1.
a) Find the U.S. inflation rates between 2002 and 2007 from the IMF website and calculate the Purchasing Power Parity (PPP) exchange rates for Countries A, B, C and D in the case study. (The inflation rate in each country in the case can be calculated from the Consumer Price Index. For Example: inflation rate for country A=14.7%= 132.9 – 115.9 /115.9
[20 marks]
b) Did Purchasing Power Parity theory hold in these countries? Which currencies are over- or under-valued against the US dollar?
[4 marks]
c) Find the U.S. dollar lending rates (prime rate) between 2002 and 2007 from the IMF website or the U.S. Federal Reserve website and calculate whether International Fisher Effect (IFE) theory held between the exchange rates of Countries A to D and the US dollar.
[16 marks]
d) Based on your PPP and IFE calculations above in which countries do you expect a significant depreciation or appreciation (convergence to the PPP equilibrium rate) in the near next three to five years?
[10 marks]
Inflation rates for all the countries including USA between 2002 and 2007
So based on the inflation rates the relative purchasing power parity can be calculated as below for the timeframe of 2002 to 2007.
P= (1 + Iy) ÷ (1 + Ix)
Iy is the inflation rate for a foreign country y for the whole period of 2002 to 2007.
Ix is the inflation rate for country x, which is USA in our case.
We can see that apart from country D which has seen a lesser inflation rate over time, all the other countries have seen more inflation than USA. This means that the currency of those countries will devaluate against dollar except for the country D.
If we compare the values found above, we see that for the country C and D there is not much difference in the PPP values. There are little chances of exchange rate adjustment in those two currencies. However, there is a huge difference in PPP as calculated from the inflation and exchange rates for the country A. This is a huge aberration and as the value is much lower than the target value, there is a high probability that the currency of country A will highly depreciate against dollar in near and medium term. This thing also can happen if a country regulates its currency and the market is not open. Looking at the difference in PPP and exchange rate it seems that the country A may be regulating its currency.
For the country B, there is a difference in PPP values (1.62 and 1.38). This generally happens when there is a constant high inflation in a country for a long period of time. The prices of goods in country B can go up quickly but the exchange rate takes time to correct it.
US average annual Prime Lending rates between 2002 and 2007 are as below:
2002—4.25%
2003---4.00%
2004---4.75%
2005--- 6.50%
2006 ---8.0%
2007--- 7.50%
The lending rates for the countries A, B, C and D are as below:
Fisher effect states that “a rise in the domestic inflation rate causes an equal rise in the interest rate on deposits of domestic currency in the long run, with other things constant.”
As per Fisher effect we should see that the change in interest rate and change in inflation should be in line compared to US rates.
As per Fisher effect, interest rate change should have been equal to inflation rate change with respect to US interest and inflation rate respectively. We see that among three of the four countries the pattern follows Fisher effect. The reduction in inflation between 2002 and 2007 has caused the interest rate to come down as well. The interest and inflation rates may not be exactly same but close. However, for the country D during this time period the interest rate has gone up compared to the US rate whereas inflation has gone down. There is a chance that in the country D, there will be an exchange rate correction which will cause domestic money supply to change and which will either cause inflation to go up or interest rate to come down in long term.
For Country A, interest rate probably will go up and so will the exchange rate in the long run to reach the equilibrium.
As per the IFE calculation we see that the country B and the country C have followed the Fisher effect equilibrium. From PPP calculation we saw that PPP based on inflation and exchange rate follows each other in the countries C and D. From the two we can say that the country C is in equilibrium and there is not much changes expected in this country in terms of the change in exchange rate.
In the country D, exchange rate followed the inflation rate change. However, the interest rate of the country is higher than expected. In medium to long term the interest rate will come down in the country D, assuming all other factors to remain constant.
In the country B the Fisher effect seems to hold true. Less inflation has triggered fall in the interest rate between 2002 and 2007 but as per PPP for the country B, there is a difference in PPP values (1.62 and 1.38) when calculated using exchange rate and inflation. This generally happens when there is a constant high inflation in a country for a long period of time. The prices of goods in country B go up quickly but the exchange rate takes time to correct itself. The currency of country B probably will see devaluation in future years.
For the country A, there is a difference in PPP as calculated from inflation and exchange rates. This is a huge aberration and as the value is much lower than the target value, there is a high probability that the currency of country A will highly depreciate against dollar in near and medium term. This thing also can happen if some countries regulate their currencies and the market is not open. Looking at the difference in PPP and the exchange rate, it seems that the country A may be regulating its currency.
2. In the case study, Susan from Tower Associates is not familiar with the financialization literature. Discuss how financialization can be a possible cause of country crises by referring to the arguments and evidences in Ertürk (2003), Gabor (2010) and Kaltenbrunner (2010).
[50 marks]
Financialization is a concept which started gaining popularity during 1970s in US and UK. This process makes the financial sector as the dominant sector in the economy. The process of financialization often changes the basic structure of the real and financial structure. The one and the most important manifestation of financialization is the importance of trading as income generating and risk diversification instrument (Kaltenbrunner, 2010). In a classical financial system banks borrowed money from capital markets or savings accounts and used those money for lending based on standard risk diversification procedure but in this new financialization concept banks shift from the standard model to a new regime. They use intermediating and investing in financial assets to generate profit. The financial sector now through different instruments bundle different financial products and can trade them in an open market. Products which were previously illiquid now can be traded and the risk for those assets can be diversified. This has expanded the volume of the total financial sector. Another financial instrument called derivative also has revolutionized the way investors trade. With this instrument an investor can now hedge the exposure. This market also has helped the financial market to grow rapidly in last few decades. From 2.8% of GDP in 1950 the share of financial sector grew to more than 8% of GDP in 2012 in US. Same is the case with most of the developed economy. Financial sector now is one of the biggest sectors in many countries.
Kaltenbrunner argues in his paper that short term trading operation is important and so is liquidity into a financialized market. Brazil, for example, provided the liquidity of its financial assets by opening its market in 2003 and deregulating most of its sectors. This increased the volatility of Brazilian currency as Brazilian Real was no longer reflecting the domestic economic condition; rather it started reflecting the international market condition. During the financial crisis of 2007-2010 this increased liquidity and deregulation caused financial crisis in Brazil although the actual crisis was in US market. This happened because of the fact that as soon as the crisis happened most of the investors unwound their position in the market and so they did the de-leveraging with the available liquid assets including the ones in Brazil in which they have invested. (Kaltenbrunner 2010)
As the financial trading market is becoming more and more global with the globalization of economies and development in technologies, more and more international investors are investing in other countries. It is often seen that the growth of financialization in many developing countries can be linked to foreign banks and foreign investors. These foreign investors or banks borrow from the short term money market and invest in the currency markets. Both these instruments are highly speculative and risky because wherever those investors go they carry that risk with them in that country. Central bank of a country decides how a foreign investor can invest in the country and so there is a potential to reduce the risk of economic vulnerability due to excessive financialization by proper laws by central bank. (Gabor, 2010) In Eastern Europe almost same thing happened as in Brazil. Western European Banks after the 2008 crisis started reducing its exposure in Eastern European countries causing a subprime crisis. This was again caused by the available liquidity in the Eastern European market. This could have been avoided if central banks could have managed the liquidity well. Also delinking of an economy from the global risk will not work well from an economy, rather prioritizing the debt by the central bank will make it more robust against such volatilities (Gabor, 2010). Financialization can work for any economy given that it is regulated by the central banks and most importantly financial organizations employ good governance system (Erturk 2003). It is often seen that in a highly financialized market the power of financial sector becomes very large. It starts dominating the overall market behaviour. This new power in the hands of bad management and poor governance structure can create havoc. Turkey in 2002 was a prime example of that. Even US 2007 crisis to some extent was triggered due to poor governance structure.
Work Cited
Ertürk, I. 2003. Governance or Financialization: The Turkish Case, Competition and Change, December Vol.7 No.4
Gabor, D. 2010. (De)Financialization and Crisis in Eastern Europe, Competition and Change, December Vol. 14 No.3-4
Kaltenbrunner, A. 2010. International Financialization and Depreciation: The Brazilian Real in the International Financial Crisis, Competition and Change, December Vol. 14 No.3-4
Jay, Paul.2012.Financialization and the World Economy, The Real News, Viewed on 15th August 2013 <http://therealnews.com/t2/index.php?option=com_content&task=view&id=31&Itemid=74&jumival=8875>
Palley, Thomas I. Financialization: What It Is and Why It Matters. Viewed on 15th August 2013 <http://ideas.repec.org/p/uma/periwp/wp153.html>
Durden, Tyler. 2013. Guest Post: Financialization = Inequality, Viewed on 15th August 2013 <http://www.zerohedge.com/news/2013-06-25/guest-post-financialization-inequality>
Krippner, Greta R. The Financialization of the American Economy. Viewed on 15th August 2013 <http://ser.oxfordjournals.org/content/3/2/173.abstract>
