International Finance
A floating currency refers to a system of currency valuation where by the exchange rate of a country’s currency depends on the supply and demand of that currency relative to foreign currencies. Floating rates of exchange usually vary freely because they are determined by trade activities in the forex market. A floating system of currency valuation is the complete opposite of the fixed rate of exchange. The fixed rate of exchange regime is where by the rate of exchanging the currency in relation to other foreign currencies is set at a constant rate.
Countries can either choose the fixed rate of exchange regime or the floating rate of exchange regime in determining the exchange rates of their currency. If the floating rate of exchange is in use, and the currency of a country either appreciates or depreciates drastically within a short period of time, governments can intervene. Usually, the government does not intervene in a floating rate of exchange regime. But in case the currency appreciates very fast, the government can increase the supply of the currency in the market to help control the exchange rate from appreciating further. Increasing the supply of currency will increase the supply of it in the forex market. This will meet the demand of the market. In cases where the currency depreciates, the government, through the central bank or the Federal Reserve will release some of its foreign currency reserves into the forex market. This will meet the demand for foreign currencies in the forex market hence controlling the exchange rates.
Many countries all over the world prefer the floating regime of exchange over the fixed exchange rate. These countries’ policies are based on the assumption that the currency regulates itself. The forex market dynamics of demand and supply are left to dictate the value at which a currency is to be exchanged for other currencies. This may cause a deficit balance of payment if the currency appreciates in the short term. This is because if the currency appreciates, the country is able to buy imports at a relatively low cost due to the superior currency. The country’s exports will be relatively expensive for the buying nations because their currency will be weaker than the other currency hence they will buy less. This causes a deficit balance of payment because the imports will be more than exports. If the currency depreciates in the short run, the country will experience a surplus balance of payment. This is because the weak currency makes foreign countries to buy a lot of goods and services. At the same instance, the country will not import as many goods and services as before because their currency will have a lower purchasing power. This causes an aggregate surplus balance of payment. Theoretically, there can never be a long lasting deficit or surplus balance of payment in any given economy. This is because there is the assumption that a currency’s value will always tend to be steady due to forex market reactions. Any change of currency, whether appreciation or depreciation results in the market forces reacting to return the value of that particular currency to normalcy.
However, over the past two or three decades, some countries have experienced huge surplus and deficits in balance of payments. This is what is now popularly called global payments imbalances. These are the instabilities in the level of balance of payments for countries all over the globe. A surplus global imbalance is situations where by countries around the globe accumulate a lot of foreign reserves. The countries tend to have a high level of production, and then they export most of their production due to the surplus production. Similarly, these nations produce enough output for the country’s consumption so that they do not have to import. The result is an aggregate more export than imports, hence the balance of payment.
For the global deficit balance of payment, the countries seem to produce less output for its own citizen’s consumption. Therefore, they have to import more goods and services to supplement the existing production. These countries already produce very little output. They do not have the capacity to produce goods for export. Such countries spend so much on imports that they exhaust their foreign currency reserves. Therefore, there is a deficit balance of payment in such a country.
The past thirty years have been periods of hard and good economic times for different countries. These economies have experienced economic booms and economic crisis at some stage. It is the imbalances in the global balance of payments that result in these crises and booms. The booms and crises can be explained using the credit interest rates in these countries. Usually, during financial and economic booms, the banks and other financial institutions lend a lot of finances to citizens and investors. The interest rates are usually low, so the public deem it fit to borrow money so as to invest it. In the United States for example, in 2007, many people and investment institutions borrowed heavily in order to finance their mortgage or housing projects during the housing bubble. At such times, the public prefers to take the opportunity to invest in something rather than hold money.
Banks and lending institutions take advantage of the high rate of borrowing. They lend most of their finances until they run out of finances to lend. At that point, the bank owners want to maximize profits, they try to acquire more funds so as to continue lending. The only option is short term liability. These banks and financial institutions acquire short term liabilities by borrowing foreign currencies. The lending could be directly to the public/citizens in the form of issuing bonds and other financial assets and equities. Another option is the lending of money to the investment vehicles such as investment institutions and companies. The borrowing of foreign currencies increases and accumulates the risk in the economy. Any changes in the global funding conditions would be adverse to the national economy of such a country. This is because when there is a collapse in the international exchange rates, the national currency will be superior to the foreign currencies hence the country can borrow and repay the foreign money easily. This will result in an economic boom for that country but the foreign credit providing countries will experience financial crises.
In cases where the international credit providers remain intact but the national economy encounters some instability. The national currency will lose its value. This will have adverse effects on the national economy. The national currency will lose its value against foreign currencies. The banks and financial institutions will find it hard to repay their loans that they owe the foreign markets. The short term liabilities now become burdens to the national economy as a whole. The risk taken by the financial institutions will have failed to bear fruit. The institutions will have to pay the foreign lenders a higher amount of money than they borrowed. This will cost a lot of the national economy resources, hence resulting in a deficit in the balance of payments. This will slow down economic growth and reduce the gross national product significantly. This is how a financial crisis starts. This particular country will encounter a financial crisis. The country will not be able to export its product because it will not be in a position to produce surplus goods and services for export. It will also not be able to import foreign goods and services because first, its currency has lost value and secondly its purchasing power will be lost. Subsequently, the trade partners of this country will also start making economic losses. They will not be in a position to buy goods from their trade partner because the partner is not producing goods that meet the international demand. Then they cannot sell their goods to their trade partners because the partner has no purchasing ability in the international market due to its weak foreign currency. The result is a financial crisis for that country and it trade partners.
Economic policies of the world’s developed countries are to blame for past financial crises. These policies that were adopted by the developed nations led to collapse of the financial markets whose effects spread to other nations hence causing global imbalances. An example is the American situation that led to the 2008 financial crisis. The Federal Reserve reduced the interests, used inappropriate monetary policies to handle the then economic situation. These factors, accompanied by the financial innovation of American financial institutions and market distortions led to the financial recession.
The federal monetary policy reduced the effectiveness of the fiscal policies in the regulation of the economy. The monetary policy that was adopted during the time of the housing bubble was wrong. The step that was taken to reduce lending rates led to the loss of value of the US dollar. In response, there were increased net inflows of capital into the American financial markets. This coupled with the financial policies of other nations like China led to more capital inflows. The Americans borrowed funds from China at cheap interest rates to fund the increasingly unsustainable housing bubble. The Chinese economy was also booming. There were high savings and one way to invest these savings was by lending to foreign economies like America who wanted to finance their own projects. The housing bubble failed hence leading to the financial crisis. Most of the housing projects that were underway never reached completion. Subsequently, the increased debt of America to foreign countries had increased drastically. This led to the depreciation of the dollar further during the crisis. This financial crisis in America affected the whole world because the American dollar is used universally in foreign market trading. Most countries’ economic activities were adversely affected because the dollar had lost it value. The global payment imbalance led to the financial crisis.
Usually, if there is a lot of saving over investment in the developing economies’ financial markets, there will be surplus current accounts for this class of economies. At the same time, there will eased conditions of the financial deficits for those countries hence there will be a reduction in the world interest rates. The increased savings catalyze a credit boom in the developed nations and increases risk taking in these countries. The surpluses in the developing economies like China and deficits in developed economies like America are the global payment imbalances that can lead to a financial crisis. The developing countries have a surplus hence they have a lot of savings. The developed nations take the risk to borrow these savings to invest in their capital markets. That is how the credit boom is financed. The increased savings to investments in the emerging economies (surplus economies) were responsible for the fall in world interest rates.
Therefore, global payment imbalances are the root cause of financial crises in the world. These payment imbalances are caused by instabilities between investments and savings in an economy. Those countries with huge deficits in their current accounts and those that have huge surpluses like China should find ways of balancing their payments. This can be done through several ways. First, there are the stimulus packages all over the world. This will encourage even growth in world economies hence there will be few cases of deficit balance of payment. Then there should be measures to increase government savings in all world economies so as to reduce instances of external borrowing. The world economies should also implement policies that will trigger economic growth hence reduce chances of imbalance of payments.
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