THE CURRENCY EXCHANGE RATE SYSTEM: A GLOBAL VIEW
Introduction
Government decision is two-fold in that it should ensure economic progress for public welfare while maintaining its culture from other nations. These conflicting functions for the state enable it to initially guard its political boundaries, but ultimately persisting to relax this aspect in order for economic boundaries to propagate its uncultivated land. In analogy, this situation had affected how it manages its currency exchange and its valuation. Governments created monetary and fiscal policies to control foreign investments and local activities for the greater good of its constituents. Thus, a country shift from fixed to floating exchange rate system is popular global stories since each of them have individual interest to perform well economically reflected in Balance of Payments. Presented in this paper is the classic trade liberalization of China that has implications to its currency system. There is also a discussion about the effects of floating exchange rate system to the BOP of United States and United Kingdom wherein hypothetical cases are discussed and given bearing to analysis. Lastly, a conclusion is installed to illustrate key findings in the paper.
The Case of China
It is the case of the already economic-awaken China. By opening its doors to international commerce, its exchange rate system aroused concerns from the world commodity currency of United States Dollar. Thus, the formerly fixed exchange rate Renminbi had to realize appreciation which is out of the conventional state-owned decision-making and policy. The China’s Central Bank is unwilling to accept command from the US, partly some of inherent protection to Western imperialism, rather chose to act according to its own will. Due to this, it is slowly but indirectly granting the wishes of the commodity currency through seemingly adapting some features of floating exchange rate system.
Perhaps, one of the unchallenged consequences of international trade, floating exchange rate system ensures that the economic performance of a nation will be reflected through its own currency. As in the case of the reincarnated China, foreign direct and portfolio investments serve as key contributors to its fast surging economy. A lively-active market entails inflation which in turn increases the local demand for the currency of both consumers (to buy the products) and producers (to finance capital requirements). Hence, as supply and demand law posits, its currency faces appreciation.
However, tagging the country as one of the best destinations of FDI, due to demand potential of its enormous consumers and labor-cost advantages, did little to tickle government authorities. Emanated by 8.03 to 8.02 appreciation against the dollar, such minimal increase posted the highest gain of the currency since it began revaluing Renminbi to accord international market forces. Can be viewed as highly conservative floating exchange rate system, it also recently allowed its major banks to reflect revaluation trends. But why is China so conservative to embrace the “invisible hand” of currency valuation? Is it purely political regimen to imply world power, protection of local producers/ consumers or simply adaptation flaws for a millennia-old centrally-planned form of governance?
Probably, China does not want risks to emerge abruptly parallel to its abrupt adaptation of floating system. It can lead to inflation and adverse effects to balance of payments which the state cannot act on readily because national forces widened into complex and ever-changing international forces. Rather, the state wanted a smooth shift as it builds the necessary institutions to help its policies address the exchange rate issues in the future. Thus, the gradual approach of China to freely float its currency in the international arena is preferred both for the benefit of its population and install supremacy of its government against other countries. Local producers are given the time to obtain efficiency in its operations, as reflecting the US measure of the under-priced of Renminbi could mean more expensive export merchandise detrimental to its balance of payments. In a similar way, consumers are provided with cues on what to expect to their wages and price level in the upcoming future, therefore, preventing public panic of any abrupt development. Lastly, the state avoids its political ideals to be inflicted by other customs especially to affect the minds of its citizens. This argument is concretized how the government created their own internet search engine to filter down political and “destructive” global information.
Effects of Floating Rate in the Balance of Payments
In the case of United States, allowing the market to determine its exchange rate implied stability of currency. Since, Bretton Woods, US government started to intervene in foreign exchange to signal if the value of its currency is inconsistent with economic indicators. However, starting 1990s, this intervention became minimal while floating rate seemed to correctly economic performance of the country. A benefit from hands-off approach is that trading partner’s confidence is enhanced regarding the price of US exports and in the same manner the latter payment for the former imports. Trade is stimulated for the advantage of cross country exchange of goods and services. As a result, the Balance of Payment in terms of current account for both of them is skewed in the positive values.
On the other hand, the lack of government intervention in currency value could discourage its labor to work abroad. This can happen when a certain country that uses fixed system largely decreases the value of its currency for some economic purposes. Without US retailing its own version, labor would not be motivated to earn in that country which is previously be exchanged with more dollars when they go home. The loose of motivation and turn-over of overseas employment would then reflect low unilateral transfers from worker remittances that would have been realized when workers abroad gives back a large portion of their foreign earnings to their home country. In effect, this situation limits the capability of current account to increase, thus, also affecting the positive net gain of BOP.
Focusing on the capital accounts, floating system could undermine the real value of local assets, thus, accepting undervalued portfolio investments from foreigner-investors. Without local government’s intervention in currency valuation, regional clusters like Asian countries (Japan, China, Hong Kong, Korea, etc) could have cooperative effort to control the dollar in the international market as these countries are equipped with enough foreign currency reserves. They can buy US stocks and could own US assets at undervalued price and could profit by selling these at a premium or when the period comes when the US government smells the collusion. Until this recognition, capital accounts in securities and bonds are understated resulting to negatively skewed total of BOP.
Finally, official reserves like foreign currency reserves could also be inappropriately and inefficiently applied when needed in emergency situations. When US will wait for a substantial change in dollar performance in the world market before the government will act on a threat of say, oil price hike announced by the Middle East, it could be too late to restructure its monetary policy as the market did not see what is in the eyes of the US government. The tendency of the market to be complacent with inter-government relations, especially when conflict between countries are held in indirect and non-obvious way, will leave US without enough foreign currency reserve (preferably currency of Saudi Arabia or Iran) to hedge the conflict-led oil increase. And simply, it will loose a lot of dollar that will put greater pressure to approach negative BOP due to the outflows in trade payments.
Unlike other countries that replaced gold as their country’s tool to influence their currency, United Kingdom remain to emphasize holding their gold reserves instead. In fact, it had auctioned gold accumulation. The country invests in international holdings such as foreign currency assets to have more money to hedge undue fluctuations in the currency market. With this, it operates just like US that it possesses some degree of control of its own currency while guarding its own from others. This aim has substantial liquidity and prevents dependence from dollar instead to sterling have vast implications for the country and the trading partners with regards to BOP.
Since sterling is dependent from the performance , a basket of currencies, economic recession or government intervention of a single or maybe a couple of countries that have no substantial effects to the market value of its currency. Thus, UK BOP will continue to stabilize in current levels in an event that currency concerns of one trading country ensued. If that country’s currency appreciates, UK’s relation to other trading partners will not be affected because UK currency is stable. Thus, BOP will not be shaken off substantially due to minimal looses of sterling to pay imports of that country.
However, these diverse international indicators adversely affect UK’s ability to recognize currency problems in advance as it purely based its decision due to market results. Unlike other developing countries like Philippines who is highly dependent to US currency performance and accepted its currency to be a term currency of the dollar, UK could slip to sudden currency trap that could have substantial sacrifice to its BOP. Say, an oil price increase is again initiated by Middle East suppliers; it has to determine the action of the majority of the countries before it will act. On the other hand, Philippines will only have to obtain substantial feature of US policies and currency movements to be able to have the most logical, perhaps, strategic response to oil inflation. As a result, emergency situations can bring huge current account outflows from the coffers of UK Treasury. Undoubtedly, this fact could be one of the reasons why its government tries to own optimal value of foreign assets to hedge any currency fluctuations in the future.
Conclusion
Wealthier countries have the ability to obtain substantial amount of foreign reserves to hedge unintended fluctuations in the world market. This inequality of liquidity makes poorer countries dependent to them in their economic judgment. More appropriately, poor countries acting like so when the wealthy counterpart is an important trade partner. As a result, its floating rate performance will have the same direction as the wealthy one. The problem is in the event of global recession, these poorer countries will not be saved by their partners’ mere currency harmony rather it involves the former to save its currency within its own borders. Thus, there is little and partial advantages of both fixed and floating system for the poorer one. Trade liberalization at the international level demand its local producers to be efficient and technologically competitive to push the local BOP upward while the government is duty-bound to replenish foreign reserves for future contingencies. Globalization means independence and competitiveness of both currency and national economy. As China handles its global position, poorer countries should have the billion dollar reserves in their Treasury to obtain not only economic security but also national identity.
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