2nd March, 2012.1. Outline how fluctuating currency exchange rates can affect an international construction project. A fluctuating exchange rate is also called a floating exchange rate wherein a currency’s value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating or a fluctuating exchange rate is called a floating currency. A floating exchange rate is more preferable than a fixed exchange rate since free forces of demand and supply are allowed to determine the exchange rate. Due to these automatic adjustments, a country is able to reduce impact of shocks and foreign business cycles and also preempt any possibility of having a balance of payment deficit.
In cases of extreme appreciation or depreciation of a currency, central banks normally intervene to stabilize the currency. Hence, the exchange rate regimes of floating currencies may be technically known as a managed float (MacDonald 2010, pp 189)A floating exchange rate can affect an international construction project both positively and negatively. To a smaller extent, a flexible exchange rate boosts international trade since there are no restrictions under the regime.
An international construction company therefore benefits since there is free movement of capital, be it physical or monetary. Given the fact that a fixed exchange rate can be altered, this alteration can be done in favor of the international construction project (Marsh 2010, PP 98). To a greater extent, a floating exchange rate has a number of draw backs hence International investments are not promoted by fluctuating exchange rates. Therefore an international construction project will not work well in such a currency regime because lenders cannot expect the exchange rate to remain stable over a long period of time.
If for instance the construction company imports construction materials, it could be forced to wait until stability is reached, or otherwise incur losses. As a result of unstable conditions of uncertainty and instability of the exchange rate, the volume of international trade and foreign investment is reduced (Marsh 2010, PP 123). Flexible exchange rate system involves greater responsibility of inflationary effect of exchange depreciation on domestic price levels of a country. This implies that if the international construction project is run by use of domestic currency, more in terms of local currency is spent because of inflationary tendencies caused by flexible exchange rates.
Flexible exchange rate may discourage a construction project because it results to speculative capital movement which eventually leads to the problem of extremely high liquidity preference (Marsh 2010, PP 65). In a situation of high liquidity preference, there is a tendency of hoarding a currency, interest rates increments, and fall in investments and there is large-scale unemployment in an economy. Under flexible exchange rate system, there is immobility of factors of production.
This therefore deprives flexible exchange rate system its advantages arising from adoption of monetary and other policies for maintaining internal stability. Such policies produce desirable effects on production and employment only when supply of factors of production is elastic. In such a case, the international construction project may not work well because of immobility of essential factors of production.