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Foreign Exchange Rate Determination The Balance of Payments (BOP) Approach The relationship between the BOP and exchange rates can be illustrated by the use of a simplified equation that summarizes BOP data: (X – M) + (CI – CO) + (FI – FO) + FXB = BOP Where X = exports of goods and services M = imports of goods and services CI = capital inflows CO = capital outflows FI = financial inflows FO = financial outflows FXB = official monetary reserves If the sum of the current and capital accounts is positive, a surplus demand for the domestic currency exists in the word If the sum of the current and capital accounts is negative, an excess supply for the domestic currency exists in the word Fixed exchange rate countries: The government bears the responsibility to ensure a BOP near zero. To ensure a fixed exchange rate, the government must intervene in the foreign exchange market and buy or sell domestic currencies (or sell gold) to bring the BOP back to near zero. It is very important for a government to maintain significant foreign exchange reserve balances to allow it to intervene in the foreign exchange market effectively. Floating exchange rate countries: The government of a country has no responsibility to peg its foreign exchange rate. The fact that current and capital account balances do not sum to zero will automatically (in theory) alter the exchange rate in the direction necessary to obtain a BOP near zero. The Asset Market Approach The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others): Relative real interest rates Prospects for economic growth Capital market liquidity A country’s economic and social infrastructure Political safety Corporate governance practices 1 Foreign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability. The asset market approach is also applicable to emerging markets, however in these cases a number of additional variables contribute to exchange rate determination. Illustrative Cases The Asian Crisis of 1997 The roots of the Asian currency crisis extended from a fundamental change in the economics of the region, the transition of many Asian nations from being net exporters to net importers. The most visible roots of the crisis were the excess capital inflows into Thailand in 1996 and early 1997. As the investment “bubble” expanded, some market participants questioned the ability of the economy to repay the rising amount of debt and the Thai bhat came under attack. The Thai government intervened directly (using foreign currency reserves) and indirectly by raising interest rates in support of the currency. Soon thereafter, the Thai investment markets ground to a halt and the Thai central bank allowed the bhat to float. The bhat fell dramatically and soon other Asian currencies (Philippine peso, Malaysian ringgit and the Indonesian rupiah) came under speculative attack. The Asian economic crisis (which was much more than just a currency collapse) had many roots besides traditional balance of payments difficulties: Corporate socialism Corporate governance Banking liquidity and management What started as a currency crisis became a region-wide recession. The Russian Crisis of 1998 The crisis of August 1998 was the culmination of a continuing deterioration in general economic conditions in Russia. From 1995 to 1998, Russian borrowers (both government and non-governmental) had gone to the international capital markets for large quantities of capital. Servicing this debt soon became an increasing problem, as it was dollar denominated and required dollar denominated debt service. The Russian current account (while a healthy surplus of $15 - $20 billion per year) was not finding its way into internal investment and external debt service. Capital flight began to accelerate, and hard currency earnings flowed out of the country. As the Russian rouble operated under a managed float, the Central Bank had to intervene in foreign exchange markets to support the currency if it came under pressure. During the month of August, 1998, the Russian government continued to drain its reserves and had increasing difficulties in raising additional capital in support of its reserves on the international markets. 2 By mid-August, the Russian Central Bank announced it would allow the rouble to fall, postponed short-term domestic debt service and initiated a moratorium on all repayment of foreign debt owed by Russian banks and private borrowers to avert a banking collapse. The Argentine Crisis of 2002 In 1991 the Argentine peso had been fixed to the US dollar at a one-to-one rate of exchange. A currency board structure was implemented in an effort eliminate the source inflation that had devastated the nation’s standard of living in the past. By 2001, after three years of recession, three important problems with the Argentine economy became apparent: The Argentine Peso was overvalued The currency board regime had eliminated monetary policy alternatives for macroeconomic policy The Argentine government budget deficit – and deficit spending – was out of control In January 2002, the peso was devalued as a result of enormous social pressures resulting from deteriorating economic conditions and substantial runs on banks. However, the economic pain continued and the banking system remained insolvent. Social unrest continued as the economic and political systems within the country collapsed; certain government actions set the stage for a constitutional crisis. 3