Exchange Rate Fluctuation & Balance of Trade (GROUP X)

Presented by: Jeenal Karani (16) Mayuri Modi (29) Swapnil Parikh(36) Preeti Rathi(40) Kautik Shah (46) Robin Shah (49)

Flow of our Presentation

Bretton Woods System Types of Exchange Rate

Intervention by Government
Exchange rate Fluctuation and Balance of Trade J Curve Theoretical Model

The Asian Crisis - Empirical Model

Economics - Group X

Bretton Woods System

Economics - Group X

The Pre-Bretton Woods Period

Gold Standard System
A reduction in Gold reserves due to deficit of BOP contraction of money supply

price decline Export goes up import goes down

BOP conditions restored

Economics - Group X

The Bretton Woods System

IMF (International Monetary Fund) IBRD (International Bank for Reconstruction and Development) ITO (International Trade Organisation)

The Bretton Woods rested on 2 Pillars

The maintenance of stable exchange rates

A multilateral credit mechanism institutionalized in the IMF and supervised by it

Economics - Group X

The Par value system / Pegged exchange rate system (1947-1971)

Each country define its currency in terms of gold or US Dollars The value of the US dollar was set at 1/35 of an ounce of gold and The United States promise Dollar earned Interest

Provided a steady and sufficient increase in international liquidity

Economics - Group X

BREAKDOWN OF THE BRETTON WOODS SYSTEM

The Worlds supply of gold did not increase adequately to meet the requirements of rapidly expanding international trade and finance The US had a large deficit in BOP during 1960s. To meet these deficits, the US used its gold reserve for making payments to other countries (Germany and Japan). Due to surplus BOP Germany and Japan acquired not only gold but a large quantity of the dollars from the US which they kept as reserves. Had countries holding dollars tried to exchange them for gold, it would have hurt International trade. In view of large and persistent deficit in BOP, the US govt. withdrew its convertibility of dollar into gold at $35/ounce The floating of dollar Managed Float System in India
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Exchange Rate Types & Reason for fluctuation

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Types of Exchange Rate

Nominal Real

Exchange Rates
Fixed
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Floating

Fluctuates- Why ??
1.Political Stability

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2.Natural Calamities

3.Frequency of transactions

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4. Economic Stability

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5. Demand and Supply

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Interventions By Government

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Intervention by Government
Done When? Done by whom?
Floating Exchange Rates in the Economy Ministry of Finance/Treasury

Central Bank intervenes in currency market or Foreign exchange market when there is huge number of buying or selling of currency leading to depreciation/appreciation of currency beyond a prescribed limit
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Types of Intervention
Jawboning Intervention Concerted Intervention

Operational Intervention

Sterilized and Unsterilized Intervention

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Sterilized & Unsterilized Intervention

Unsterilized Intervention: Selling Foreign currency to increase money supply in the economy Sterilized Intervention To offset the effect of Unsterilized Intervention Purchase of Government Securities

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Economics - Group X

Instruments of Sterilization
Open Market Operations CRR Bank Balances with RBI Repurchase Agreements FOREX Swaps

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Important Points
Intervention conduction is never disclosed otherwise it will lead to speculation causing opposite effect
Intervention is one of the measure for FOREX but it can never substitute Monetary Policy

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Exchange Rate Movements & Trade Fluctuation

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How does exchange rate affect BOT?

Example : If there is a situation in which, there is a depreciation of the dollar vis--vis the rupee. Then this makes U.S produced goods cheaper to Indian importers.

This in turn will boost the price competitiveness of U.S. firms vis-vis the Indian firms. For example if there is a movement from one dollar for Rs. 40 to Rs. 30 per dollar and assume that U.S. exporters charge a set price in dollars, say $10, for each unit sold.
The price in paid by consumer decreases from 400 Rs. to 300 Rs. Thus this will lead to an increase in the exports of US and a sharp decrease in the exports of Indian Goods.
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How does exchange rate affect BOT?

$1 = Rs 40

Cheap Exports for USA Expensive Imports for USA

Cheap Imports for India

Expensive Exports for India

$1 = Rs 30

Economics - Group X

Pass-through effect
Pass-through effect is simply the effect of changing economic circumstances on the cost of production "passed through to the final retail price of the product

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In case of devaluation of currency, imports become expensive which is passed on by the producer to the final consumers This leads to consumers preferring the foreign substitute and thereby worsening the terms of trade
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Hedging the Risks

Leading and Lagging Income and Expenditures A trader can lead (pay in advance) or lag (pay late) his foreign currency payments, depending on whether he expects the foreign currency to appreciate or depreciate, in the near future.

Example : In foreign trade, for example, if a manufacturer has to pay $1 million on a certain date for imported material and receives an export order for $1 million, it might try either to delay the payment for imports or to press for an early payment by the buyer, or both, so that the cash inflow from export is used as cash outflow for imports. It will thus try to escape devaluation risk in import-payment and default risk in export-receipt by juggling two cash flows.
Economics - Group X

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Hedging the Risks - Part II

Netting Receipts and Payments It is the idea of netting involves matching (or clubbing) the receipts and payments in a currency, so that any losses in receipts are compensated by the gains in payments and vice versa

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J Curve Theoretical Model

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J Curve
J Curve theory states that In charting A country's trade deficit will worsen initially after the depreciation of its currency because higher prices on foreign imports will be greater than the reduced volume of imports In Equity The theoretical trend of the internal rate of return over several years. Most funds operate at a loss at their beginning, due in part to their start-up costs. Later, if the fund is successful, the internal rate of return rises significantly.
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J Curve (an illustration)

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J Curve : BoT Model with FOREX

It refers to the trend of a countrys trade balance Devalued currency Lesser buying of foreign goods in the domestic market due to higher value of exchange currency Immediately following the depreciation the effect on volume of imports and exports The trade balance may improve on what it was before the devaluation
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continued
As a result, a country will import and export the same amount of goods for a time, with lower relative prices on the foreign goods, thus increasing net exports If there is a currency revaluation or appreciation the same reasoning leads to an inverted J-curve

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Economics - Group X

Country Status Model

Another 'J-Curve' refers to the correlation between stability and openness The x-axis of the political J-Curve graph measures the "openness" (of freedom) of the country The y-axis measures the stability of that country It suggests that those states that are 'closed'/undemocratic/unfree (such as the Communist dictatorships of North Korea and Cuba) are very stable; however, As one progresses right, along the x-axis, it is evident that stability decreases

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Country Status Model

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At the other end of the graph to closed states are the open states of the West, such as the United States of America or the United Kingdom Entire curve can shift up or down depending on economic resources available to the government, Eg China , UAE
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Empirical Model Asian Financial Crisis

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Asian Crisis : An Overview

Started in July 1997 in Thailand Affected currencies, stock markets, and other asset prices of several Asian countries Impact business operations dramatically because It impacts the availability and cost of financial instruments Increases political risks Making it difficult to plan, organize ,lead and control business globally
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Reasons and Effects

Reasons Large private current account deficits The maintenance of pegged exchange rates became too expensive Excessive exposure to foreign exchange risk Effects Massive devaluation of currencies Downfall in stock exchange Loan defaults increased

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Asian Crisis .continued

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Learning from the Crisis

Liberalization of domestic financial systems should precede or accompany the opening up to foreign investors
Financial system supported by effective regulation and supervision of financial institutions Prudential limits on foreign currency exposure

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Economics - Group X