International Monetary System
Introduction
The exchange rate has a significant impact on foreign trade of the country, because the competitiveness of country’s products on world markets largely depends on the level of exchange rate. The exchange rate affects the direction of international capital flows. The decision about investing of the national capital in assets of any country is taken on the basis of the expected real return on invested capital, which depends on the interest rate and the expected changes in the exchange rate (Brigham and Houston, 2011).
The currency parity is at the heart rates of convertible currencies. However, the match of exchange rate with the exchange parity is a rare phenomenon in modern conditions. The exchange rate depends on several factors, namely the purchasing power of correlated currencies, the level of inflation in the countries concerned, the ratio of demand and supply of given rates in the currency markets, and others. State regulation of the exchange rate is aimed at its increase or decrease based on the objectives of monetary policy, and is mediated by the formation of the exchange rate. The exchange rate is used in the different directions of state regulation of the economy (Madura, 2012).
Changes in exchange rates affect the reallocation between the countries of that part of the gross national product, which is sold in foreign markets. Economic, social and political consequences of exchange rate fluctuations depend on the monetary and economic potential of the country, its export quota position in the world economic community (Madura, 2012). Therefore, the basis of the temporary exchange rate as prices of monetary unit in foreign means of payment creates a complex of currency-formed factors, manifesting themselves primarily through the supply and demand of this currency on the money market. The resultant of these factors determines at any given time a particular value of the exchange rate. Nevertheless, purchasing power parity is the basis of the real exchange rate (Brigham and Houston, 2011).
Real and nominal exchange rates are key indicators of the country in the first place for its investment attractiveness. However, the real rate is paid more attention, because it is able to more accurately reflect the current situation in the state. The nominal exchange rate represents the value of the currency of one country by monetary units of the other one. Purchasing power parity is the level of exchange rate, equalizing the purchasing power of each. According to this concept, the exchange rate is always changing just as much as it is necessary to compensate for the difference in the dynamics of prices in different countries (Brigham and Houston, 2011).
The nominal exchange rate does not account for purchasing power of the currency, so it does not characterize the competitiveness of the economy. In general, considering fluctuations of Euro, British pound and Japanese yen (Table 1), it is obvious that the US dollar enhanced its position within the last five years. Euro’s nominal rate decreased by over 25%, British pound – by almost 5% and Japanese yen – by 51.67%. The biggest devaluation was of Japanese yen. Changing the competitiveness of countries is shown by the real exchange rate. By PPP Japanese yen’s and Euro’s exchange rates revaluated by 1.3% and 1.2% respectively, while British pound devaluated (OECD, 2016). The growth of the real exchange rate of the Japanese yen and Euro means that foreign prices expressed in yen and Euro increased in comparison with the corresponding Japanese and European goods’ prices. As a result, Japanese and European products become cheaper than imported, and it is profitable to purchase by both domestic and foreign consumers. That is how improving the competitiveness of the national economy is expressed. In case of depreciation of the real exchange rate as it happened to British pound, domestic goods become relatively more expensive and hence less competitive (Brigham and Houston, 2011).
Figures 1 and 2 show changes in the PPP exchange rates for the Korean won, Japanese yen, British pound and Australia dollar. It is seen that within five years Japanese yen and Australian dollar revaluated, while British pound and Korean won – devaluated. Australian dollar revaluated by 4.6% compared to 1.3% of the Japanese yen. The British pound devaluated by 0.09% and the Korean won – by 4.3%. The reasons for currencies’ devaluation and revaluation are inflation and imbalance of the balance of payments gap in the purchasing power of currency units of different countries (OECD, 2016).
Therefore, among all analyzed currencies the Australian dollar is the strongest by PPP, while the Korean won is the weakest currency.
Yield Differentials
Most fundamental factors are related to each other and interest rates are not the exception, in order to predict the dynamics of exchange rates on any term it is necessary to see and be able to read these relationships. Differential is primarily a difference, and in this case it is the difference between the key interest rates of central banks. Interest rates are an important tool of monetary policy, for example, if the European Central Bank’s refinancing rate changes, as it was, it directly affects the value of the interest rates on loans, deposits and other money market instruments (Madura, 2012).
3-month interest rates for the US dollar, Japanese yen, Euro, Polish zloty, Russian ruble and British pound are 3.5%, 0%, 0.05%, 1.75%, 11% and 0.5% correspondingly. The fact of low interest rates in the USA, Japan, European Union, Poland and the United Kingdom caused respective currencies’ depreciation against the dollar in contrast to the theory of uncovered interest parity, because Japan, Poland, the United Kingdom, the USA and European Union have free floating exchange rate regime. Russian ruble is devaluated according to mentioned theory, because it does not have certain managed arrangement (The Financial Times, 2016).
If one of the central banks raises interest rates, it thus increases the yield of money market instruments and triggers the flow of capital from one country to another. It turns out that the growth of the difference in interest rates leads to an increase in the exchange rate of the country. At the same time, we should not forget about such important macroeconomic indicators as inflation and unemployment, because the growth of the consumer price index, as a rule, is the evidence of higher prices for goods and services, and, therefore, makes it necessary to increase the refinancing rate, but it will not promote the growth of investor interest in increasing investment in the economy of a country (Madura, 2012).
Examination of Forecasts
One of the directions of the monetary policy is forecasting the exchange rate, which is carried out by banks, firms and TNCs. The aim of the forecasting is to improve currency risk insurance and increase of efficiency of solutions in international financial management. Forecasting allows making the right choice regarding currency for payment in foreign currency contracts; currency of international loan and payment; currency, which is due to corporations in the bank; and the currency, in which foreign investment company or foreign bank assets are denominated (Brigham and Houston, 2011).
Taking into account the information from Trading economics, it is noticeable that Euro is expected to appreciate by the end of 2016, but depreciate by 2020. Japanese yen is projected to depreciate by 4.2% by Q4 2016, but appreciate by 21% by 2020. Concerning British pound, it is forecasted to appreciate by the end of the year, but depreciate by 2020 by 20.7%. Russian ruble is estimated to devaluate by Q4 2016, but revaluate by 20.8% (Trading economics, 2016).
As for the forward rates, for Euro it is opposite to the predicted exchange rate, namely the value of Euro is expected to depreciate. British pound’s forward rate informs about currency’s depreciation. Japanese yen is expected to depreciate. Russian ruble is projected to depreciate (The Wall Street Journal, 2016).
Speaking about actual exchange rates, the value of Euro is low, but by 2020 is expected to be lower. The value of Japanese yen is actually higher, than expected by the end of the year, but lower than it is estimated by 2020. Actual exchange rate of British pound is predicted to fluctuate negligibly within 2016, but by 2020, the level of depreciation will be noticeable. The actual rate of Russian ruble is higher than is forecasted within the year, but it is quite low compared to predictions by 2020. Thus, such rates are estimated applying an autoregressive integrated moving average (ARIMA) model adjusted applying company’s experts’ anticipations. The modeling of previous ways of conduct of analyzed currencies is based on the application of vast sums of historical information and the coefficients of the econometric model are calibrated through the consideration of experts’ assessments and upcoming prospects (Trading economics, 2016).
Conclusion
The problem of exchange rate plays an important role in the monetary and economic policy, as the currency exchange rate changes affect the relations of the redistribution of GDP through the world markets for goods, services and capital. During the forecast of the exchange rate, multifactor of its formation in the market, especially those currency formed factors that dominate in a given situation, is taken into account. The magnitude of the exchange rate is influenced by the following factors, namely supply and demand of currencies, inflation, interest rates and the yield of the securities, the state of balance of payments, economic crises, wars, natural disasters, etc. (Madura, 2012).
Among all analyzed currencies the Australian dollar is the strongest by PPP, while the Korean won is the weakest currency. In general, considering fluctuations of Euro, British pound and Japanese yen, it is obvious that the US dollar enhanced its position within the last five years. By 2020, it is projected that Euro and the British pound will depreciate, while the Japanese yen and Russian ruble will appreciate.
References
Brigham, E. F. and Houston, J. F. (2011). Fundamentals of Financial Management. Concise 7th ed. Cengage Learning.
The Financial Times (2106). Bonds & Rates. Retrieved from http://markets.ft.com/research/Markets/Bonds [Accessed: 8 March 2016]
Madura, J. (2012). International financial management, 11th ed. Mason, OH: South-Western/Cengage Learning.
OECD (2016). 4. PPPs and exchange rates. Retrieved from https://stats.oecd.org/Index.aspx?DataSetCode=SNA_TABLE4 [Accessed: 8 March 2016]
The Wall Street Journal (2016). Currencies’ Overview. Retrieved from http://www.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3021 [Accessed: 8 March 2016]
Trading economics (2016). Currency. Retrieved from http://www.tradingeconomics.com/currencies [Accessed: 8 March 2016]
