Exchange rate movements and pegged currencies - Free Essay Example

INTRODUCTION Successful money requires both trust in the reliability of its issuer and a reasonable degree of stability in its value (Black, 1985). The US Dollar (hereon USD) replaced the Pound Sterling after World War II as the dominant world currency because of the size of the American economy, its global trade and its developed financial markets. The USD has been the benchmark for other national currencies after the breakdown of the Bretton Woods System in 1972 since then it has been the most important currency of the International Monetary System and no other currencies have so far been able to overtake its standing (Salvatore, 2000). The Euro was introduced on January 1, 1999, at the value of $1.176. The Euro has become the second most important international currency since its creation; it depreciated drastically against the dollar within one year from its introduction. This report will trace the movements of the USD against the Euro since the introduction of Euro in 1999 to date by explaining its movement during four major trends which are January 1999 to January 2002, February 2002 to December 2004, January 2005 to June 2007 during which it remained more or less stable and it has been highly volatile from beginning of the subprime crisis (mid 2007) till date. The Euro was launched at 1.176 Dollars on the 1st of January, 1999. Many observers and analysts predicted the Euro to appreciate against the USD, but as shown in figure 1, the Euro rose to a maximum of $1.1877 on January 4th and then depreciated by 39% in relative to the Dollar and reached an all time low value of 0.852 Dollar per Euro in October 20 00, which continued till June 2001 leading to an appreciation of the Dollar (Wong Khan, 2006). The depreciating value of the Euro persuaded The European Central Bank (hereon ECB) to raise interest rates seven times during, its borrowing rate from 4.75% to 2.5% and also had interfere in the foreign exchange market four times during November 1999 and October 2000 (Neaime Paschakis, 2002). Several studies have been conducted to explain this movement. The empirical analysis by Corsetti and Pesenti (2000) state that the high growth and interest rates in the US when compared to the Euro zone during the introduction of the Euro lead to an increase in the value of the Dollar relative to the Euro. This can also be supported by Merendith (2001), whose empirical study states that an increase in equity prices in the mid-1990s in US lead to increase in market capitalization in relative to its gross domestic product, increasing both consumption and investment which increased the demand of US D. An increase in demand caused the long term real interest rate to increase sooner than the short term real interest rate, since uncovered interest rate parity is one of the determinants of exchange rate, this lead to an appreciation of Dollar when compared to the Euro. Cohen and Loisel (2001), state that the tight fiscal policy imposed by Maastricht fiscal criteria and a loose monetary policy was also one of the reasons for low interest rate in the Euro zone which lead to the appreciation of the Dollar against the Euro. Neaime and Paschakis (2002) studied the effects on the differences between the US and Euro zone in respect to inflation rates, risk return opportunities, cyclical behaviour and trade and capital flows on the Dollar- Euro exchange rate, their results suggest that the appreciation of dollar from 1999 to 2000 can be explained by the positive shock to aggregate demand in the US during this time period. While Arestis et al (2002) states that, the diversified economic conditions of the Euro member countries lead to a weak economy in the zone due to which the Euro depreciated against the Dollar. But Musa (2001) argued that the weak base of the euro zone was not a reason for the depreciating euro, he stated that it was normal for a new currency to depreciate against the hard currencies such as the USD and Yen. He expected the Euro to become stronger after few years of its inception. The high social security payments, strict employment opportunities and the restrictions on working and opening hours in the Euro zone when compared to the American markets made companies to invest in the US during the introduction of the Euro, which lead to an appreciation of the Dollar (Neaime Paschakis, 2002). This can be supported by Felstein (1997b 2000) who states that euro may remain weak because of the structural rigidities in Europe economies. In this modern world, the more developed economy is likely to attract high return capital investments. The IMF report 2001 states that, the quick growth in the US long term investments such as equities, bonds and direct investments attracted high capital inflow into the US economy which lead to an appreciation in the Dollar value during this period. A study on the balance of payments data shows a rise in direct investment by Euro resident in the US during this time period. This can also be supported by several empirical studies which state that there is a significant relationship between capital inflows and exchange rates. The Dollar started to depreciate against the Euro from February 2002 to December 2004. The US economy lost its attractiveness after the September 11, 2001 terrorist attacks, due to which the stock markets declined, interest rates in the US fell to rates that not have been seen in the past 30 years, increase in US trade deficits and uncertainty about accounting practices. The war in Iraq contributed towards the depreciation of the USD (Mussa, 2005). On February 28, 2002 all national banknotes and coins in the Euro zone were withdrawn from use, this made Euro a store value and an exchange medium. This increased the challenge to the Dollar because in the long run, the Euro might be able to displace the USD and become the international reserve currency (Shams, 2005). Although the dollar was depreciating, its depreciation with the Euro was large when compared to other currencies. In 2004 the dollar dropped by 11% against the Euro while it dropped by only 5% against the Yen, this was because export-oriented Asian countries such as Japan were not prepared to allow their currencies to appreciate against the Dollar due to which European countries have to bear a disproportionate amount of the adjustment burden. This resulted in the dollars share in the foreign exchange market to fall from 94% in 1998 to 89% in 2004 (Carbaugh Hedrick, 2008). The Euro reached a height of 1.36$ in December 2004, caused by the purchasing power parity (PPP) of the euro zone which was 10% to 15% overvalued when compared to the USD. The GDP of the Euro zone was roughly three quarter of the US. All these factors prompted the Euro to become more attractive than the Dollar, which lead to a depreciation of the USD during this period (Mussa, 2005). The Dollar value remained more-or-less stable from the end of 2004 to the beginning of 2007, where the change in the value of dollar against the Euro was very minimal. The inflation rates in the Euro zone and the US was quite similar during this time period. The US current account deficit continued to increase despite the Dollar depreciation during the past few years, which implied the Dollar had to remain in the more-or-less same value against the Euro and depreciate further against the emerging Asian market, with a lesser extent to Japan to overcome this situation (Mussa, 2005). The movement of Dollar against the Euro has been very volatile from the beginning of the subprime crisis till date. Instability of the financial markets, interest rates cuts by the Federal Reserve (Galati Wooldridge, 2006), expansion in the US monetary policy which lead oversupply of dollars, all lead to a strong depreciation in the Dollar value during the second half of 2007 and the beginning of 2008. This also reduced capital investments in the US economy and lead to a deterioration in its store value. Also the euro zone started to grow faster and restore confidence. In 2002 the Euro was worth 86 cents, but by the end of March 2008, it was worth $1.54, the dollars value had dropped by 30% in 3 years (Carbaugh Hedrick, 2008). The crisis spread over the global economy during the second half of 2008.The Dollar was expected to drop rapidly when the Federal Reserve cut down interest rates between September to December 2008, but the reverse occurred and the Dollar appreciated drastically. This was because of the increase in net purchase of US treasuries, which are perceived as highly liquid and riskless compa red to US private securities. Even though the foreign demand for US assets was less during this period, the demand among Americans was high. Americans repatriated capital from abroad which lead to an increase in the demand of dollars when compared to its supply of dollars. The issue of international bonds in USDs for all countries fell by 40% compared to a global drop of international bonds by 15%, which lead to a drop in supply of dollar securities drastically when compared to the global supply of securities. The increase in the demand of the Dollar caused the Dollar to appreciate during this time period (Quere, 2009). The sudden drop in Dollar against the Euro during the last quarter of 2008, was due to the bankruptcy of Lehman Brothers and the government takeover of several other firms. The USD started with a positive note against the Euro in the beginning of 2009 when the US president Barack Obama stated his plans of stimulating economic growth by investing $775 billion over the next 2 years. However the currency movement largely depends on the economic data published by various central banks. This was also supported by the week data published in the Euro zone, such as the cut in interest rates, the drop in manufacturing sector Purchasing Managers Index and the rise in unemployment rates.[1](Currency Market Review) The optimistic view that the U.S Federal Reserve might increase interest rates in the near future and the rising debt levels in Greece which is expecting a helping hand from the ECB, have caused the USD appreciate against the Euro in the beginning of 2010[2]. (Forex Review) CONCLUSION The Dollar appreciated during the initial years after Euros introduction due to high interest and growth rates in the US which favoured high return investments in the US than the Euro zone. This was followed by a three year period where the USD depreciated to the 9/11 attacks and the war in Iraq. The Euro started to stabilize during this time period and its store in value increased. The Dollar began to be more stable after this period, till emergence of the subprime crisis. However, its progress was thwarted by the onset of the subprime crisis which sapped the value of the Dollar to 1.54$ per Euro, caused by interest rate cuts by the Federal Reserve, instability of the US financial markets, loose monetary policy and bankruptcies. After its shaky foray during the early years of the subprime crisis, the Dollar value is starting to regain against the Euro following the economic growth plans proposed by the US president Barack Obama and due to the high debt levels in Greece and an expe ctation of an increase in interest rates in future. However the Dollar value in the future remains to be highly unpredictable. Hong Kong should dismantle its fixed exchange rate peg with the US dollar. Instead it should peg its currency with the Chinese Renminbe (CNY) or allow its currency to float freely. Discuss. INTRODUCTION The Hong Kong Dollar (hereon HKD) is officially linked to the US dollar (hereon USD) at the rate of 7.8 HKDs to one USD. This fixed exchange rate peg with the USD which has been in existence since 17th October 1983, ensures the HKDs stability against major world currencies which is an advantage to Hong Kong. This stability plays an important role in maintaining the external trade in goods and services which is equivalent to around three times its gross domestic product (GDP). The linked exchange system is effective in Hong Kong because of its flexible and responsive economy, the strong and solvent banking system, prudent fiscal policy followed by the government and the large amount of foreign reserves possessed by the country to maintain the link. (Yam, 2005) The Hong Kong Financial Secretary has determined that, the structure of the monetary system shall be characterised by Currency Board Arrangements. As stated by Officer (1989, 1993), currency board is an invention in which t he activities of the market participants determine the exchange rate, instead of depending on the government to manipulate the exchange rate through foreign exchange controls or direct selling of foreign currencies by the central bank. According to Schwartz (1993) and Williamson (1995), A currency board issues cash with 100% foreign exchange reserves backing at a fixed exchange rate against a designated currency. Hong Kong used Silver dollars as legal tender till 1935, and then the HKD was fixed to the British pounds until 1972 and then it was fixed to the USD for the following two years. HKD was allowed to float freely during the time period 1974-1983 and it was re-pegged to the USD in 1983 again. This can be summarized in the following table. This report will discuss and analyse the implications if the Hong Kong Monetary authority decide to dismantle HKDs peg with the USD and re-peg to the Chinese Renminbi or allow it to float freely. The link adopted by Hong Kong has bee n functioning smoothly in the highly volatile market which consisted of the Hong Kong stock market crash in 1987, the 1990 Gulf War, the 1997/1998 Asian financial crisis and the current subprime crisis. The stability of the HKD to external shocks can be shown by the following diagram, Kennedy (2003), summarized that providing a nominal anchor to a monetary policy, encouraging trade and investment, precluding competitive depreciation and avoiding speculative bubbles as the four main advantages of maintaining a fixed exchange rate and he also stated that giving independence to monetary policy, allowing automatic adjustment to trade shocks, retaining seigniorage and lender- of- last- resort capability and avoiding speculative attacks as the four advantages of freely floating exchange rate. As stated by Kennedy (2003), under the linked exchange system followed by Hong Kong, fluctuation in the value USD can cause needless volatility in Honk Kongs international price competitiveness . This can be supported by Chan and Kwan (1998), who stated that the devaluation of the Taiwan Dollar in October, 1997 initiated a series of speculative attacks on the Hong Kong Dollar. Many politicians and economists argued that Hong Kong should give up its peg with the USD as it has already lost its international competitiveness after many years of inflation. Hong Kong also faced many problems in maintaining their peg to the USD, when the dollar appreciated against the Euro and the Yen between the time period 1995-2001.Hong Kongs foreign reserves as at October, 1998 amounted to US$ 8 billion, which was the worlds third largest (Rogoff, 1998) which made it very strong to withstand speculative attacks. At the same time Hong Kong is the only Asian country with a currency board that got through the 1990s successfully. As cited by Tsang (1998), a floating exchange rate regime will cause a considerable amount of instability and uncertainty in a small open economy as Hong Kong because it would not allow for much monetary autonomy. This can also be supported by Hausmann et all (2000) who stated that, the high level of internal flexibility of Hong Kong to absorb external shocks makes it more suitable for a hard peg than a floating exchange regime. As summarized by Rogoff (1998), Hong Kongs ability to support its currency relies on Chinas willingness to put stability on the HKD above all other foreign exchange reserves. As stated by Cheng et all (1999), one of the important goals of Hong Kong, is to become the national financial center of China. The massive capital inflows from China to Hong Kong does not depend only on Hong Kongs legal and financial systems but it is largely because of its peg with the USD which is an international currency. If Hong Kong decides to dismantle its peg and float its currency freely, Hong Kongs attractiveness as Chinas financial center might decline considerably. Suttle and Fernandez (2005) stated that, Hong Kong would have to f ace a big challenge if it dismantles its peg with the USD because it would have to develop an exiting strategy from the USD peg and it would have to develop a full monetary union with China. Therefore if Hong Kong dismantle its peg with the USD and floats it currency freely, it would have to pursue an independent monetary policy which will not have the same clarity and effectiveness as the Linked Exchange Rate System. Re-pegging the HKD with the CNY is one of the most popular theories and a lot of research and arguments have been done on this topic. As stated by Greenwood (2009), In the past it was silver, in the future it may become the Renminbi, but that depends on how quickly China moves to full convertibility. Hong Kong monetary authority has injected more than 25.8 billion USD into the financial system in 2009 to maintain its currency peg with the USD, as funds pour into the city from China, which is the worlds fastest growing economy.[3] As stated by Dean and Eslake (200 7), Hong Kongs economy and financial system is becoming increasingly linked with China, but right now there are too many restrictions in replacing the USD with the CNY because the CNY can be traded only by exporters and importers which means it is only convertible on the current account. Hong Kong would not be able to peg its currency with the CNY unless it becomes fully convertible both on current and capital accounts. This seems to be a long term proposition. If Hong Kong pegs its currency with CNY despite this problem, it would affect Hong Kongs position as a global financial centre. It may increase the risks faced by Hong Kong, where there could be rapid increase in interest rates and a banking sector crisis. The HKD CNY peg might be possible when the Renminbi becomes fully convertible but as Greenwood (2009) said I dont think thatll happen quickly. This is not possible in the near future; it is only feasible in the long run. CONCLUSION As summarized by Mussa et al (2000), no single exchange rate regime is suitable for all countries due to the different economic situations and the various roles played by them in the global financial markets. Considering the Hong Kongs global financial position, the massive capital flows from China, issues with the exit strategy from the Dollar peg, compatibility issues, and the CNYs convertibility, it can be concluded that dismantling the peg with the USD and letting the currency to float freely is not advisable while the re-peg with the Chinese Renminbe might be possible only in the long run. The 27 year Linked Exchange Rate system followed by Hong Kong which withstood many major external shocks remains to be the best option currently available for Hong Kong. Page 2 https://www.iamtn.org/content/currency-market-review-1 https://www.forexhelp.com/article/1450 www.bloomberg.com