Exposure to Exchange Rate Risk - Term Paper Example

Introduction Foreign exchange intervention is the act of monetary authorities buying and selling currency in the foreign exchange market to influence exchange rates. There are a number of researchers who have already studied what affects exchange rate movements and how it affects volatility of a particular company. Moreover, there have been published papers and articles showing how various types of intervention to foreign exchange affects the productivity level of both small and big enterprises and through which channels it might operate. It should be noted that after the breakdown of the Bretton Woods system of fixed exchange rates in 1973, the Articles of the International Monetary Fund (IMF) were amended to provide that members "would collaborate with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates." IMF members could choose their own exchange rate arrangements subject to the provision that they avoid exchange rate manipulation and encourage orderly economic growth. Many countries choose to float their exchange rates and conduct occasional foreign exchange intervention to influence the value of their currencies (Humpage, 1994). Nature of Exchange Rates Risks Central banks choose to intervene for different reasons. The Foreign Currency Directive of the Federal Reserve System, for example, directs intervention to "counter disorderly market conditions," which has been interpreted differently at different times. Often, unwarranted exchange rate volatility or deviations from long-run balance exchange rates have prompted intervention. Multiple central banks often coordinate intervention, intervening in the same direction on the same day (Humpage, 1994). The response rule of central bank intervention to economic conditions is known as the central bank's intervention reaction function. Neely (2002) estimates a typical reaction function for U.S. intervention with a friction model. A friction model permits the dependent variable – intervention - to be insensitive to its determinants over a range of values (Rosett, 1959). This is appropriate for a variable such as intervention that takes the value zero for a large proportion of observations. The study confirms previous findings that U.S. intervention "leans against the wind" and is conducted to counter misalignment. Leaning-against-the-wind intervention is conducted to oppose strong short-term trends. For example, if the U.S. dollar (USD) has been depreciating, a USD purchase would constitute leaning against the wind. Misalignment means that the exchange rate deviates from what the monetary authorities might regard as long-run fundamentals, such as those implied by a purchasing power parity relation (Humpage, 1994). When a central bank buys (sells) its own currency in exchange for a foreign currency, it decreases (increases) the amount of its currency in circulation, lowering (rising) its domestic money supply. By itself, this transaction would influence exchange rates in the same way as ordinary domestic open market operations; however, most central banks routinely "sterilize" their foreign exchange operations; that is, they buy and sell domestic bonds to reverse the effect of the foreign exchange operation on the domestic money supply (Edison, 1993). For example, if the Federal Reserve Bank of New York bought $100 million worth of euros (EUR) in a foreign exchange intervention, the U.S. monetary base would increase by $100 million in the absence of sterilization. Other things equal, interest rates and prices would also change. To prevent changes to domestic interest rates and prices, the Federal Reserve Bank of New York would sterilize the intervention - sell $100 million worth of government securities - and absorb the liquidity. Complete sterilization would also require that the foreign central bank - the European Central Bank (ECB) in the case of the EUR--automatically reverse the effect of the intervention on the foreign money market by increasing the supply of foreign currency through open market operations. The net effect would be to increase the relative supply of U.S. government securities versus foreign securities but to leave domestic and foreign money supplies unchanged. Because fully sterilized intervention doesn't affect either prices or interest rates, it doesn't influence the exchange rate directly. But official intervention might affect the foreign exchange market indirectly through the portfolio balance channel and/or the signaling channel. The portfolio balance theory recognizes that sterilized intervention changes the relative supplies of bonds denominated in different currencies. If bonds in different currencies are imperfect substitutes, investors must be compensated with a higher expected return to hold the relatively more numerous bonds. The higher return must result from a change in either the price of the bonds or the exchange rate (Edison, 1993). The signaling channel suggests that official intervention communicates, or signals to the market, information about future monetary policy or the long-run equilibrium value of the exchange rate. Complicating a belief in the signaling channel is the fact that central banks often conduct intervention secretly. In fact, 77% of central banks report that they sometimes or always conduct intervention secretly to maximize market impact (Neely, 2000). Measurement of Exposure In the present context, central bank intervention functions all over the world are notoriously unstable over time, meaning that the structural parameters of an econometric model might not be stable when the economic environment changes. Estimation of an intervention model will provide results that are specific to the size of the market and intervention and the nature of the reaction function, including the purpose of intervention. Intuitively, the signaling channel depends on intervention signaling future monetary policy or coordinating expectations. If intervention is instead conducted randomly, then it will contain no information and will not influence exchange rates (Humpage, 2004). In fact, the World Bank has conducted a review of adjustment lending by the Bank and the International Monetary Fund which examined the policies and programs of the 15 major recipient governments. Results of the analysis reveal that programs designed to fix one problem often created a problem in another area, and frequently the programs were not tailored to a country's individual needs. The findings show that while progress was made in exports incentives and exchange rate flexibility, fiscal reforms were not as successful as external accounts. Findings also show that reforms of the public sector management were slow and disincentives to agriculture were reduced in some countries (Humpage, 2004). In the 1980s the task of adjustment has become more difficult as conditions in the international economic environment have worsened. For most developing countries the terms of trade deteriorated further in the 1980s, real interest rates rose, and the debt crisis spread. The growth of industrial countries remained below the levels of earlier decades and the growth of demand for imports from developing countries slowed down (Ito, 2002). The World Bank began its lending for structural adjustment in 1980. Although at first expected to be short-lived (three to five years), adjustment lending in fact increased. The scope of Bank adjustment lending widened with the introduction of sectoral adjustment loans, and the share of adjustment lending in the Bank's total lending steadily increased, reaching nearly 25 percent in fiscal year 1988 (Ito, 2002). Compared with the Bank's more traditional lending for investment projects, adjustment lending has higher risks as well as higher rewards. An economic crisis can focus policymakers' attention and help develop a consensus on the need for the necessary policy changes. External financing at such a time can provide additional resources to ease current difficulties and help persuade the doubtful that the proposed changes are worth making. But external financing can also, by reducing the import constraint, make it possible for a country to avoid, or at least postpone, the needed adjustments. In this case it can become a substitute for, rather than a complement to, the desirable structural changes (Kearns and Rigobon, 2005). Some of these concerns were behind a request by the Bank's Board of Directors for a review of adjustment lending. This and the companion article by William McCleary are drawn from this review. In what follows we assess the programs of policy reform thus far undertaken by countries in the process of adjustment-irrespective of whether the Bank or Fund, or both, were involved in supporting the programs-and offer some conclusions about how to design and execute such programs. The conclusions that follow are based on detailed studies of 15 major recipients of the Bank's adjustment lending, and also on a quantitative comparison of the performance of 30 countries that received adjustment loans from the Bank before 1985 with that of a group of other developing countries. Particular attention was paid to the experience of 12 countries which had each received three or more adjustment loans (the low-income countries Ghana, Kenya, Malawi, Pakistan, and Zambia, and the middle-income countries Brazil, Cote d'Ivoire, Ghana, Jamaica, Republic of Korea, Morocco, and Turkey); these countries are referred to as the Bank's major borrowers for adjustment. All of the major borrowers for adjustment, except Colombia and Nigeria, had programs with the Fund, as did most of the other countries studied (Kearns and Rigobon, 2005). All these interventions initiated by the World Bank were all aimed at assisting various companies – big or small – in coping with the fluctuating and seemingly unpredictable foreign exchange rates of that time. These were the measures that were done in order to achieve stability among companies, especially those smaller ones who were striving hard to penetrate the international market. Tools to Reduce Exposure to Negative Effects of Foreign Exchange Rates Considerable progress has been made in achieving exchange rate flexibility and in improving incentives for smaller companies who were trying to venture in the international market. By 1987 the real exchange rate had on average depreciated by about 40%, compared to the 1965-81 level, in the 15 countries reviewed. The adjusting countries' export volumes grew substantially, though their export values increased much less, because world prices of these exports were declining (Kim, 2003). Businesses in the then smaller and developing countries like Korea and Turkey have been strong performers in boosting the supply of exports, but most other countries still have much more to do to boost exports with price and non-price instruments. Several countries have replaced quantitative restrictions by tariffs and have reformed their tariff structures (Kim, 2003). There has been more resistance to lowering import protection and the implied bias against exports. The 12 major borrowers for adjustment typically discriminated less against imports than did other countries studied from the same regions. Liberalization is made easier if exports are doing well, and if it is seen by the private sector as a sustained, medium-term program. It would benefit each country to establish and announce a strategy that includes replacing quantitative restrictions on imports by tariff protection, reducing tariff dispersion, and lowering protection against imports that do not compete with domestic production (Kim, 2003). The most noted and seemingly effective tools to prevent exposure to harmful effects of fluctuating foreign exchange rates are: Fiscal policy. Progress in fiscal reform has been less adequate than that in the external accounts. Some countries' initial reductions in fiscal deficits, brought about primarily through cuts in expenditure (particularly investment expenditure), were not sustainable, while revenues were difficult to expand. In others, external shocks had been underestimated and debt service payments rose sharply in the budget-both because interest rates were higher and because devaluations raised the domestic currency cost of foreign debt repayments. As a result, a widening gap between the fiscal deficit and the current account deficit can put increasing pressure on the private sector to generate a net surplus, leading to cuts in private investment and growth, often accompanied by higher inflation (Pasquariello, 2002). Some success has been achieved in rationalizing public investment, with the help of the Bank's investment reviews. There has been much less progress in reforming taxes and reallocating current expenditures. Given the urgency of reducing fiscal deficits, in most countries tax policy initiatives have been dominated in recent years by near-term revenue measures. Exceptions are Indonesia, Mexico, and Turkey which have undertaken thorough tax reforms. Reforms to relieve the financial pressure on the private sector and to generate increased domestic savings and investments through growth-oriented fiscal policy have generally been insufficient (Pasquariello, 2002). Public sector management. Institutional reforms of the public sector, promoted by almost every adjustment program, have been slow. Some success has been achieved in holding back the creation of new enterprises and the growth of employment in them. Some public enterprises have reduced their losses, but largely through price increases permitted by their monopoly position, rather than through improvements in their efficiency. Efforts to improve resource use in utility companies have proved elusive and their financial losses remain high. Few of the reforms attempted have had much impact on planning, policy analysis, or debt management in the public sector. After initial delays, several countries, among them Jamaica, Niger, Panama, and Togo, have made progress in divesting public enterprises. Others, including Ghana, Senegal, and Turkey, have not. It is too early to evaluate the performance of enterprises since their privatization (Pasquariello, 2002). Financial sector. In the few cases, such as Argentina, Chile, Indonesia, and Turkey, where financial reforms have been attempted, experience shows that an appropriate macroeconomic policy framework is critical for their success. Financial reform is made more difficult if large budget deficits lead to high interest rates (as in Brazil and Turkey), crowd out the private sector, and worsen the quality of banks' portfolios. High budget deficits financed by an inflation tax increase the opportunity cost of holding money, so that the monetary base declines (as happened in Argentina). In some countries, the government has increased revenue by raising reserve requirements and through statutory sales of government bonds at low and often negative rates to raise finance. Financial repression has often increased as external financing of the budget deficit has declined (Pasquariello, 2002). In any event, financial reforms have tended to be protracted; the organized financial system in many developing countries is technically insolvent because of poor management, insufficient supervision of bank lending, and incorrect signals on lending during financial repression. Thus, much remains to be done in improving regulation and in restructuring. It will have a limited impact unless the financial repression emanating from high fiscal deficits is reduced. Conclusion The information presented above shows that there are only two possible directions if one company goes global (may it be a big company or a small one) – and this is to succeed or to fail. Foreign exchange rates are one of the big factors that measure the company’s success or failure when venturing to international market. It can be generalized that performance was and will always be more successful in countries undertaking adjustments to foreign exchange rates than in those that were not. Thus, when trying to assess the effects of adjustment programs, it will be easier to link policies to intermediate targets, such as export performance and industrial efficiency, than to final targets, such as improved incomes and wellbeing. Improved incentives such as those stemming from a depreciated exchange rate explain in part the stronger performance (such as export and/or import). Strong statistical relations have also been found between real devaluations and subsequent export growth and between export growth and GDP growth (Reitz, 2005). References: Edison, Hali J. "The Effectiveness of Central-Bank Intervention: A Survey of the Literature After 1982." Special Papers in International Economics No. 18, Princeton University, Department of Economics, 1993. Humpage, Owen F. "Institutional Aspects of U.S. Intervention." Economic Review, Federal Reserve Bank of Cleveland, First Quarter 1994, 30(1), pp. 2-19. Humpage, Owen F. "Government Intervention in the Foreign Exchange Market." Unpublished manuscript, Federal Reserve Bank of Cleveland, February 2004. Ito, Takotoshi. "Is Foreign Exchange Intervention Effective? The Japanese Experience in the 1990's." NBER Working Paper 8914, National Bureau of Economic Research, April 2002. Kearns, Jonathan and Rigobon, Roberto. "Identifying the Efficacy of Central Bank Interventions: The Australian Case." Journal of International Economics, May 2005, 66(1), pp. 31-48. Kim, Soyoung. "Monetary Policy, Foreign Exchange Intervention, and the Exchange Rate in a Unifying Framework." Journal of International Economics, August 2003, 60(2), pp. 355-86. Neely, Christopher J. "The Temporal Pattern of Trading Rule Returns and Central Bank Intervention: Intervention Does Not Generate Technical Trading Rule Profits." Journal of International Economics, 2002, 58(1), pp. 211-32. Neely, Christopher J. "Using Implied Volatility to Measure Uncertainty About Interest Rates," Federal Reserve Bank of St. Louis Review, May/June 2005c, 87(3), pp. 407-425. Pasquariello, Paolo. "Informative Trading or Just Noise? An Analysis of Currency Returns, Market Liquidity, and Transactions Costs in Proximity of Central Bank Interventions." Unpublished manuscript, New York University, November 3, 2002. Reitz, Stefan. "Nonlinear Impact of Central Bank Intervention on Exchange Rates?' Unpublished manuscript, Deutsche Bundesbank, September 2005. Rosett, Richard. "A Statistical Model of Friction in Economics." Econometrica, April 1959, 27(2), pp. 263-67. Read More