This section imparts knowledge using empirical evidence that is published in newspaper journals and articles and is related to our topic of interest, to augment the understanding of the financial concepts and phenomena that take place in the economy. Following are some critical reviews of articles pertaining to topic: Exchange rate risk, determinants and its impact on foreign trade.
Exchange Rate Fluctuations, and its Causes.
The issue of the undervalued currency of China (Renminbi). and not just undervalued the word 'substantial" puts the emphasize on the meaning shedding curious gazes as to what might be the reason behind this, has been presented in an article "Question of Value" published in 2007. However, the year 2007 and the year following that were expected to bring appreciation according to the author. The low valued currency helped in the exports volume increment but at the same time incurred costs in other sectors. The so expected appreciation would bring prosperity to the economy, indicating an economic growth or a path led to success. On the other hand, the appreciated currency would, by all means, even if little, impact the exporting sector negatively making the goods sold to foreign countries less cheaper and making the existence of Chinese goods in the competitive market all the more tougher (2007).
El-Erian (2007), further takes the discussion forward with appreciating Chinese currency and at the same time the threat of protectionist trade measures and the falling dollar. He sheds light upon the problem of falling dollar and how it would be a problem being a constraint upon the federal reserve bank to take measure against the economic down turn led by the crisis in the real estate. On the other hand, the Chinese Yuan has been allowed to appreciate modestly in the past two year from the time the article was written keeping an eye for the threat of protectionist measures. Already the appreciation had caused much apprehension for the Chinese, dollar falling further would be putting too much on their plate. The Depreciation of Dollar would imply further appreciation in Chinese currency which would threat the exports sector much. Nevertheless the depreciation of dollar by and large is a development for the world economy despite some negative consequences it may have on trade. And the circumstances are much more predictive for the weak dollar than the reality assumes, and it sure is likely to remain that way(El-Erian, 2007).
The important issues discussed by the author in "Question of Value" diverts our attention towards the sterilization efforts, issuance of liabilities and Sino-US relation that are the main factors affecting the pace of the appreciation expected. The so long undervalued Chinese currency's expectation to rise was induced by the central bank's intention of sterilization for the manipulation of exchange rate, however all depended upon the success of this effort. The central bank can control the exchange rate by buying or selling the currency and hence stimulation an increase or a decrease respectively in the relative supply of the currency in circulation. Furthermore in sterilizing it insulates itself from the foreign exchange operations in order to prevent potentially adverse impacts of capital inflow or outflow. Thus in order to appreciate the Chinese Renminbi against US dollar the central bank of china would buy the domestic currency and create a shortage of supply, therefore increasing its value and it would sell the American dollar for the reverse effect. Hence, the Chinese currency would appreciate (Question of Value, 2007).
El-Erian (2007), taking a step further, reasoned the apprehensive condition of the Chinese, to see the falling dollar after all their efforts to keep the appreciation of their own currency modest. The threat of declining exports leading to broadening of trade balance was imminent. And to top it off the depreciating dollar only sought to be a cause for an augmentation of risk in the painstakingly controlled economy. The article but also points out that despite the negative consequences of the weakening dollar on trade given the predictable circumstances of a likely depreciation, it also implies a development of world economy against US. Because depreciation of dollar would in effect mean appreciation of the currencies that it must be held against which includes all the other countries of the world. Thus from the perspective of other countries an appreciation would be taking place implying a growth affect in their respective economies and indicating a surge of development in those countries. (2007)
The Negative and the Positive Impacts
Another author contributed in the same line of argument, though his inclination was towards the impacts then cause. His interest was in the issue related to the one raised by the author of "Question of Value (2007),in a periodical titled "Currency Pressure", however, his argument is in resonance to the arguments of both the authors of the articles that were published before on fluctuations of exchange rates, in 2007, "Question of Value" and "Foreign Exchange - How Far will it fall?" and critically analyzed above. The author in this article specifically talks about the strong appreciation of most Asian currencies against USD while there being still others, which were weaker than they were before the global financial crisis. The appreciation of other currencies has put the undervalued currency under pressure to appreciate further. China in this respect has continued to keep its currency undervalued. A rapid appreciation would imply a slower accumulation of foreign reserves. This brings two aspects under concern. First is the rising threat of protectionism from European countries and the US and the other is the giving full control of monetary policy back to Government. (2009)
Our author the third article in hand (2009) forces to contemplate upon the issue that is the rapid appreciation of currencies in Asia, especially China who has been keeping a modest appreciation rate in light of the threat of protectionism from EU and US. The weaker currency if allowed to appreciate rapidly would instigate protectionism from EU and US on now not so cheap goods owing to the devaluation of USD itself as well as the appreciation Asian currencies. However this would also imply developmental growth in other countries (referring to China) relative to the US. (2007). Furthermore another incentive for letting the currency appreciate for China and other Asian countries would be that letting the exchange rate fluctuate on its own terms, the Government will finally be free to use the monetary instruments to manipulate and reshape their monetary policy which otherwise had been committed to keeping the exchange rate fluctuations in check.
From the discussions regarding the exchange rate by three different authors of three articles so far, it has been an enlightening experience to contemplate upon the issues faced in the real world by the real economies regarding the Foreign exchange rate fluctuations, how they are affected differently by the conditions of the economy in different countries, and the what reactions it induce in the effected economies. The Exchange rate fluctuation is now better understood in terms of two countries respected currency values. We can see a number of different impacting factors changing the rate which include the loosening of monetary policy in to let the Chinese currency appreciate against all currencies and on the other hand the devaluation of dollar appreciated the Chinese currency even further. Resultantly changing the relative development indicators of the countries effected.
Furthermore, the effects on the foreign exchange rate we also saw the application of the effects that the fluctuations of FOREX have on the economies, which is an exposure to the risk of losing trade as mentioned in our literature review (2009). The rapidly increasing currency value also come forth rapidly rising prices of exports goods which would induce a fall in demand of worse protectionist policies in the importing countries for the exported goods of the country experiencing currency appreciation. Besides the risk of protectionism and other changing exchange rates negative impacts the positive impacts include in the likely situation of appreciation as mentioned above, loosening of control on exchange rates frees the monetary policy to concentrate on the other sectors of the economy. Also the appreciating value of the currency creates major attraction for short-term and high-return investment seekers (2010). This can be explained better by Ying Huang's argument on the main reason of speculative fund inflow to China.
Ying Huang attempts to decipher the main reason for the inflow of funds into Chinese economy in the article "What Causes Speculative Fund Inflow to China". The massive overseas funds inflow, according to the author, is primarily due to the appreciation in the Chinese Currency which makes it attractive to investors. These funds aim to earn a higher comparative return on short term basis due to high interest rates offered in China as Opposed to that of the United States. And, although, the housing and the stock market appear to be the main attraction of investments since funds may appear to target investment in these markets, however, the attractive appreciating Chinese currency is the major reason of the speculative inflow of funds and not these markets. (2010)
An appreciating value of Chinese currency shows promising future to the investors who seek high returns in a very short period. The reason being that, in spite of the high interest rates offered to the investors the appreciating value of currency increases the return by an even larger total than just with the high returns. The high returns and increasing value by the virtue of increasing Foreign exchange rate is major attraction for investors. The article pointed out the fact that even though the housing and stock market appear to be the investment targets reeling in the major influx of funds from overseas, however the main star of the speculative flow is the attractive currency of Chinese owing to its appreciating nature. The housing and stock market do not cause this major influx, however they do become the target investments eventually directly or indirectly (2010).
This pretty much elaborates our discussion on foreign exchange rate, however, we still need further evidence upon the risk exposures that have been mentioned as an effect to these fluctuation in terms of their impact on economy or investors and why or why not investors decide to take precautionary measures in taking shelters from this kind of risk exposure.
Risk Exposure- Avoid it or Avoid Avoiding it?
A decent explanation can be induced by analyzing the perspective of Georgina Lee in her published article "Chinese State-Owned Businesses Face Tougher Derivatives Scrutiny". Lee talks about the increased scrutiny that Chinese state owned businesses have to face now. The derivatives market used to hedge the investments against interest, currency and commodity risk are put under surveillance in order to put constraints on this phenomena and discourage these market transactions that would eventually lead to 'too much' hedging that all the risk averse investors would start using these financial instrument to secure their investments. The State-owned Asset Supervision and Administration Commission was spurred into action after several State-owned Enterprises, their subsidiaries and affiliates suffered high losses due to failed foreign exchange, fuel and interest rate hedging contracts (2009).
Although, according to Georgina Lee, the use of derivate securities as financial instruments to hedge the investments against certain kind of risks may be a very attractive phenomenon of wisely securing your assets against risk, but it brings forth the new kind of risk associated with it, that is the probability of losing profits in case unexpected adverse circumstances would come into play. The article discusses the new limitations and regulations put to scrutinize the state-owned businesses and restrain them from using derivative securities. After observing several high profile losses incurred to state-owned enterprises, the SASAC came into action to prevent further losses due to failed foreign exchange, interest and fuel hedging contracts.
Lees discussion is merely elaborates why Chinese Supervision Commission had to keep in check the derivative markets in order to prevent another experience like past of failed securities. However, it is more of a choice in other countries than of a legislative measure, which is made after analyzing the costs incurred in using the financial hedging instruments. Larry Krischner, Emily Halbrook and Jared wade elaborated on this discussion in a very comprehensive manner in an article that was published in 2009 titled " The Power of Dollar" (2009).
Krischner, Emily Holbrook and Jared wade elaborate upon the Foreign Exchange Rate risk exposure and how and why different companies manipulate the financial derivatives as instrument to manage their risk. Also they write that a few companies would rather not address the foreign exchange risk exposure at all. According to the authors, it requires a great deal of understanding, assessment and prioritization of the exposures before they can apply these any hedging instrument to gain from such investments. They observe that where many companies have become complacent with their foreign exchange risk management practices, there exist other companies that would rather condone addressing to such exposures. There are many things to consider and much effort required before utilizing any instrument to manage against such risk exposures. (2009)
The implication by the authors enlightens us about the importance of better understanding of the foreign exchange rate fluctuations and risk exposure before they can be manipulated into profit extraction or general hedging against an expected risk of adverse circumstances. The reason for some companies being comfortable with their hedging or risk management practices stands that they understand the further risks attached to it and after having properly assessed, analyzed and derived from the given risks and they have weighed their expectations of gains with current condoning alternative and have reached to a conclusion to generate expectations of comparatively more gains through hedging. These preliminary requirements are basic necessity and incur some cost as well which discourages other companies from using financial instrument to their own advantage. Thus it can be derived that although risk exposure management may be beneficial for companies to hedge against exchange rate risk, however, it requires careful analysis of international exposures with due consideration given to internal control by the companies.
The analysis above provides quite an insight on the choices faced by the investors and the reason why they chose to or chose not to use financial derivatives to hedge against the foreign risk. At the end it all depends of your weighted analysis of cost and benefits and risk involved that contribute in the final decision making process. Despite all these discussions we know from intuition that we as humans would prefer lesser risk. Putting this natural instinct upon financial intuition it should be an understood fact that investors would go for a stable investment of low risk provided he choice is a decision made after thorough analytical efforts. However in light of all the above analysis and our major intuition we should see that due to the depreciating dollar value, many countries' investors should have switched to a more stable currency as a reserve currency but we observe that dollar still remains to be the reserve currency all over uncontested with the exception of the challenging statement delivered by Governor of People's bank of China, covered by Montecillo, Paolo Luis G. in an article, published in 2009, titled "Dollar Uncontested as Reserve Currency" (2009).
Montecillo reflects the view of the Governor of People's Bank of China, Zhou Xiaochan, that current global financial system faces vulnerability and systematic risks. He also emphasized that reform must create an international reserve currency with stable value, rule based issuance and manageable supply. The article further illustrates on the point made that they are serving as a "unit of account" and as a "medium of exchange". Moreover its "store of value" is also considered from the perspective of both the government and the private sectors. Following the perspective Governor of people's Bank of China actually challenged the statement of BSP(the Bangko Sentral ng Pilipinas ) that despite declining value of dollar (from 72.7% in end- June2001 to 62.8% as of end- June 2009: the article quotes) dollar will remain the world most widely used currency-Uncontested reserve currency- as no alternative existed as then.
Another type of risk associated with the foreign exchange rate fluctuation has been thoroughly highlighted in this article enlightened by the challenging statement of Governor of People's Bank of China. With the declining value of dollar with respect to other currencies, in effect appreciating them against the USD, the risk associated with them puts the investors in reserve currency at exposure. The stable foreign reserve currency is the requirement for foreign transactions and for investment purposes. However, a fluctuating reserve currency would create imbalance of gains and losses and putting the market players at a high risk of losing money who have invested in a currency with declining value, for example, and need to pay in other currency that would have appreciated against the reserve currency in effect. Thus the declining value of Dollar though may not have challenged its world-wide demand as a reserve currency, but China has contested that perspective in term of demanding a relatively stable alternative and seek shelter from the exposure this foreign exchange rate fluctuation risk(2009).
