PART III THE GLOBAL ECONOMY

Chapter 17 Foreign trade: patterns and policy

Chapter 18 Capital flows, foreign investment and labour migration

Chapter 19 The balance of payments: what it is and why it matters

Chapter 20 Coping with exchange rates

Chapter 21 Exchange rate regime

17 Foreign trade: patterns and policy

This chapter considers the global economy, and is concerned with the world-wide consensus in favour of free trade. Trade continues to grow faster than world output, its composition becoming more intra-industry in nature (trade in similar goods). Important developments have occurred, particularly the completion of the Uruguay Round and the setting up of the World Trade Organisation (WTO). Economic theory explains the significant benefits which trade can yield, static and dynamic. However, problems are encountered in the attempt to quantify these gains, and their credibility is questionable. There are losers, notably those who lose their jobs. Comparative advantage can change over time and government has an important role to play in sustaining a country’s comparative advantage and improving the efficiency of national industries. However, the complete liberalisation of trade has yet to be achieved, new trade issues are emerging related to labour standards, the environment and competition, and the future will provide tests for the world trade system and WTO in ensuring that trade is both free and fair.

uQUESTIONS FOR DISCUSSION

Q1. According to official estimates, world income will increase by over $500 billion following implementation of the Uruguay Round. What, in your view, are the main sources of these gains? Why have so many countries, both developed and developing, participated in this major movement towards global free trade?

The Uruguay Round extended the coverage of the GATT (General Agreement on Tariffs and Trade) to trade in services and agricultural products, and based on the “new” and more “realistic” GATT world economic model, world income is due to increase by $510 billion following its implementation. The following are now recognised as the standard gains from the liberalisation of trade (outlined in the text):· gains from comparative advantage due to more efficient resource allocations in

participating countries.· gains from intensified competition and contestability of markets (including X-

efficiency gains, particularly relevant to service industries).· gains from the exploitation of economies of scale and scope.· gains from the stimulus to investment and, in turn, to economic growth.In this context, a large proportion of the projected gains are seen to derive from the reduction of agricultural protection, and hence improved market access. This explains why the EU emerges with one third of the total gains (see box 17.3, pp. 457). However, industrial countries are also major beneficiaries, despite viewing the liberalisation of agriculture as a “concession”. However, caution must be adopted in accepting these figures. The possibility of sectoral immobility (and consequent unemployment) needs to be taken into account. Also, more dynamic benefits are excluded from the above estimation. Trade liberalisation causes income distribution to change, and only if it is redistributed optimally can we say unambiguously that society gains from free trade.

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Many countries have participated in the movement towards global free trade because of the prevailing consensus that trade generates significant gains for poor and rich countries alike. Most economists would agree with the positive view of the gains from trade, which have been identified in the analysis of Europe’s Single Market Programme as well as the Uruguay Round. In both developed and developing countries, specialisation according to comparative advantage yields gains from trade which increase the resources available for investment. Many studies have concluded that developing countries’ experience with protection has not been favourable. Import-substitution strategies have not led to self-sustaining growth. Eastern European countries have likewise become persuaded of the practical benefits of outward-looking policies.

Q2. What is comparative advantage and what determines it? Can a comparative advantage be developed through judicious use of economic policies?

Comparative advantage refers to a country's relative cost advantage in certain industries. It contrasts with the idea of absolute advantage. As explained in the text, a country could have an absolute disadvantage in all products relative to another country, but it can still obtain gains from trade by exporting those products in which it has a comparative advantage. This is the core proposition of the theory of comparative advantage (or costs). Porter's competitive advantage is similar to an absolute advantage concept; and should not be confused with comparative advantage.

Comparative advantage in the simplest framework is explained by differences in costs. Thus countries with abundant low-cost labour are likely to have a comparative advantage in labour-intensive goods. Porter's diamond presents a richer framework within which to analyse the determinants of comparative advantage.

Comparative advantage is not static, nor cast in stone; it changes, and government can speed or hamper this change. Japan is often cited approvingly as an example of successful use of government policies to alter the pattern of comparative advantage. But since governments are as limited as anyone else in their power to predict the future, emphasis should be on the word judicious when discussing policies for intervention to 'develop' future comparative advantage. Government policies can affect comparative advantage, both positively and negatively, as Porter points out. Successful interventions lay the groundwork, ensure a level playing field, and let the market forces decide which specific activities will prove most competitive. (See Porter chapter 9 for a good discussion of this issue.)

Q3. Why do smaller countries trade more as a percentage of GNP than large countries? Does this help or hinder their efforts to improve living standards?

Openness produces better results because it involves working “with” rather than “against” the market. Small countries’ trade constitutes a larger proportion of GNP than larger countries’ because, in essence, exports provide a means of escape from the limitations of their small size. Scale economies arise as a result of the opening of foreign markets to domestic producers. This extension of the market allows specialisation and consequent reductions in unit costs. Profits increase, as do funds

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available for further investment, clearly contributing to more rapid economic growth and the improvement of living standards. Also, with increased exports, more products can be imported while simultaneously avoiding excessive balance of trade deficits. This will enhance the welfare of consumers with a wider range of products from which to choose. The increased liberalisation of trade by smaller countries helps avoid monopoly influences, and their associated inefficiencies (see pp. 453). Trade will provide the awareness and incentive to remain competitive in the presence of ever-changing market conditions to firms within these countries. These dynamic gains plus the static gains of comparative advantage are particularly relevant to smaller countries.

Of course, trade also creates a burden of adjustment on import-competing industries in small countries, as well as large countries, and this downside needs to be factored into the cost-benefit analysis of free trade.

Q4. The WTO's Trade Policy Review Board has on occasion expressed concern about the vulnerability of some developing economies arising from their heavy export reliance on a limited number of products and markets. Explain why such concentration might be a problem. What measures would you suggest to help a country achieve greater export diversification?

Developing countries are often characterised by structural, institutional or sociological rigidities which limit the flexibility of response to price changes. Because of the nature of their exports, some economists concluded that a liberal international trade system does not work in developing countries’ favour. Because these countries specialise in goods with a low price- and income-elasticity, fluctuations in demand can convert into large fluctuations in export prices. In the last decade, most developing countries saw their terms of trade (defined as the ratio of changes in a country’s export prices to import prices, see text p.20) worsen considerably. If the 1979 index was 100, they had fallen below 70 by 1990 (Source: The Future of North-South Relations, European Commission, 1992). Declining commodity prices as well as developing countries’ failure to diversify their export base are responsible for the trend. Both domestic policies and the trade barriers of developed countries explain this lack of diversification. Thus, high rates of protection on processed materials and simple manufactures discourage the type of export diversification most feasible for developing countries. Export-stabilisation schemes and preferences granted by industrialised countries to developing countries have relieved balance of payments tensions, but have encouraged overproduction which has worsened the terms of trade problem.

Whether these concerns are sufficient to invalidate outward-oriented trade policies by developing countries is doubtful. Measures to achieve greater trade diversification would include:· export trade promotion agencies (trade fairs)· training of labour and management in export-oriented activities· attraction of export-oriented FDI· export marketing supports for SMEs

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So, concentration on a narrow base of primary products may be viewed as an unsatisfactory basis for development, especially if world demand for them is inelastic. The situation can be worsened by the commercial and fiscal policies being pursued by some developing countries. For example, export taxes are a major source of budget revenue in many developing countries, but they reduce the margin of competitiveness of national producers and can discourage investment. Diversification and export-promotion are of greater long-term benefit, in terms of greater stability in national income, but new industries must be efficient if they are to prove of lasting benefit. (Instructors should refer to the above reference and to EU/LDC News,vol.3 no.4, December 1996, for material concerning these issues.)

Q5. Adjustment to freer trade can involve heavy economic costs to the people affected, arising from financial and employment losses in import-competing industries. What measures should the government take in order to minimise these adjustment costs?

The opening statement is correct. Adjustment can be costly. Shareholders in import-competing industries can often lose, and so do employees, as a result of trade liberalisation. It takes time for an employees who is made redundant to find a new job; and in the case of blue collar employees the new job may entail a fall in pay.

Economics suggests a number of approaches to the adjustment problem:1) provide a reasonable transition period to allow time to adjust, 2) assist affected industries to become competitive through training and re-equipment support, 3) where industry has no reasonable hope of viability, provide a welfare 'floor' for redundant employees, 4) re-training assistance, 5) get industrial development agencies to seek out replacement industries. In addition to these microeconomic measures, governments should implement policies that encourage growth (adjustment is easier in a rapidly growing economy) and price and wage flexibility.

Q6. Is there a case for the government using subsidies to encourage the development of domestic industries by helping them win export markets? Is this fair play, or is it a form of hidden protectionism?

The use of subsidies as an export-promotion policy has its foundations in the infant industry argument, i.e. protect them at set-up stage and some time beyond until they can sustain competitiveness on export markets. Export subsidies provide a viable alternative to a protectionist trade policy, leaving consumers free to buy the good at the world market price. However, there is always a danger that such subsidised industries will lag behind in technological advances and the updating of production processes. Entering the global market immediately ensures a continuous incentive to remain competitive. There may be a strong case for such subsidisation for the purposes of regional economic development.

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Export-promotion policies, such as subsidisation, are interventionist rather than protectionist, and could be considered “fair” if agreements have been reached with other competing countries. Without such agreements, pursuing such a policy could result in retaliation by other countries who see it as unfair. Export subsidies will more often than not amount to “beggar-my-neighbour” strategies, with the gain to the domestic firm coming at the expense of the foreign firm(s) and the taxpayer. Hence export subsidies are categorised as non-tariff barriers (NTBs) and do not constitute fair play in a world of increasing trade liberalisation.

uEXERCISES

Q1. Suppose that in Sweden 1 unit of labour can produce 10 units of timber and 10 units of steel, whereas in the UK 1 unit of labour can produce 8 units of steel and 6 units of timber. In what product does the UK have a comparative advantage? In what product does Sweden have a comparative advantage? Would your answer be different if 1 unit of Swedish labour could produce 14 units of steel instead of 10?

Sweden UK

Timber 10 6

Steel 10 8

Sweden has an absolute advantage in the production of both goods, and a comparative advantage in the production of timber. The UK has a comparative advantage in the production of steel. In a state of autarky, one unit of timber will exchange for one unit of steel within Sweden. In the UK, one unit of timber will exchange for 1.3 units of steel. Timber is more expensive in the UK than in Sweden. If one unit of Swedish labour could produce 14 units of steel instead of 10, one unit of timber exchanges for 1.4 units of steel within Sweden, while in the UK one unit of timber exchanges for 1.3 units of steel. Timber is now more expensive in Sweden than in the UK. Sweden’s new comparative advantage lies in the production of steel, while the UK’s now lies in timber-production.

Sweden UK

Timber 10 6

Steel 14 8

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Q2. Examine EU-Japan trade figures in recent years. In every year since 1958 (with the exception of 1961) the main European countries have experienced deficits on merchandise trade with Japan. Comment on the extent and structure of the trade imbalance. Compare this imbalance with EU trade balances with other countries and regions. In the light of your empirical findings, should Europe’s trade deficit with Japan be a cause for concern?

Between 1980 and 1992 the total EU trade deficit with Japan has grown significantly from ECU 9 billion to ECU 31 billion, but has fallen to ECU 22 billion in 1994. This is the largest trade deficit the EU has with any of its trading partners. The most significant deficit occurs in the industry of machinery and transport equipment, with relatively insignificant deficits occurring in energy and other manufactured products.In comparison to deficits with other trading partners, that with Japan is large. However, balances with other partners appear more volatile e.g. in 1980 the EU had a deficit of ECU 23 billion with the US, which turned into a surplus of ECU 21 billion in 1986. It reached a deficit of ECU 20 billion in 1991 and is now in surplus at ECU 2 billion. A similar pattern can be seen with Saudi Arabia. The EU’s deficits with several countries have fallen over time and turned into surpluses, e.g. Hong Kong, Kuwait. A surplus with China in 1985 has turned into a significant deficit in 1994. (Source: Eurostat, External and intra-European Trade, Statistical Yearbook 1958-1994.) The structures of these imbalances varies significantly from country to country. Due to the extent of the deficit with Japan relative to other countries, it may appear to be a cause for concern. However, the balance of payments on current account of the EU has been in surplus since 1993 and reached $85 billion in 1997 (IMF World Economic Outlook, May 1997). This suggests that the EU has no balance of payments problem as such and the Japanese surplus must be seen in this context.

3. Japanese car imports into Europe have been restrained by voluntary export quotas. Use a demand and supply diagram to show the effect of this quota on the price of Japanese cars in Europe. One research study found that the effect of the quota was to raise the price of the average Japanese car to the EU consumer by 12 per cent. It also found that the price of competing European cars rose by 7 per cent. How would you explain this?

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A voluntary export quota is a quantitative restriction on the amount of imports voluntarily agreed between two parties (firms or nations). Beginning with the assumption that Japanese cars are close substitutes for European cars, the effect of the quota is to raise the price in Europe of Japanese cars due to the restriction of supply of these cars to the European market. In the diagram the free trade position is at point E. A voluntary export quota of Q’Q is imposed, and the supply of imports schedule becomes FS’. The quantity of imports falls from the free trade level OQ. The price to the importing countries’ consumers increases from OP to OP’, while the price on the world market decreases to OP’’.

Because the price of Japanese cars has risen by 12 per cent, the demand for them will contract. Consequently, the demand for domestically-produced (European) cars will expand. At the prevailing price of European cars, this creates an excess demand for them, and consequent pressure on their price to rise to induce domestic suppliers to increase production, hence the 7 per cent rise in the price of European cars in the question. Why does the price of European cars not rise by 12 per cent? This could be explained by domestic suppliers sustaining their competitive edge, or by product differentiation, e.g. European producers can claim to supply better quality cars in justification of a higher price, which cannot be incorporated into this simple diagram.

Q4. Analyse the following assessment of the effects of protection (see quote in book). Can it be reconciled with the theory of the gains from trade outlined in this chapter?

This is a difficult question to answer and perhaps should be a question for discussion. As is clear from the quote, foreign car makers have been festooned with red tape by the Japanese authorities. Such indirect protection of domestic producers does not seem consistent with the theory of the gains from trade, but they can perhaps be reconciled in some way. Competitive forces on the domestic car market in Japan have been very strong. Their approach to industrial policy has focused on excessive competition, based on the so-called business-stealing effect, whereby the motivation for a producer to enter the market is to steal some market share from other firms. Domestic producers also compete for foreign export markets. As a large economy this would leave it less prone to collusion and monopoly influences. Also, the X-efficiency gains (outlined on pp. 452-454) from intense competition would likely have been achieved, despite the lack of competition from foreign producers. So, because competition on the domestic market was so high, the potential X-efficiency gains from opening up to foreign producers would have been low. Japanese car producers appear to have undertaken the ongoing process of continuous improvement and innovation (to exploit the “dynamic “gains of production) without the need for foreign firms competing on the Japanese car market.

So, although the gains from trade appear pervasive from the evidence presented in the chapter, competition from abroad could have prevented Japanese firms from getting established and achieving critical mass. Protection of the Japanese car market from foreign producers therefore may have been justified, at least in the initial period.

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Retaliation, of course, sets limits to the amount of protection that should be given. (Another contentious sector in Euro-Japanese trade relations has been that of alcoholic beverages.)

Q5. Sometimes protection is justified on the grounds that it is good for all industries. One favourite ploy is to list all the domestic goods and services purchased by the protected industry and to compute all the extra jobs thereby ‘created’ as a benefit of protection. What is wrong with this approach?

The obvious limitation with this approach is its failure to account for the opportunity cost of labour and other factors of production, i.e. the uses to which they could be employed if they were not used to service the protected industry. Clearly, if labour was deployed from the production of the domestic goods and services purchased by the protected industry, in the production of the protected good itself, it could be employed elsewhere. (It may take time for these workers to be reemployed i.e. some unemployment is inevitable.) Many economists would take the view that an industry which needs to be protected is not worth having (except in the infant industry case), and the gains from comparative advantage are evidenced worldwide. Specialisation in a good which needs to be protected from external competition may in many cases translate to a comparative disadvantage in its production.

Domestic Resource Cost (DRC) analysis attempts to identify goods in which a country has a true comparative advantage and therefore, may be used as a measure of the costs of using protection of a domestic industry or sector. It is expressed as a ratio of the cost of domestic resources (valued at social opportunity cost) used to produce one unit of the good and the value-added in the good. If this ratio is less than one, the economy would benefit from transferring resources into the production of the commodity. If greater than one resources would be better employed elsewhere.

Q6. Consider the following statement by Adam Smith (see quote in book). How would you explain continuing high levels of protection of the wine industry in many countries? Make the case for and against complete liberalisation of the industry.

Adopting Ricardo’s theory of specialisation on the basis of comparative advantage, the answer to Smith’s question would obviously be no. Producing wine in Scotland for thirty times the cost of imports from abroad would defy economic rationalism as well as Ricardo’s theory. Yet high levels of protection of the wine industry in many countries continues to be observed. Why? · the wine industry is characterised by strong special interests. Many farmers, poor

and rich, are dependent solely on their wine output for their livelihood. Without protection, new producers can enter the market (such as those from Eastern Europe) and threaten jobs in the domestic wine industry.

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· protection will often be defended on the grounds that agricultural markets tend to be unstable, demand and supply (in the short run) being price-inelastic.

· account has to be taken of the short-run adjustment costs associated with liberalisation. Workers in the wine industry will be displaced by import competition, the scale of adjustment depending on the countries involved (see p.464). Labour markets do not clear in many countries around the world, especially in Europe, so complacency concerning the adjustment capacity of a country’s wine industry is ill-advised. A surge in imports may exacerbate unemployment.

On the other hand, there are persuasive arguments in favour of liberalisation: · the existence of excess supply - the EU’s notorious ‘wine lake’- which cost the EU

taxpayer, through subsidies and other supports, $1 billion in 1994. · freer trade would mean cheaper wine to the consumer through more efficient

allocation. · resources spent on lobbying, rent-seeking and influencing costs to maintain

protection could instead be devoted to R&D and other efficiency-promoting investment.

Q7. What are the three most important export industries in your country? Examine their export performance during the past decade. What factors explain your country’s comparative advantage in these industries? Is Porter’s Diamond useful in this exercise?

Students should identify the three most important export industries by reference to the trade statistics, followed by a study of the basis for the comparative advantage in each one, accounting for both specific and general advantages. These are often difficult to identify.

Although Porter’s Diamond appears an attractive means of explaining countries’ comparative advantages, its limitations are conspicuous when attempting to apply it to real-world industries. It will generally provide a useful ex post analysis, but is of much less use ex ante. However, even ex post, there is nothing in the Diamond to tell us the relative importance of each factor. It may also exclude relevant factors in some cases.

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18 Capital flows, foreign investment and labour migration

This chapter addresses international trade in factors of production, illustrating that, like trade in goods and services, it is mutually beneficial to the concerned parties. Capital has become increasingly mobile internationally. Information technology and the removal of foreign-exchange restrictions have reduced transactions costs. Gains are derived as capital is allocated to sectors and locations where its productivity is highest. Foreign Direct Investment (FDI), with its “growth-enhancing attributes”, has brought benefits to both home and host countries. Domestic capital has become harder to tax and governments’ fiscal policies are more constrained. Capital mobility also has important side-effects, not all of which are unambiguously beneficial; for example, erosion of the revenue base. Also, speculative flows can be destabilising. Neo-classical analysis points to a similar profile of conclusions regarding labour mobility. Labour migration, predominantly from poorer to richer countries, serves to enhance global productivity, but unfavourable fiscal effects and social and economic externalities cannot be ignored. Ease of travel and improved communications have stimulated labour migration to a point where it has become a dominant issue in many countries.

uQUESTIONS FOR DISCUSSION

Q1. Explain the contribution made by multinational enterprises to (a) a host country, and (b) a home country of your choice. Is it possible for you to conclude that both host and home country benefited from investment by multinationals?

This is a difficult question to answer and could be undertaken as a group exercise. Students could take one of two approaches:· analyse their own country as a host to and home of MNEs.· analyse a particular industry in terms of separate host and home countries. The guidelines outlined in the text (pp. 497-503) should provide sufficient criteria on which to base their conclusions. Some cost-benefit analysis may be required, and consideration of counterfactual situations in terms of issues such as employment and tax revenues will be necessary.

As outlined in the text (p. 497) most cases will permit a conclusion that both home and host country benefit and the consensus among economists (despite ever-prevailing feelings of suspicion) is that the potential gains outweigh the potential losses from this business strategy of globalisation. Where investment incentives are substantial, their effectiveness should be carefully evaluated in any cost-benefit analysis.

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Q2. ‘The value of migration as a means for enhancing economic efficiency is well known. However, at some point, it can become socially disruptive and inefficient, notably where local regimes perform so poorly that mass emigration occurs.’ (‘One market, one money’, European Economy, October 1990, p. 27)

Do you find the efficiency arguments for migration convincing? What criteria would you use in deciding the point at which migration becomes disruptive?

Analysis of figure 18.3 (p. 505) is enough to convince any student of economics of the possible welfare-enhancements attributable to labour migration. Global productivity is enhanced as labour moves to locations where its productivity is highest. Provided one accepts the simplifying assumptions of the neo-classical model, the conclusion that migration results in increased efficiency is straightforward. However, the model needs to be extended to include more variables than relative wages, such as, for example, the psychic costs of migration, quality of life and the possibility of the migrant failing to find employment. The time dimension is also important (see pp. 507-508). Even if migration is welfare-enhancing there are losers. Migrants come into direct competition with natives for employment, with adverse income effects on the relevant sections of society. From a sending countries’ viewpoint, a “brain-drain” is undesirable, that is, highly skilled workers leaving the country (good examples are Ireland and Hungary). Redistribution is possible, but governments find difficulties arranging it within their own countries, never mind doing it between different nations.

Despite the potential for increased efficiency and positive externalities, migration can reach a point where it becomes socially disruptive. Migrants can contribute to problems of homelessness or social friction. When migrants receive more than they contribute to the public finances of the host country, there is a case for its discouragement. The criteria used to judge whether or not migration has become socially disruptive are outlined on pp. 508-510.

Q3. Free trade between the EU and its European and North African neighbours is often considered as a superior alternative (economically speaking) to mass migration. Explain the reasoning behind this belief.

Trade theory shows how foreign trade can act as a partial substitute for international factor mobility when factors are immobile between nations. Like trade in the factors of production, trade in goods and services constitutes a mutually beneficial exchange (see chapter 17). By enhancing free trade, those products required by Eastern Europe and North Africa can be brought to them. The opening up of EU markets is conducive to the development of an industrial base in these countries. For the following additional reasons free trade is seen as a superior alternative to mass migration:

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1. The psychic costs of migration, for example, the disutility of working away from home and of migrant status, are avoided.

2. The adverse externalities associated with mass migration (such as social friction, or a fiscal burden in the event of migrants not being employed in the host country) are avoided.

3. One of the adverse effects of migration is that poorer people in the host country suffer with increased competition for jobs. In a theoretical sense, trade in goods and services has the same effect, as developed countries must adjust their labour force to the imports of developing countries (see chapter 17, pp. 461-464). Technically, the income distribution effects are the same. Hence, to compensate the losers in the EU, we need to concentrate on the upgrading of the labour force. One paper’s conclusions take the following form: “only development policies which increase employment opportunities in the sending countries will bring a long-term solution to the migration problem”.(Source: EU/LDC News, December 1996, with reference to a paper by David O’ Connor and Leila Farsakh, OECD, 1996 entitled “Development Strategy, Employment and Migration. Country Experiences”.)

4. Free trade can often lead to inflows of FDI into the less developed area, i.e. bringing capital to the people rather than people to the capital. Foreign direct investment endows host countries with the technical and marketing know-how necessary to reap the benefits of the free market. It also serves to upgrade their labour force. Convergence occurs not by levelling poor and rich countries to a single average, but by bringing the standards of poorer countries up to the level of richer countries. The role of the non-traded sector as a vibrant job-spinner must not be underestimated.

Q4. ‘The international mobility of capital, both in the form of portfolio capital and direct foreign investment, can make a significant positive contribution to economic welfare.’ Evaluate this statement. Examine some of the problems associated with enhanced capital mobility.

The above statement is correct. Analysis of the basic model (pp. 481-483) illustrates capital mobility as a mutually beneficial phenomenon, creating a potential net welfare gain. Capital mobility also enhances government discipline in the macro-management of the economy. If governments permit excessive budget deficits, capital will flow out of the country and interest rates on their debt (due to greater risk premia) will rise as has happened in Italy and Sweden. Capital mobility accentuates the need for fiscal discipline. Foreign direct investment has the potential to play a major role in a country’s development, the European Commission describing it “as a dynamic process which raises total wealth to the advantage of all those involved”. FDI and MNEs generate employment, tax revenues, foreign exchange, and positive spillover effects.

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However, the basic model of capital mobility disregards the existence of gainers and losers. Taxation can be implemented to compensate the losers, but problems of tax incidence will always prevail. In addition, speculative flows of capital can be destabilising and can lead to other problems such as inflationary pressures, short-term misalignments of the exchange rate and the erosion of a country’s tax base. FDI and MNEs can impose (sometimes unnecessary) costs on an economy and their ability to use transfer pricing reduces the potential benefits to a host country.

Q5. ‘The international mobility of factors of production can contribute significantly to the reduction in international differences in income and wealth.’ Discuss in the context of portfolio capital mobility.

To answer this question, students need to refer to figure 18.1 (p. 482) and the discussion of the effects on the owners of the factors of production (both labour and capital) as a result of greater portfolio capital mobility (p. 483). This clearly outlines its contribution to the reduction of international differences in income and wealth. The rates of return on capital, and wages, follow a pattern of convergence. Students should consider the debate between bringing capital to the people or people to the capital (p. 511). In this context, capital mobility provides a viable alternative to labour migration. Migration serves to level up poorer countries and level down richer ones to a single average, while investment in developing countries helps them reach the standards of developed countries. The latter is clearly a better alternative. But, does more FDI in developing countries not imply less investment in developed countries? From a growth perspective, it is not a zero-sum game if FDI encourages saving in developing countries and more domestic investment there.

Q6. Of the EU’s 370 million citizens, only about 5 million live outside their country of birth, and only 3.1 million work outside it in another EU state (The Economist, 17 February 1996). Give economic reasons for this low degree of labour mobility.

One reason for this low degree of labour mobility is the high unemployment rates of foreign workers in many European countries, e.g. the unemployment rate of foreign workers in Belgium, France, Germany, and Sweden have been between 50 and 100 per cent higher than for nationals. Restrictions on citizenship also exist allowing foreigners to remain for only a limited time period. Non-state pensions are non-transferable from one country to another and in some countries, e.g. Germany, it takes up to 10 years with the same employer to acquire the right to an occupational pension. Although this problem is specific to certain categories of workers it does serve to accentuate these restrictions.

Also, as living standards converge, and wage differentials diminish, the incentive for migration dwindles, for example, as prosperity in Spain and Portugal has grown, large-scale migration from these countries has ceased.

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There are cultural and structural barriers, such as linguistic barriers, amounting to psychic costs of migration, which, compared to migration from state to state in the US, are significant. In addition, educational qualifications are not interchangeable between countries.

uEXERCISES

Q1. Suppose a country’s unskilled workforce increases by 10 per cent as a result of immigration. Trace out the effects on (a) unskilled employees, (b) capital owners, (c) skilled professionals, and (d) government finances, in the host country and home country. (Use a diagram such as Figure 18.3 to illustrate your answer.)

Would your answer change if you were told that there had been high unemployment in the host country at the time of the migration?

Using a diagram similar to figure 18.3 (with home and host as subscripts) and the book’s analysis of this diagram, the effects can be traced out as follows:(a) Unskilled employees in the home country will experience a rise in wages due to the increase in their scarcity of 10 per cent. In the host country, these workers will see a fall in their wages.(b) Because capital per worker increases and the remaining labour becomes more productive, capital owners at home suffer a loss. Capital owners in the host country gain.(c) Skilled professionals will not be directly affected. However, in the home country, the government has a smaller population with which to meet its public finances and so taxes may rise. Given that the 10 per cent are employed in the host country, taxes may fall there. Also skilled professionals will get domestic help and domestic services more cheaply, with consequent gains to this section of society.(d) In the home country public finances are adversely affected because 10 per cent of the unskilled population are no longer paying tax. An increase in tax receipts is received from the migrants in the host country. The home country’s loss may be compensated by the fact that the burden of public goods provision is reduced, while that in the host country increases. In short, it is impossible to say a priori which effect will dominate.

Figure 18.3 deals with the labour stocks of countries and assumes full employment. If labour markets were distorted, as evidenced in high unemployment, the effects would be quite different. For instance, the host country’s social welfare bill would increase as a result of immigration. The welfare consequences for the host country would therefore be far less favourable than in a full employment situation. Thus, migrants were welcomed in western Europe in the 1950s and 1960s, when unemployment was well below 2 per cent. They were seen as filling important labour market bottlenecks. It is a very different story in the 1990s when the EU’s unemployment rate stands at 11 per cent.

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Q2. A Japanese firm is proposing to set up a new ‘greenfield’ plant to manufacture auto parts in your region. List the economic benefits which you would expect to be generated by the plant, then draw up a list of likely costs.

A ‘greenfield’ operation involves the decision by a multinational enterprise to build a new plant from scratch. By drawing on the chapter ( pp. 497-502), the instructor can list the gains on a regional level as follows:· jobs created through the building and operation of the plant (valued at opportunity

cost)· externalities (marketing know-how, training facilities and technological expertise).On a national level, the above points are relevant as well as:· tax revenues generated· foreign exchange generated.The costs to the region will generally concern negative externalities such as pollution and other damage to the environment. On a national level, monetary costs such as capital and training grants, tax incentives, rent allowances, interest rate subsidies and other forms of implicit or explicit assistance must be taken into account. The MNE may engage in transfer pricing, which amounts to additional lost tax revenue and, in the eyes of some, exploitation of the host country.

Q3. Suppose the marginal product of labour curve in the sending country shifts upwards and outwards from the origin. What effect will this have on the incentive to emigrate? What factors could cause the curve to shift in this way?

Explain why free trade has been proposed, in the context of both NAFTA and EU trade relations with East Europe, as contributing to a reduction in international inequalities and an easing of the migration problem.

Like in exercise 1, the instructor might advise students to draw a diagram similar to figure 18.3 to illustrate their answer. An outward shift of the marginal product of labour curve in the sending country will cause an increase in the wage rate there, and depending on the extent of the shift will reduce or eliminate the incentive to emigrate. Only if it shifts to such an extent that it intersects DN at point A in figure 18.3 will it eliminate completely the monetary incentive to emigrate. However, due to psychic and other costs associated with emigration this elimination of total costs will likely occur somewhere below point A.

Such a shift may be caused by an injection of capital which increases productivity per worker. Technological advances also enhance worker productivity. Other possible factors are an injection of highly skilled school- or university-leavers into the labour force, in replacement of a similar number of unskilled workers. Better access to foreign markets could also raise the marginal product of labour curve in the home country.

Free trade allows market access to developed regions from developing ones, allowing the establishment of competitive industries in such less developed regions, e.g.

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Eastern Europe and Mexico, and the exchange of their output for goods and services produced by developed countries. This trade, as chapter 17 outlines, is mutually beneficial. Instead of levelling the developed and developing regions to a single average (the effect of migration), free trade allows developing regions to aspire to the standards of developed regions, and avoids the potential costs of mass migration.

Q4. There has been much concern about the migration of skilled staff in technological R&D in Central and Eastern European countries to the West. During the period 1989 to 1993, for instance, around 70 per cent of Hungarian researchers left domestic research agencies and facilities, many of them attracted by better opportunities in western Europe and America (ACE Quarterly Phare, Brussels: EC, Summary 1995, p. 17). Analyse the economic costs and benefits of such migration.

Such migration of skilled staff in technological R&D imposes significant costs on sending countries such as Hungary. It amounts to a “brain-drain” of these countries. Such skilled researchers will have drawn heavily on the education facilities of their home country, but, to the benefit of receiving countries, take their skills and qualifications elsewhere. Sending countries lose this technological expertise. They also lose tax revenues which these migrants would have paid had they remained at home. Public expenditure can be spread over a larger population in host countries, and these migrants are likely to be young, hence not drawing on health services. (The costs and benefits specific to the owners of the factors of production can be analysed using figure 18.3.)

A proposed solution to this problem is the “brain-drain” tax, whereby emigrants would pay an extra education-related tax in the receiving country which is passed back to governments in sending countries. However, due to the potential cost and difficulty of its control and supervision, such a tax has yet to be implemented. Without it, countries such as Hungary will continue to educate their population to the benefit of countries to

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19 The balance of payments: what it is and why it matters

This chapter studies the balance of payments, which provides a record of current and capital transactions between one country and the rest of the world. The current account is an significant economic variable, impacting on both the aggregate demand and indebtedness of a country. Balance of payments deficits on current account may be desirable or detrimental depending on particular circumstances, and deciding whether or not a country has a balance of payments problem is a matter of judgement. Automatic adjustment mechanisms operate through both the demand and supply sides of the economy to equilibrate the balance of payments. However, they are usually slow and rarely complete. Expenditure changing and expenditure switching policies may be required to supplement their effect. If not matched by offsetting capital flows, impending deficits or surpluses can cause exchange rate fluctuations or forced realignments, which can cause their own problems.

uQUESTIONS FOR DISCUSSION

Q1. Under what circumstances could a country simultaneously have a balance-of-trade surplus and a current account deficit?

The current account of the balance of payments is a record of cross-border transactions in goods, services, factor income, and transfers within a certain period of time. The balance of trade is only one component of the current account, measuring the difference between the value of merchandise exports and the value of imports over the same period. Three other components are services trade, the balance of trading and investment income (factor income), and unilateral transfers (see pp. 519-520). There could be a balance of payments current account deficit if the trade surplus were accompanied by a larger deficit on one or more of the other three components. In 1995, the following countries had a balance-of-trade surplus and a current account deficit: New Zealand, Germany, Sweden, Australia, Finland, Canada, Brazil, Malaysia, Mexico, Saudi Arabia (Source: World Development Report, World Bank, 1996). Students might be asked to develop case studies on the causes of this phenomena in these countries, which could be analysed in groups. Other sources of data and information include the IMF World Economic Outlook, the OECD Economic Outlook, and the OECD Economic Surveys of member countries.

Q2. How would you explain the rapid growth in capital account transactions relative to merchandise trade transactions in recent years?

The rapid growth of capital account transactions can be explained by: · the greater mobility of capital and globalisation of investment· increased liquidity of capital markets

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· the growth in the number of available securities from which investors can choose. Derivatives (futures and options) markets allow investors (even with modest sums of money) to choose from a welter of alternative securities, each with their own risk and return features

· the “emerging markets” of newly industrialising countries - Asia, Eastern Europe, and Latin America - offering new opportunities for international diversification of investment

· the growth of foreign direct investment.Also, with technological advances and the removal of exchange controls, the world capital market has become more integrated in the 1990s than at any time since the period of the gold standard.

Q3. What, if anything, does the fact that a country has a current account surplus tell us about the strength of that economy?

It is a common error to identify a balance of payments surplus with economic strength. Nothing whatever, good or bad, can be inferred from the current account balance. Some surplus countries are powerful and economically strong (Japan for example). Others have pursued unsustainable deficits, creating an excessive debt burden and lost creditworthiness as their risk ratings rise. To restore their credit rating and sustainable debt-servicing costs these countries need to run a surplus. This may require the restriction of imports which has its own consequences for consumers. This objective may also be required to ensure that a country’s investment plans are not disrupted in the future. (Commonly cited examples are South American countries.) Drawing inferences about the economic strength or weakness of a country with a balance of payments surplus or deficit can be a hazardous exercise. For example, Nigel Lawson, Britain’s former Chancellor of the Exchequer, attributed Britain’s deficit to the strength of the economy (see Box 19.1, p. 527). In retrospect, his assessment proved complacent, as the subsequent rise in this deficit to a staggering cumulative total of £100 billion from 1988-91 demonstrated. America, as the world’s largest debtor, is the envy of other rich nations with its booming output and low unemployment. But, its foreign debt is still rising, driven almost entirely by fresh borrowing to finance extra spending at home, reflected in a current account deficit of $148 billion in 1996. This deficit has been fuelled by the country’s economic boom. Americans are expressing little concern. Time will tell whether, like Nigel Lawson, they are taking a complacent view of their foreign indebtedness.

Q4. How would you define a balance of payments disequilibrium? Discuss some of the economic forces which tend automatically to restore the balance of payments to equilibrium.

A balance of payments disequilibrium refers normally, but not exclusively, to the balance on current account. A sustained deficit or surplus on this account is prima facie evidence of the existence of disequilibrium. But there is no simple rule in deciding when a country’s balance of payments is in disequilibrium. Balance of payments analysis requires judgement depending on particular circumstances. Deficits

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are often defensible and sometimes desirable in order to, for example, draw on external capital to support a country’s investment programme. But, as the text outlines (p.525), “a country can be said to have a balance of payments problem when the current account is in deficit for a sustained period of time in conditions of free trade and ‘full’ employment”. The method of financing the deficit needs examination, hence the need to evaluate the current account in conjunction with developments in the size and composition of the capital account.

Automatic adjustment mechanisms tend to restore equilibrium, by bringing ex ante imbalances between the supply and demand for foreign exchange into ex post equilibrium. A deficit country experiences a fall in the domestic money supply, and consequent falls in expenditure, income and the demand for imports. Surplus countries see, through similar effects, a rise in demand for imports. The result is a restoration of balance of payments equilibrium. But private capital flows or central bank interventions may encroach upon these equilibrating liquidity effects. On the supply side resources must be released from the production of non-traded goods and reallocated to the production of exports and import-competing goods. This is achieved by changes in the price of traded relative to non-traded goods and services, (see pp. 532-534.) But automatic adjustment mechanisms are often slow and incomplete, and additional policy action may be required, such as expenditure changing and expenditure switching policies and depreciations of the exchange rate, to speed up the adjustment process (see pp. 534-538).

Q5. What problems, if any, is a country which runs a persistent current account balance of payments deficit likely to encounter? Contrast them with the problems of a country with a persistent surplus.

Consider first the adverse effects of a deficit. The experience of the USA can be used to illustrate:First, one definite cost is the accumulation of foreign debt and the consequent obligation to deliver a steam of interest payments, rents and dividends. Second, the greater its reliance on foreign creditors, the greater is the country's exposure to the volatility of international capital markets. Third, in the event of a loss of confidence the deficit country can suffer excessively large devaluations of the exchange rate, the inflationary repercussions of which only add to the problems of the deficit country. Fourth, the further a country's international investment position moves into the red, the more ownership over its assets moves into the hands of foreigners

To illustrate the adverse effects of a surplus, one can take the case of Japan:First, surplus countries tend to be blamed for their trading partners' deficit problems. They are likely to be pressurised to import more from the deficit countries.Second, surplus countries are also likely to be subjected to 'voluntary' restraint on their exports and will be encouraged to invest more abroad (while at the same time, and inconsistently, this very increase in investment may arouse nationalistic unease). Third, such investments may be unprofitable because of exchange rate losses as the surplus itself leads to a strengthening of the currency vis-à-vis the borrower.

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Furthermore, investment decisions taken under pressure to placate the deficit countries may end up being poorly advised. Fourth, surplus countries have to be aware of the potential inflationary repercussions of a sustained surplus.

Q6. Should a tax be imposed on countries running a persistent balance of payments surplus, on the grounds that such surpluses are deflationary and a danger to the world trading system?

By definition, one country’s balance of payments surplus is another country’s (or group of countries’) deficit. In order to reduce a deficit, deficit countries may have to restrain domestic demand. In this sense, surpluses can often imply deflationary policies. Furthermore countries with large deficits often blame countries with large and conspicuous surpluses for their problems. In particular, for putting them under pressure to adopt deflationary policies and this can lead to retaliatory action and to the disruption of the world trading system.

While sustained surpluses can indeed be deflationary and also a danger to the world trading system, is a tax an effective way of dealing with this problem? Because of the “deflationary bias” associated with balance of payments surpluses, Keynes concluded that a successful international monetary system should be guided by the following ‘lessons’:

“The object.....must be to require the chief initiative [for adjustment] from the creditor countries, whilst maintaining enough discipline in the debtor countries to prevent them from exploiting the new ease allowed them in living profligately beyond their means.” (D.E Moggridge, Maynard Keynes, London, Routledge. 1992, p. 672)

He proposed a system of taxation on surplus countries in his plan for an international bank. Countries with surpluses would be obliged to deposit them in the international bank and a quota was set for each country establishing absolute limits to their positions with the international bank. Surplus countries would receive no interest on their credit balances, but pay 5 per cent per annum on balances above a quarter of their quotas and 10 per cent per annum above a half. He proposed that any excess above their quota would be confiscated.

However, countries sometimes have substantive reasons for sustaining a surplus, and the limitations of Keynes’ demand-side economics are well-known. Other ways of resolving the problem of excessive surpluses are available:1. A wider and more strict enforcement of WTO trading rules to ensure that the surplus countries play by the rules and do not acquire their surpluses through protection.2. Increased macroeconomic co-ordination might be effective in encouraging surplus countries to adopt more expansionary policies if necessary.3. Rich countries should be saving, and, in some way, giving to the poor. Following the war, the US had a period of sustained surpluses. This reflected the transfer of real resources from America to the shattered European economy. It involved a classical-type transfer of real resources from surplus to deficit countries; to levy a tax on this

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transfer would clearly be unjust to the donor country. Hence Keynes’ proposals, influenced as they were by exclusive concern about the demand-side implications of surpluses, were not adopted..4. Surplus countries could be encouraged to invest abroad.

Another important consideration is that, like the brain-drain tax discussed in chapter 18, such a tax would be difficult and costly to administer and supervise.

uEXERCISES

Q1. Honey and Moon from Korea spend a holiday in Britain. During their visit, they affect all four major components of the current account of the UK's balance of payments. What transactions could they have made?

To affect the merchandise trade balance, Honey and Moon would have purchased some of Britain’s imported goods. This serves to reduce a British current account surplus or increase a deficit. During their stay Honey and Moon may take guided tours. In this case they import a service from Britain to Korea, with a positive effect on Britain’s services trade balance. However, if they are on a working holiday, they may export services from Korea to Britain, e.g. consultancy, which has a negative effect on Britain’s services trade balance and overall current account.

The earnings of Honey and Moon while in Britain enters, as an import of foreign factor services, in Britain’s balance of trading and investment income with a negative sign. As non-residents, Honey and Moon may receive income flows from British stocks or bonds which they may have purchased in the past, with a similar effect on the balance of trading and investment income. Both adversely effect Britain’s current account. In sending remittances to family members in Korea, Honey and Moon can effect the fourth component, i.e. unilateral transfers (or the balance of international transfers). This enters Britain’s current account with a negative sign.

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Q2. Classify the following transactions in the UK balance of payments:

a. British Airways purchases a jet from Airbus for £60 million, and receives a three-year credit from a French bank to finance the transaction.

b. A US. tourist travels to Britain and spends £1000 financed by dollar travellers' cheques.

c. Mercedes Benz sells DM400,000 of its cars to a UK distributor, allowing 90 days' trade credit until payment is due.

d. Herr Schmidt in Bonn, West Germany, sends his grandson in London DM 4,000 for his university fees.

e. A resident in Phoenix, Arizona, receives a £40,000 dividend from British Telecom plc which is deposited in a local bank.

(a) The British Airways purchase of the jet enters Britain’s merchandise trade balance on current account as an import, while the £60 million three-year credit from the French bank enters Britain’s capital account as an inflow.

(b) Britain’s invisible exports increase by £1000. Its official reserves in on capital account increase by the amount of American dollars used to finance the £1000 spent by the tourist. America’s official reserves fall by £1000.

(c) This transaction enters Britain’s merchandise trade balance as imports. Initially, short-term capital inflows increase by DM 400,000 representing the credit made available by Mercedes Benz. In 90 days, the DM 400,000 is paid to Mercedes Benz, reducing Britain’s official reserves in the capital account.

(d) This could enter Britain’s balance of international transfers with a positive sign, as Britain is the recipient of the transfer. In the capital account official reserves would increase by DM 4000. However, the DM 4000 is used to pay university fees and becomes a service export, entering Britain’s current account with a positive sign.

(e) The £40,000 dividend is paid to a non-resident and enters Britain’s balance of trading and investment income with a negative sign. UK reserves fall by an equal amount.

Q3. Consider any country with a balance of payments deficit on current account. Reviewing the economic record of the country, should the authorities take steps to reduce this deficit? If so, how should this be done?

The UK economy in the mid 1990s might be taken as an example of a deficit country where the authorities decided that no remedial action was required. By contrast the

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US deficit is seen as a problem by the Clinton Administration. The United States is the world’s biggest debtor, but their GNP is also the largest, with no danger of it being unable to pay its foreign debts. However, foreign borrowing by the US has been to finance budget deficits rather than investment, which means future generations of US citizens will face the burden of repaying the foreign debt. Total spending can be curtailed with concentration on reduction of the level of imports. Developing countries, such as India for example, frequently see the current account deficit as serious constraint on faster economic growth. Unlike more developed countries, their access to world capital markets is problematic and uncertain, due to excessive debt burdens and consequent lost credit ratings. See question for discussion 3 and, for example, the Mexican case.

Students should discuss the measures proposed to reduce the deficit using the expenditure reducing and expenditure switching classification described in the text.

Q4. Review recent trends in the current account balance of payments of a major industrial country. How would the current account balance be affected by: a) faster economic growth in your economy? b) faster economic growth in the economy of its trading partners and c) rapid inflation relative to its trading partners?

Reviewing the current account balance of payments of a major industrial country, students should identify the effects of the above as follows:a) faster growth in the economy will stimulate demand for imports and will, other things being equal, tend to worsen a balance of payments deficit. (This answer would have to be qualified if the prime cause of the faster growth happened to be a boom in exports.)b) faster growth in trading partners is good for the home country’s exports and could be expected to strengthen the balance of payments.c) inflation will make exports less competitive and imports more competitive relative to domestic goods and so will worsen the balance of payments. Perhaps in the very short run there might be J curve effects but these will not last.

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20 Coping with exchange ratesInternational transactions have to be financed using foreign exchange. This involves exchange rates. This chapter explains how exchange rates affect business and how they are determined. It goes on to analyse one of the chief problems facing an international business: how to cope with exchange rate volatility. Various options for dealing with exchange rate risk are outlined.

At firm level, this volatility can mean the difference between prosperity and closedown for exporting or import-competing firms, depending on the level of exchange rate “pass-through”. Economic theory provides explanations of how exchange rates are determined. Purchasing Power Parity (PPP) theory is the best known but others focus on the balance of payments, money supply growth rates and portfolio asset effects. Each theory has limitations at theoretical and empirical levels.

Exchange rates are difficult to predict because of random and sometimes violent changes in economic ‘fundamentals’ and irrationality in foreign exchange markets. Businesses must identify their exposure to exchange rate risk and apply risk-reducing measures, using the forward market, swaps and options and other hedging instruments. Internal mechanisms include netting, leads and lags, and matching assets and liabilities. These instruments are costly to firms but so is exchange rate volatility, so the benefits of reduced exposure must be balanced against these costs.

uQUESTIONS FOR DISCUSSION

Q1. Purchasing power parity states that countries with high inflation rates tend to have depreciating currencies. Can you explain why?

First, PPP should be explained. In this context, relative PPP is being referred to. Second, the consequences of one country having a sustained higher inflation than its trading partner might be explained step-by-step as follows:

· exports become less cost competitive· import-competing industries find it harder to compete against foreign rivals· the current account balance of payments position deteriorates· capital may start to flow outwards as markets start talking of a possible

weakening of the currency· in the short run these pressures may be resisted by running down reserves

or by interest rate hikes.· eventually if the inflation persists the exchange rate will have to be

devalued.

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Q2. Why should the discovery of a natural resource, say North Sea oil, be expected to lead to a strengthening of a country's currency? Taking the rise in sterling in the early 1980s as an example, what effect would you expect such an appreciation to have had on: a) Britain's manufacturing sector, b) British exporters, c) British consumers?

The discovery of oil will lead to an increase in the supply of foreign currency, and consequently a strengthening of the currency, through the following mechanisms· an initial net capital inflow into the country ( from new investment opportunities

etc.).· as the economy becomes self-sufficient in its energy needs, energy related imports

will decline.· as the domestic oil industry develops its capacity, it may begin to export oil,

further strengthening the currency.The net effects on the relevant sectors can be summarised as follows:(a) The manufacturing sector, is exposed to foreign competition and, as the appreciation makes imports cheaper, we should expect the sector to be adversely affected. However, an appreciation could, in certain circumstances, have beneficial long run effects as it forced manufacturers to develop more efficient production techniques and to compete in terms of quality rather than price.(b) As they become more costly in the world markets as a result of an appreciation, exports will decline and British exporters will lose.(c) Consumers would tend to be better off after the appreciation as the prices of traded goods become less expensive.

Q3. Why do large differences in interest rates continue to prevail between countries notwithstanding the increasing international mobility of capital which must tend to reduce them?

Differences in interest rates persist between countries for two reasons:

First, if a currency is expected to devalue, its investors will require an additional premium to compensate for the expected depreciation. The covered interest rate parity theorem states that the domestic interest rate less the foreign rate is equal to the expected change in the exchange rate. Expected currency movements are at the root of international interest rate differentials. Many factors can cause an expectation of exchange rate depreciation, such as lax monetary policy ( which leads to inflation and a devalued currency), persistent balance of payments deficits, lack of cost competitiveness, and large and growing amounts of public debt.

Second, risk premia may be required by some investors to invest in some countries. For example, if the country is already highly indebted, and if the risk of default if high, its interest rate is likely to remain higher than its trading partners’.

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Q4. Why are exchange rates volatile? What can government do to try and reduce such volatility? Does government action sometimes cause volatility?

There is no easy answer as to why exchange rates are volatile. However it is generally accepted that volatility arises from the following sources;

Macroeconomic shocks to the system: changes in the conduct of monetary and fiscal policy will affect exchange rates. Demand and supply shocks, such as acts of god, war, and changes in tastes, preferences and technology will affect exchange rates.The interaction of uncoordinated monetary policy and these shocks should also be mentioned as a source of instability .

Price stickiness in other markets: for example if wages are inflexible, labour market shocks could have repercussions in the currency market.

Lack of perfect rationality in the forex market: the existence of speculative bubbles and bandwagons (whereby the actions of investors cause spiralling upward movements in prices, for no apparent economic reason) reflects the propensity of investors to act according to the dictates of “animal spirits” and the herd instinct rather than perfect rationality. Speculation (holding a risky position in a currency in the hope of earning profits) itself can be a source of instability in the forex market. For example, suppose speculators expect a fall in the value of a currency. This gives rise to anticipatory purchases of foreign currency, propelling the exchange rate downwards and causing an expectation of a future fall.

Related to this point is the use of charts and technical analysis in the forex market. Some traders, rather than basing their strategies on economic fundamentals have developed techniques to predict trends and patterns from currency data. The use of these “charts” may cause distortionary effects in the forex markets. For example, if a large enough group of traders use the same charting method, this creates the potential for volatilty. Such volatility can be exacerbated where chartists and fundamentalists exist in tandem.

Government action to reduce volatility in the foreign exchange markets can take several forms:· interest rate policy, institutional mechanisms such as controls on exchange rates

and international capital movements, high capital reserve requirements, and taxes on speculation

· the introduction of specific monetary and fiscal policies that are seen to be consistent with the accepted long run value of the currency. In such cases monetary and fiscal policy need to be credible to avoid time inconsistency problems.

· sovereign governments may negotiate international agreements seeking exchange rate co-operation and co-ordination of policies. Normally these agreements provide for a system of (semi) fixed exchange rates amongst member countries and detailed institutional mechanisms/arrangements in the event of currency instability and needs for realignments. The European Exchange Rate Mechanism (ERM ) is an example of such an international agreement (essentially where

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European Monetary Authorities agree upon a system of semi-fixed exchange rates between member countries - see Chapter 21)

Government action can exacerbate volatility in a number of ways:

If open market operations and central bank intervention are seen to be at odds with market sentiment about the value of the currency, such “confused signals” will give rise to volatility. A similar result arises when intervention in the currency market is seen to be inconsistent with prevailing monetary and fiscal policy. For example, the currency crisis of 1992, and sterling’s eventual withdrawal from the ERM was partly due to the market’s perception that the sterling/DM link was unsustainable and that monetary policy was tighter than required for the weak British economy (see chapter 21).

Q5. Since the advent of flexible exchange rates, foreign exchange risk has been a major source of concern for multinationals. Is exchange rate exposure a problem just for multinationals or could a firm with a wholly domestic market orientation also be affected?

A firm with a wholly domestic orientation can be affected by exchange rates. Even if a firm sold 100 per cent of its output on the domestic market, a depreciation of the currency, by making imports more price competitive, could erode its sales. If the firm operated in the non-traded sector, it might still be affected by the exchange rate, through changes in the price of any imported inputs. Finally, exchange rate fluctuations and subsequent exchange rate management affects real variables in the entire economy ...interest rates, inflation, employment etc.

Q6. Explain why firms with highly price-elastic demand for their product (price-takers) are more likely to be affected by currency fluctuations than those with low price-elasticity of demand (price-makers).

Consider the effect of an appreciation of the domestic currency on a price-taking firm. After the appreciation, the foreign currency equivalent of the domestic price increases. But any rise in the foreign price charged results in a severe loss of sales, and, in order to preserve the original profit margin, the firm will have to lower its prices in the foreign market by the extent of the appreciation. By contrast, foreign producers need not change their prices, therefore world prices remain at their original level. As the domestic firm is a price-taker on the world markets, it must either accept original price (by cutting costs and/or reducing profit margins) or go out of business. Note, that a depreciation of the domestic currency would result in windfall profits for the firm.

On the other hand price-makers can adjust their prices to maintain profit margins in the light of currency fluctuations. Given an appreciation, they can charge higher prices in the export market, knowing that foreign demand is relatively inelastic and/or there are few other firms that can undercut their prices.

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Q7. It has been said that "good currency risk management and good business management are synonymous". Do you agree? Discuss the main market instruments which a firm can purchase in order to reduce its foreign exchange exposure can be reduced.

In world of uncertain exchange rate movements, currency risk management should be given a high priority by firms that trade in the global economy. However, currency risk is not the only type of risk to which firms are exposed. Other sources of risk include basic price risk (uncertainty as to the future prices of assets and commodities), default risk, inflation risk, term structure risk, general market risk, consumer confidence, political risk... etc. Sometimes these factors may manifest themselves via exchange rates, however this is by no means necessarily true all of the time. (For example the risk that a firm’s employees will strike is unlikely to be caused by or reflected through currency movements.) In order to formulate proper business risk management, managers must identify all risk factors that could affect the business and use the appropriate strategy/instruments to deal with the risk.

The main instruments available to reduce foreign currency exposure include:Forward currency contracts - These contracts commit the user to buying or selling a particular currency at a specific date in the future. They are mainly used for trade between two private parties and are tailor-made to suit the needs of both parties. Given that they are tailor-made, forward contracts can be engineered to totally eliminate a firm’s exposure to exchange rate risk.

Futures contracts in general do not eliminate total risk. Futures contracts relate to standard quantities (this quantity may undershoot or overshoot in the cover it provides on the firm’s position in foreign currency). Furthermore the maturity date of the future contract may not correspond to the dates of the firms “spot” activities. Therefore a perfect hedge is not usually available with regards futures (the type of risk referred to above is known as basis risk). However as futures trading occurs on an organised exchange, and one deals with a clearing house rather than another private party, the risk of default (risk that one of the contractees will renege on the contract) is significantly lower than that of a forward contract.

Option contracts can also be used to manage foreign currency risk exposure. This is a contract that gives the buyer the right, but not the obligation to buy or sell a specific amount of currency at a particular rate on or before a specified date. Whilst futures and forwards involve binding commitments, an option is best thought of as a form of insurance. It eliminates “downside” risk, but leaves the opportunity to benefit from positive “upward” exchange rate volatility. However the holder of an option must pay a premium to the seller of the option.

These are the three classic forms of derivatives used in currency management. Recent years have seen enormous growth in “exotics” or complex derivatives. These derivatives usually have some special features that differentiate them from regular (“plain vanilla”) instruments. The appearance of such derivatives is primarily due to the increased volatility in the currency markets.

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Q8. A company can also deal with the exposure problem through internal exposure management. What does this entail?

Internal exposure management is often used by small firms (where the costs of using traded instruments is higher than any potential gains) and in emerging economies where the market for traded instruments is undeveloped or indeed does not exist.

Internal exposure management, involves the use of “natural hedges”, i.e. process where a firm can offset its risk exposure without recourse to traded instruments. A good example of a natural hedge is that of an exporting firm relocating its production facilities to the export market so as to match its costs and revenues in one currency. In recent years, due to the appreciation of the DM German firms are increasingly moving their production out of Germany in favour of their main export markets.

Other forms of natural hedges include netting agreements (whereby groups of companies trading with one another in different countries calculate their positions with respect to each other and pay the difference between what they owe and what they are owed), diversification of sales and purchases (reduce volatility of net foreign currency position by diversifying trade into many geographical regions). The reasoning behind diversification is that not all currencies can simultaneously move in the same direction. If one currency appreciates then necessarily another currency or group of currencies must depreciate. If a firm’s exports are diversified into many markets, there would be a tendency for currency movements to cancel one another out.

uEXERCISES

Q1. Suppose the one-year interest rate on British pound deposits is 10 percent, the dollar interest rate is 6 percent, and the current $/£ spot rate is $1.50. a) What do you expect the spot rate to be in 1 year?b) Suppose both the United States and United Kingdom implement new policies that lead to an expected future spot rate of $2. Suppose further that the dollarinterest rate rises to 7%. What spot rate would be consistent with these twochanges?

(a) The interest rate parity theorem states (approximately):

Rd - Rf = - %DS

where Rd refers to the domestic interest rate, Rf the foreign interest rate, and %DS to the expected percentage change in the exchange rate. Assume that sterling is the domestic currency and the dollar is the foreign currency. A simple application of the theorem

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leads us to expect that sterling will have depreciated by about 4% (10% - 6%) over the year.

A 4% sterling depreciation will raise the cost of a dollar from 0.6667p to 0.693p. This is equivalent to a change in the $/£ spot rate from $1.50 to $1.44.

As a check on result consider the following transactions;

1) Invest $1.50 @ 6% for 1 year, yielding 9 cents at the end of the year (payoff of $1.59)

2) Invest £1 @ 10% for 1 year, yielding 10 pence at the end of the year (payoff of £1.10)

At the initial date, both these transactions cost the same amount. Given absence of arbitrage opportunities in the financial markets we would expect both of them to yield the same net return, i.e. that $1.59 = £1.10. A $/£ exchange rate of $1.445 will guarantee such an outcome, i.e. an exchange rate that has depreciated by about 4%.

Purists may note that both methods yield slightly different results (1.445 vs. 1.44). This discrepancy arises as the formulation of the uncovered interest parity theorem used in the examples and text is an intuitive approximation to a more general theorem. The more formal version of the theorem states

S = 1 + Rf

SE 1 + Rd

(b) In this case the interest rate differential (Rd - Rf) is 0.03. Therefore we expect the currency to depreciate by about 3%.Therefore,

S - 2 = 3 S 100

Þ S = $ 2.06

A current exchange rate of $2.06 per £ is consistent with the data.

Q2. “Overly hard currencies cut first into profits and then into market share, fewer jobs, financial instability and social unrest." Comments of this nature were often made during 1995, as the Japanese yen soared and the Japanese economy declined. What indicators would you use to determine whether a currency is "overly strong"? Explain the effects mentioned above (loss of profits, market share etc.). Use data on Japan or on any other currency which you think might be overvalued to illustrate your answer.

The following are useful indicators to determine whether a currency is “overly strong” (overvalued):

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(1) A country’s balance of payments position, which is adversely affected with an overvalued currency. The balance of payments current account balance is another frequently used indicator. Imports will be high and exports low in the event of a currency being overvalued. Of course, the current account balance needs to be considered in light of capital movements.

(2) According to The Law of One Price, if two goods are identical, they will sell at the same price. Inspired from this is the theory of absolute PPP, according to which, the exchange rate will be such that the general level of prices will be the same in every country. But as empirical studies show, actual exchange rates diverge considerably from their expected levels on the basis of absolute PPP. Observing this divergence between actual exchange rates and those predicted by PPP can give an indication of whether or not a currency is “overly strong” (see p. 556 and the analysis of table 20.1).

(3) Relative PPP, a theoretically more realistic hypothesis, postulates that prices in different countries tend to change at the same rate over time, after correction for changes in the exchange rate. If a country is deflating faster than its currency is depreciating, that would indicate a degree of overvaluation.

(4) Interest rate differentials are another useful indicator. The Uncovered Interest Rate Parity (UIP) theory says that the domestic interest rate less the foreign rate should equal the expected change in the exchange rate. A country with interest rates lower than those abroad is likely to be overvalued.

(5) With an overvalued currency the domestic currency price of exports may be too low. As a result, revenues may be insufficient to continue production. Import prices will also be low, making domestic import-competing firms uncompetitive and unsustainable. So, looking at the number of domestic firm closures (in the export and import-competing bracket) may give an indication of whether or not the currency is overly strong.

With an overly strong currency, exporters’ domestic currency sales revenues will be below potential (see pp. 547-8 and consider the effect of an appreciation of sterling). Although the resulting cost structure is favourable, due to cheaper imported raw materials and intermediate goods, the former effect is likely to dominate. Hence, exporting firms lose profits. Import-competing firms suffer similar effects due to cheaper import prices on the domestic market. Profits can also be eroded when rules require a firm in an overly strong currency to write down holdings of foreign assets denominated in weak currencies. Due to decreased profits, the supply of exports fall and exporters lose market share. Foreign producers increase their supply of exports with a resulting loss in market share for import-competing firms. With these lost market shares and the effects on profits outlined above, jobs in export and import-competing industries become threatened and some may be lost. The adverse effect on the country’s balance of payments position can, as chapter 19 outlines, be a source of financial instability, as can the possibility of job losses. Although consumers gain from lower import prices, the possibility of severe job losses can create social unrest. Trade unions, as well as export and import-competing producers, will put pressure on the authorities to devalue the currency.

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Using Japanese and perhaps German data, students may find the long run effects to be ambiguous. While their currencies rapidly appreciated, exporters in these countries sustained competitiveness and success.

Q3. A British company has to make a US $1 million payment in three month's time. It has a dollar balances of that amount available now. It decides to invest it for three months. Given that

the US deposit rate is 5% per annumthe sterling deposit rate is 8% per annumthe spot exchange rate is £0.55p the three-month forward rate is £0.60.

a) Where should the company invest for better return?b) Assuming that interest rates and the spot exchange rate remain as above, what forward rate would yield an equilibrium situation?c) Assuming that the US$ interest rate and the spot and forward rates remain as above, where would you invest if the sterling deposit rate were to rise to 14% per annum?d) With the originally stated spot and forward rates and the same dollar deposit rate, what is the equilibrium sterling deposit rate?

As all transactions referred to in the question relate to a three month time period, we first need to find the three month interest rate. If the US deposit rate is 5% p.a. then the three monthly rate is approximately 1.25% (5¸4). Similarly, the three month Sterling rate of 2% is calculated in a similar fashion (8¸4).

(a) The company faces two options in deciding where to invest its dollar balances of 1 million:

Strategy 1: Convert the dollar balances to sterling which will yield £550,000 and invest @ 2%. Buy dollars forward in three months at a rate of £0.50. The payoff will therefore be:

£550,000 @ 2% = £561,000 (after three months) ® converted into dollars @ £0.50

® $ 935,000

Strategy 2: Invest the dollar balance @ 1.25 % . After three months the payoff will be:

$ 1,000,000 ® invested in the US @ 1.25%

® $ 1,025,000

Þ For a better return the company should invest in dollars now.

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(b) If the firm is indifferent, the covered interest rate parity theorem should hold, i.e. the percentage difference between the current spot and forward exchange rate should approximately be the same as prevailing interest rate differentials

S - Sfw x 100 » Rd - Rf

S

Given that Rd = 2, Rf = 1.25, then %DS = -0.75%

- 0.75 = 0.55 - Sfw x 100 100 0.55

Þ Sfw = 0.5459

(c) If the sterling rate were to rise to 14% p.a. then the three month rate would be 3.5%. The firm is now faced with the same two strategies as in part (a).

Strategy 1: Convert the dollar balance to sterling now and invest @ 3.5%. Buy dollars forward in three months at a rate of £0.60. The payoff will therefore be:

£550,000 @ 3.5% = £569,250 (after three months) ® converted into dollars @ £0.60

® $ 948,750

Even with the higher sterling rate this strategy will still not cover liabilities of $1,000,000.

Þ The firm will stick to the original strategy of investing in dollars now.

(d) Using the covered interest rate parity theorem we can find the equilibrium 3 month sterling rate

- S - Sfw x 100 » Rd - Rf

S

If S = 0.55, Sfw = 0.60, Rf = 0.0125, then using the formula

Rd = 0.1034

The equilibrium three month rate is 10.34%, therefore the yearly rate is 41.36%With such a rate both strategies will yield the same result.Note, some students may note that when a sterling rate of 10.34% investing in sterling (strategy 1) yields $1,01,1458. This is less than $1,025,000 from strategy 2. This discrepancy arises as a result of using the approximate version of the covered interest rate parity theorem.

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21 Exchange rate regimes

With an increasingly integrated world economy there is ongoing debate about the most suitable type of global exchange rate system. Some argue for greater fixity of exchange rates while others believe a system of independent floaters is, though far from ideal, the best available. The major currencies float freely against each other, while others seek more stable arrangements; for example, many small countries peg their currencies to “anchor” currencies. While larger countries are adhering to flexible rates, an exception is Europe’s proposed monetary union, whereby several major currencies will merge into a single currency. Although a floating system has advantages, it has one major drawback, that is, exchange rate volatility, which is costly to business and is accompanied by sustained misalignments. Consequently, interest has rekindled in the theory of optimum currency areas. Attention has also focused on measures available to the authorities to moderate currency variation, such as direct intervention, altering domestic interest rates, capital controls and others. None provide a definitive solution to the problem of volatility. Exchange rate expectations cannot be controlled contrary to long run fundamentals. Economic and Monetary Union (EMU) is a major initiative by European governments to impose stability on Europe’s monetary arrangements. Opinions on its are still divided. Potential gains exist, but too much rigidity may weaken member states’ capacity to adjust to both external and internal shocks.

uQUESTIONS FOR DISCUSSION

Q1. Discuss the advantages of the system of independent floating exchange rates. Does the choice of a floating regime indicate that the authorities do not care about the level of the exchange rate?

A system of independent floating exchange rates gives economies a degree of monetary policy independence. For example, on leaving the ERM the UK authorities gained a substantial degree of monetary autonomy (see ex. 3). This monetary autonomy can be used to influence the exchange rate. Switzerland used it to insulate its economy from inflationary forces in the 1970s. The UK has used it to enhance the competitiveness of British exports.

Floating exchange rates are a form of automatic stabilisers to adverse shocks. The swift adjustment of market determined exchange rates helps countries to remove excessive trade balance deficits/surpluses. Moreover, a floating regime tends to promote exchange rates moving in the direction of purchasing power parity (otherwise there exists potential arbitrage possibilities). The use of the floating exchange rate as an automatic stabiliser is even more important given price inflexibility in the labour and product markets. In order to avoid unemployment adverse shocks may require either wage/price flexibility or exchange rate flexibility. Exchange rates are not subject to institutional rigidities present in the labour/goods

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markets (wage bargaining, minimum wages, menu costs etc.) and thus may prove to be a more expedient method of adjusting to shocks to the system, both politically and economically.

Finally floating exchange rates place less stringent official foreign reserve requirements on countries. As CBs no longer need to intervene in the currency markets to maintain a particular exchange rate, they will not need a high level of foreign reserves. This point is of particular importance to emerging economies who may have scant foreign reserves. Most countries, even free floaters, consider the level of the exchange rate to be important and many will try to influence it indirectly (hence ‘dirty floating’).

Q2. Why are some European politicians willing to surrender control of monetary policy and face stringent budgetary rules in return for monetary unification?

Outline the economic benefits of EMU. Saving the single market and having a say in the formation of Europe's monetary policy are big factors for France but cut little ice in Germany. Some political leaders are convinced that the economic benefits outweigh the economic costs. Another possibility is that they consider the political benefits sufficient to outweigh any possible economic losses. Clearly opinions differ throughout the EU on these important issues. Many in Britain for example are convinced neither of the economic or political advantages of participating in EMU. Economists can help by pointing out the conditions for economic gains to be obtained. Advocates of the Stability and Growth Pact would say that fiscal constraints are not something which offset the gains from EMU but rather are an essential precondition of such gains being obtained.

Q3. What criteria would need to be satisfied for the countries of the EU to constitute an optimal currency area? Does the EU at present satisfy these criteria in your view?

Optimum currency areas are groups of economic regions whose economies are closely linked by trade and by factor mobility. The constituent economies should have a similar economic structure. Finally the degree of fiscal federalism in the area should be high (ability to transfer resources from members with healthy economies to those with ailing economies) Such an area’s economic interests are best served by a fixed exchange rate.

Is the EU an optimum currency area?

Whilst the extent of intra-European trade has increased over the years, most EU members still only export about 10 - 20 % of their output to other members. This is relatively small compared to the extent of inter-state trade in the US.

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Labour force mobility is quite low in the EU. A brief glance at the diverse unemployment rates present in the EU is testament to this. (The UK in 1997 has an unemployment rate of less than 6%, and France greater than 12%.) We can largely ascribe this lack of mobility to linguistic and cultural differences amongst the member states which will not be easily eradicated.

EU countries do not share a similar economic structure. Countries of northern Europe tend to be more endowed with capital and labour than those of southern Europe. Moreover the business cycle is not exactly synchronised across the EU (see chapter 16). In the mid 1990s some countries are booming (UK, Ireland) whilst others were stagnant (France, Germany).

Finally the degree of European fiscal federalism is quite limited. Despite the importance of EU structural funds to some of the poorer nations, the EU’s powers to tax and transfer resources from one area to another is small relative to those of national governments powers, (EU fiscal intervention is less than 2% of EU GDP). Furthermore, given the current political environment it is unlikely that member will elect to transfer fiscal authority to a EU body in the near future.

Thus, the evidence suggests that the EU at present is not an optimum currency area. A key issue is whether monetary union could itself change institutional parameters and help the EU to become one.

Q4. Discuss the economic advantages and disadvantages to the UK of participation in EMU.

Using the text (pp. 603-606), the standard advantages and disadvantages to the UK of participation in EMU can be outlined. Static gains include:· the elimination of transactions costs.· the reduction of other bank charges, commissions and delays associated with cross-

border bank payments.· the elimination of exchange rate uncertainty and hedging costs.· greater transparency in prices.There are also dynamic gains of the form:· greater economies of scale and benefits in terms of market depth and efficiency

through completion of the internal market in financial services.· the reduction in uncertainty (about exchange rates and monetary and fiscal policy)

could encourage investment and raise the growth rate.These dynamic gains could be further enhanced if business expectations were boosted by a successful launch of EMU. If the European Central Bank (ECB) performs its duty, low inflation will prevail and the new single currency will compete with the dollar and yen as a major international currency and reserve asset, enhancing the role of the EU in the international monetary system. By participating the UK can share in these gains.

The disadvantages of participation can be listed as:

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· loss of autonomy in economic policy (loss of the exchange rate as an instrument of economic adjustment at national level and surrender of monetary policy to the ECB).

· efforts to meet the fiscal requirements may prove contractionary.See also the discussion on the economic impact of EMU (pp. 605-606) concerning methods to deal with asymmetric shocks, and question for discussion 3.

As well as the above costs and benefits (which will effect different countries in different ways) the UK must consider advantages and disadvantages particularly relevant to its own economy. The UK has important trade links with EU countries, which could be jeopardised through non-participation, for example, in 1995 exports to and imports from the EU accounted for 20 per cent of the UK’s GDP (source: Economist Intelligence Unit, Country Report). By participating, the UK can avoid losses in competitiveness caused by appreciations to which sterling may be subjected. Against this must be weighed the dangers of asymmetric shocks which domestic policy would be debased from addressing. Problems for the banking system in adopting the single currency and abandoning sterling must also be considered.

As with every country in the EU, the UK must analyse carefully the extent of benefit and loss in both a general and specific sense in its decision whether or not to participate in EMU.

Q5. What is an “anchor” currency? Why should a country wish to “anchor” its currency to another?

An “anchor” currency is one to which the currency of another country, particularly prone to currency instability and speculative attack, can be tied. That country pre-commits to some range of variation around the anchor currency. An anchor should be the currency of a stable, low-inflation country. Domestic monetary and fiscal policies in both countries must be consistent with this exchange rate policy, and the authorities must be able to defend the arrangement through intervention in the forex market. Clarification of the precise relationship with the anchor is also required. Political will to maintain the arrangement is a necessity, which requires keeping adjustment costs to the minimum. Excessive adjustment costs may make the link unworthwhile. In addition (as the text outlines on pp. 592-3) the theory of optimum currency areas stresses the following important requirements for such a link:· substantial trade and investment links (see box 21.1, pp. 587-589)· similar economies with regard to structure and policy· extensive labour mobility between the countries in question· wage and price flexibility· counter-cyclical fiscal transfers are desirable but not essential in the presence of

the three gone before· establishment of credibility associated with the link.Small countries which feel vulnerable to speculative attack will seek security by linking their national currency to an anchor. Small industrial countries will usually have close trading links with one dominant trading partner. By anchoring its currency, these small countries can eliminate the harmful effects of exchange rate

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fluctuations. Domestic industry can feel more secure as they will be less prone to these harmful fluctuations, and the country is less prone to speculative attack if the link is credible. In addition it’s inflation rate can converge to the low level of this trading partner, for example, Austria and Germany (see box 21.1, p. 587).

Q6. Evaluate the measures available to the authorities to moderate currency variation in a floating exchange rate regime.

There are five main measures available to the authorities to moderate currency variation in a floating exchange rate regime:1. Direct intervention in the forex market involves selling foreign exchange (official) reserves to prevent a depreciation and buying them to prevent an appreciation.2. Intervention through interest rates involving a change in the rate at which banks borrow from the central bank, which raises rates throughout the economy. In theory, this makes it more expensive for the speculator to sell domestic currency (in terms of opportunity cost).3. Impediments to short-term capital movements involves throwing “sand in the wheels” of the forex market through, for example, direct controls on capital movements, taxation of gains from currency speculation, enforcement of high capital reserve requirements and others (p. 595).4. Enhanced international co-ordination of economic policies to maintain the viability of exchange rate zones (within which their currencies would be allowed to fluctuate). Such co-ordination would involve interest rate reductions and measures to expand aggregate demand by the government with the depreciating currency in order to prevent further depreciation of their neighbour’s currency.5. Ministerial and government statements on exchange rate policy can have a calming effect on the market (though, if not careful, they can easily back-fire).

Each of these five measures has its own limitations, none providing a definitive solution to exchange rate volatility. Careful evaluation of each is required (see pp. 594-596). Official reserves are finite and often ineffective in the presence of large capital flows. It may also have adverse implications for monetary policy. In buying foreign reserves with domestic currency to ease upward pressure on the exchange rate, the resultant expansion in domestic money may be excessive in relation to monetary targets. Higher interest rates affect all borrowers, including the business sector, not just currency speculators. Governments with high debt/GDP ratios will face higher debt-servicing costs. Higher rates can also add to forex market nervousness and create further havoc, and are hard to sustain for the sole purpose of defending a currency. Impediments to capital movements are popular but have limited long-term usefulness due to the difficulties in identifying speculative transactions, and their effect on genuine long-term investors who are penalised in terms of higher long-term interest rates. The problem with policy co-ordination is that national interests will always take precedence over international priorities. Ministerial and government statements can help calm the market, but can also exacerbate the situation with contradictory statements and repeated assurances.

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These measures will be effective only if the exchange rate position is credible, and the decision on which to use must be made carefully. If retreat is necessary, retreat to a defensible position is the only option. Speculators must be convinced that the traded sector can ‘live’ comfortably with the new rate. As the Mexican peso crisis portrayed, this is not an easy task (see pp. 597-598).

uEXERCISES

Q1. The forex market is not the only market to exhibit volatility. Think of the stock market or the housing market. Why should governments intervene to stabilise prices in one but not the other? What is so special about the exchange rate?

Although governments do intervene to some extent in the housing market and in the stock market, only very rarely would they do so for countercyclical stabilisation reasons.

The basic reason is that the exchange rate affects a very significant range of prices in the economy - especially in a small open economy. The exchange rate therefore can have repercussions on the general price level, on inflation policy on a country's cost competitiveness, and on the level of employment. Hence governments see it as important to overview the exchange rate level and also the exchange rate regime. Whether such concern can be translated into effective action is another matter. This chapter indicates that the exchange rate can be influenced in a sustainable way only if other aspects of policy are consistent with the exchange rate policy.

Q2. Examine the UK’s current exchange rate regime. Why has this regime been chosen? List (a) the advantages and (b) the disadvantages of the present regime.

Since its withdrawal from the Exchange Rate Mechanism (ERM) in 1992, the pound sterling has been broadly free floating. The UK maintains no commitment to any fixed parity bands in its exchange rate policy.

The present regime was chosen following the UK's withdrawal from the ERM. This withdrawal was caused by speculative pressure on the pound, resistance to which proved excessively costly, in terms of loss official reserves and real economic costs. However, the UK is committed to low inflation. Hence, its exchange rate policy is not a matter of indifference. The effects on inflation of exchange rate changes are closely monitored.

(a) The advantages of the floating system are as follows· the UK can adjust its economy to competitive realities if its currency becomes

overvalued· increased autonomy in the conduct of monetary policy, particularly relevant to the

UK with its commitment to low inflation

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(b) The disadvantages of the floating system are:· exchange rate volatility which inhibits trade and investment (see p. 590)· irrational and speculative forces exacerbate the problem of volatility and can also

lead to sustained mis-alignments· domestic stabilisation measures can be undermined.

During 97 the pound sterling rose sharply in value. At the time of writing this threatens to cause considerable disruption to the traded sector of the British economy.

Q3. In January 1994, the currencies of the French franc zone in Africa devalued by about 50 per cent relative to the franc. This was followed by a rise in their inflation rate from 0.5 per cent per year in 1990-93 to 33% in 1994. GNP, which had been falling in real terms by 1 per cent annually in 1990-93, rose by 1.5 per cent in 1994. What happened to the real exchange rate of the devaluing countries? In your view, are these observations consistent with what exchange rate theory would lead one to expect?

In January 1994 the nominal exchange rate of the devaluing countries experienced a devaluation of 50 per cent. The real exchange rate equals the nominal exchange rate less the inflation differential between the relevant countries. Following the rise in their price level to 33 per cent, the real exchange rate devalued by about 20 per cent.

Countries in the French franc zone in Africa would be regarded as small open economies (SOEs). As a result of the devaluation, they would have experienced a rise in the price of their imports and a rise in the price of their exports. But the effect is not complete because of the exclusion of non-traded goods and services. Hence, as expected, there is some real effect but this is much less than the nominal effect.

END31 July 1997

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