of this, the external surpluses held by the country declined, thereby reducing the pressures from the international competition.

Thus it could be said that a country’s current account balance measured in home currency would deteriorate in the initial stage due to the devaluation of currency will subsequently improve in the later stage. Thus it is called a misleading misalignment. (Coudert & Couharde, 2005, P. 8-9). The equilibrium in the exchange rate is defined as the rate that would equalize a country’s sustainable savings and investment balance with its underlying current account balance. (Rosenberg, 2003).

The assessments of the equilibrium of the exchange rate will not be realistic always since they depend on so many assumptions. Real exchange rate overvaluation refers to a situation in which the country’s real exchange rate is more appreciated than its equilibrium level. In order to get an idea about the exchange rate misalignment, Fundamental equilibrium exchange rate (FEER) approach is used.

There is a common suspicion that whether Yuan is undervalued and whether this undervaluation has resulted in unsustainability or caused outside imbalances of other countries. FEER is an approach that could be used to know this. FEER uses a macro economic approach. FEER is the rate consistent with both a sustainable current account balance and the internal balance. “According to this approach, the equilibrium exchange rate is defined as the real effective exchange rate at which a country could achieve simultaneously both of the basic objectives of macroeconomic policy.

These objectives are usually formulated as “internal balance” meaning non-inflationary full employment, and “external balance”, meaning a balance of payments position that appeared sustainable and desirable” In a country like China, which has a superior current account surplus than needed to keep a sustainable balance of payment place, then its currency is said to be undervalued. The currency undervaluation of China influences its competitor’s equilibrium exchange rates and there will be an international modification of current account imbalances.

The traditional approaches like BEER (Behavioral Equilibrium Exchange Rate), which is confirmed to a large sample of countries and it considers an econometric estimation between the exchange rates and the fundamental rates. Another approach is the PPP( Purchasing Power Parity) approach, which always consider the real exchange rate as stationary. (Coudert & Couharde, P. 4). For a deeper analysis and also to calculate the real exchange rate, FEER is used. FEER calculates the real exchange rate in consistent with the sustainable current accounts and it also take into consideration the competitive and other demand factors. (Coudert & Couharde, 2005, P. 20).

Most of the Asian countries are the largest holders of the foreign exchange reserves. Presently, Japan is the largest holder of forex reserves followed by China.. China’s Yuan was the only currency which caught the attention of every body, but really China was not exactly in the publicity. The misalignment is not just of Yuan, but many other currencies. The most important one among them was Japanese Yen. The studies reveal that Japan has mounted its foreign exchange more than China.

Japan was also in the top list of countries who were engaged in the large scale intervention due to devaluation of currency. The Japanese government has used up most of its investments in direct interventions in the global currency market to move forward the value of Yen. This is the single largest currency intervention made by a single country. (Misaligned Japanese Yen subject to action under new U.S. senate).

The New Zealand dollar has increased progressively against most currencies over the previous years due to increased speculation. (New Zealand fired warning shots currency (the economist) [original 2007-06-16 20:50:54]).

There is a simple method for the measurement of overvaluation and undervaluation of currencies. The method is Relative Purchasing Power Parity (PPP) is the simplest method that can be used. This theory states that the real exchange rates are stable and therefore mean reverting. In this framework, deviations of the real exchange rate from its long run average can be considered as misalignments that are likely to be corrected in the future. The real exchange rate  is taken as an index based on 100 in a bench mark period and calculated as

Formula (Coudert & Couharde, P. 4).

Where

 is the nominal exchane rate ,  is the home country’s consumer price index (CPI) and  is the foreign country’s CPI. An increase in the real and nominal exchange rates stands for appreciation in the value of the curreny.

The misalignment is also calculated as the difference between the real exchange rate at time ‘t’ and its empirical long term average is 

Formula

Wherestands for the beginning of the period for calculating the empirical mean. (Coudert & Couharde, P. 4).

The PPP method is the simple method for measuring undervaluation or overvaluation of the currency of NewZealand.

References

Smith, Russell L., Farr, Willkie., & Gallagher LLP. (2005). “Fixing” currency misalignment: Would the cure be worse than the sickness? KWR International. Web.

Lession 14: Balance of payments. P. 111. Web.

Rosaria Rita, Canale. (2002). Equilibrium exchange rate theories under flexible exchange rate regimes. MPRA: Munich Personal RePEc Archive. P. 1-3. Web.

Coudert, Virginie., & Couharde, Cecile. (2005). Real equilibrium exchange rate in china. CEPII: Centre D’ Etudes Prospectives ET D’ Informations Internationals. Web.

Economics focus: Misleading misalignments. (2007). Economist. Web.

Rosenberg, Michael R. (2003). The dollar’s equilibrium exchange rate: A market view. P. 37-38. Web.

Coudert, Virginie., & Couharde, Cecile. Currency Misalignments and Exchange Rate Regimes in Emerging and Developing Countries. Cahiers du C3ED. P. 4. Web.

Coudert, Virginie., & Couharde, Cecile. (2005). Further investigation with feers: Real equilibrium exchange rate in China. P. 20. Web.

Misaligned Japanese Yen subject to action under new U.S. senate bill. (2007). Indiacar. Web.

New Zealand fired warning shots currency (the economist) [original 2007-06-16 20:50:54]. (2007). Web.