UNIVERSITY OF LUSAKA

Transcription

1 UNIVERSITY OF LUSAKA FACULTY OF OMICS, BUSINESS & MANAGEMENT UNDERGRADUATES PROGRAM INTERNATIONAL FINANCE ECF440/BF310 COURSE MODULE

2 TABLE OF CONTENTS UNIT 1: THE BALANCE OF PAYMENTS... 4 COMPOSITION OF THE BALANCE OF PAYMENTS... 4 The Current Account... 4 Capital And Financial Account... 5 The Official Reserve Account Measuring The Deficit Or The Surplus... 8 CORRECTING B.O.P DEFICITS The Elasticity Approach The Absorption approach The Monetary approach Deflation/ Fiscal Policy Direct Controls Raising Interest Rates REVIEW QUESTIONS FOR UNITS UNIT 2 : FOREIGN EXCHANGE MARKETS AND EXCHANGE RATE DETERMINATION THEORIES THE FOREIGN EXCHANGE MARKET Foreign Exchange Rates Foreign Exchange Arbitrage Types Of Foreign-Exchange Transactions Spot Transactions (Spot Rates) Forward Transactions Hedging Speculation Interest Arbitrage Interbank Trading Equilibrium Exchange-Rate Determination EXCHANGE RATE DETERMINATION THEORIES Determining Long-Run Exchange Rates Inflation Rates, Purchasing Power Parity, And Long Run Exchange Rates Law Of One Price Relative Purchasing Power Parity Determining Short-Run Exchange Rates: The Asset Market Approach Relative Levels Of Interest Rates Expected Change In The Exchange Rate FORECASTING FOREIGN EXCHANGE RATES Judgmental Forecasts Technical Forecasts Fundamental Analysis REVIEW QUESTIONS FOR UNIT UNIT 3: FOREIGN EXCHANGE RATE SYSTEMS Source : International monetary Fund De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks - Data as of April 31, The Fixed Exchange Rate System Exchange-Rate Stabilization Devaluation And Revaluation Floating Exchange Rates Achieving Market Equilibrium Page 2

3 REVIEW QUESTIONS FOR UNIT UNIT 4: MACROOMIC POLICY IN AN OPEN OMY Economic Policy in an Open Economy Economic Objectives of Nations Policy Instruments REVIEW QUESTIONS FOR UNIT UNIT 5: INTERNATIONAL BANKING: RESERVES Nature of International Reserves Demand for International Reserves Other Determinants Supply Of International reserves Gold Exchange Standard Special Drawing Rights (SDRs) Facilities For Borrowing Reserves IMF Drawings General Arrangements to Borrow Swap Arrangements REVIEW QUESTIONS FOR UNIT International Lending Risk Credit risk Country risk Currency risk The Problem Of International Debt Dealing With Debt Servicing Difficulties Reducing Bank Exposure To Developing-Nation Debt Debt Reduction And Debt Forgiveness The Eurocurrency Market Development of the Eurocurrency Market Financial Implications REVIEW QUESTIONS FOR UNIT RECOMMEDNDED TEXTS COURSE ASSESSMENT: Page 3

4 UNIT 1: THE BALANCE OF PAYMENTS This unit introduces the student to the mechanics of recording of international trade financial transactions and the resulting positions for the domestic economies as a result of the domestic economies transferring assets abroad or receiving assets from abroad. It also introduces the mechanics of how surpluses and deficits are (or should be) corrected in order to maintain the balance of payments. The student is expected to have a working knowledge of the balance of payments, its composition and mechanics and to the various trends that the Zambian balance of payments have been following and the resulting consequences for the Zambian economy according to the theoretical background of international trade. The balance of payments is a record of the economic transactions between the residents of one country and the rest of the world. Nations keep record of their balance of payments over the course of a year period; although some other nations also keep such a record on a quarterly basis. An international transaction is an exchange of goods, services, or assets between residents of one country and those of another COMPOSITION OF THE BALANCE OF PAYMENTS The Current Account The current account of the balance of payments refers to the monetary value of international flows associated with transactions in goods and services, investment income, and unilateral transfers. Each of these flows will be described in turn. Merchandise trade includes all of the goods Zambia exports or imports: agricultural products, machinery, autos, petroleum, electronics, textiles, and the like. The Kwacha of merchandise exports is recorded as a plus (credit),and the dollar value of merchandise imports is recorded as a minus (debit). Combining the exports and imports of goods gives the merchandise trade balance. When this balance is negative, the result is a merchandise trade deficit; a positive balance implies a merchandise trade surplus. Exports and imports of services include a variety of items. When foreign tourists spend money at Zambian restaurants and hotels valuable services are being provided by Zambian residents, who must be compensated. Such services are Page 4

5 considered exports and are recorded as credit items on the goods and services account. Table 1.1 presents summary of the current account for Zambia for the year 2009 as it appeared in the IMF publication (all values are in million of US Dollars unless otherwise indicated ( 2010) Table 1.1 Zambian Current Account For the Year 2009 Current Account -404 Trade Balance Exports.f.o.b Of which : copper Imports: f.o.b Of which : oil Services ( net) Income (net) Of which : interest on public debt 906 4,319 3,179-3, , Current Transfers (net) Of which :Budget support grants Sector wide approach grants Private transfers Source: IMF Country Report No. 10/383, December 2010 Capital And Financial Account Capital and financial transactions in the balance of payments include all international purchases or sales of assets. The term assets is broadly defined to include items such as titles to real estate, corporate stocks and bonds, government securities, and ordinary commercial bank deposits. The capital and financial account' includes both private sector and official (central bank) transactions. Capital transactions consist of capital transfers and the acquisition and disposal of certain nonfinancial assets. The major types of capital transfers are debt relief and migrants' goods and financial assets accompanying them as they leave or enter the country. The acquisition and disposal of certain nonfinancial assets include the sales and purchases of rights to natural resources, patents, copyrights, trademarks, franchises, and leases.. The vast Page 5

6 majority of transactions appearing in the capital and financial account come from financial transactions. Table 1.2 presents summary of the current account for Zambia for the year 2009 as it appeared in the IMF publication (all values are in million of US Dollars unless otherwise indicated ( 2010) Table 1.2 Zambian Capital and Financial Account For the Year 2009 Capital and Financial account 1,005 CAPITAL ACCOUNT Project Grants External debt cancellation FINANCIAL ACCOUNT Foreign direct portfolio investment Other investments Medium and long term Public Sector (net) Disbursements Of which : Budget support Amortization Due Monetary Authority Commercial Banks (net) Other sectors Short term Errors and omissions Overall Balance Source: IMF Country Report No. 10/383, December 2010 The Official Reserve Account. The official reserve account measures the change in a nation s official reserve assets and the change in foreign official assets in the nation during the year. A nation s Official Reserve Assets include the gold holdings of the nation s monetary authorities, special drawing rights (SDR s), the nation s reserve position in the International Monetary Fund (IMF) and the official foreign currency holdings of the nation (Salvatore, 1990, p. 139). Increases in the nation s official reserve assets are debits (-) while increases in the foreign official assets in the nation are credits (+) Page 6

7 TABLE 1.3 ZAMBIA S OFFICIAL RESERVES IN 2009 Financing Central bank net reserves (- increase) Of which : Gross reserve change Of which : Use of Fund resources Exceptional financing Source: IMF Country Report No. 10/383, December 2010 Double Entry Bookkeeping. Each international economic transaction is entered either as a credit or as a debit in the nation s balance of payments. But every time a credit or a debit transaction is entered, an offsetting debt or credit, respectively, of the same amount is also recorded in one of the three accounts. This is referred to double entry bookkeeping. The reason for this is that in general every transaction has two sides. When a nation sells goods and services it receives payments and when it buys it must pay for them. Statistical Discrepancy: (Errors And Omissions) The data-collection process that underlies the published balance-of-payments figures is far from perfect. The cost of collecting balance-of-payments statistics is high, and a perfectly accurate collection system would be prohibitively costly. Government statisticians thus base their figures partly on information collected and partly on estimates. Probably the most reliable information consists of merchandise trade data, which are collected mainly from customs records. Capital and financial account information is derived from reports by financial institutions indicating changes in their liabilities and claims to foreigners; these data are not matched with specific current account transactions. Because statisticians do not have a system whereby they can simultaneously record the credit side and debit side of each transaction, such information for any particular transaction tends to come from different sources. Large numbers of transactions fail to get recorded. When statisticians sum the credits and debits, it is not surprising when the two totals do not match. Because total debits must equal total credits in principle, statisticians insert a residual to make them equal. This correcting entry is known as statistical discrepancy, or errors and omissions. In the balance of payments statement, statistical discrepancy is treated as part of the capital and financial account. (Carbaugh, 2005) Page 7

8 Measuring The Deficit Or The Surplus If total debits exceed total credits in the current or capital accounts (including the statistical discrepancy), the net debit balance measures the deficit in the balance of payments of the nation. This deficit must be settled with an equal net credit balance in the nation s official reserve account. The opposite is a surplus in the balance of payments. This measure of the deficit or surplus in the balance of payments is strictly correct only under a fixed exchange rate system. Under a freely flexible exchange rate system, the excess of expenditures over earnings abroad can be automatically corrected b depreciation of the nation s currency. Under an exchange rate system which is not freely flexible but managed, part of the excess of expenditures over earnings abroad is corrected by a depreciation of the currency and part of it is settled by a net credit balance in the official reserve account of the nation. The capital account and the official reserve account are combined in table 6.3. the net debit balance (-) $540m obtained by summing the Gross reserve change and Fund resources under financing measures the degree of Zambia s official intervention in foreign exchange markets during Only under a fixed exchange rate system would it have referred to the Zambian balance of payments deficit. Page 8

9 TABLE1.4 : The Zambian Balance Of Payments (US$m) Current Account balance Trade Balance Exports.f.o.b Of which : copper Imports: f.o.b Of which : oil Services ( net) Income (net) Of which : interest on public debt Current Transfers (net) Of which :Budget support grants Sector wide approach grants Private transfers Capital and Financial account balance CAPITAL ACCOUNT Project Grants External debt cancellation FINANCIAL ACCOUNT Foreign direct portfolio investment Other investments Medium and long term Public Sector (net) Disbursements Of which : Budget support Amortization Due Monetary Authority Commercial Banks (net) Other sectors Short term Errors and omissions Overall Balance Financing Central bank net reserves (- increase) Of which : Gross reserve change Of which : Use of Fund resources Exceptional financing Memorandum items: Current account (% of GDP) Current account, excluding grants (% of GDP) Change in copper export volume % Copper export price (US$/ton) Total Official grants (% of GDP) Gross international reserves In months of prospective imports GDP (million of US$) ,319 3,179-3, , , , , ,805 Source: IMF Country Report No. 10/383, December 2010 Page 9

10 CORRECTING B.O.P DEFICITS 1) Devaluation/Depreciation Of Local Currency Devaluation of the currency is the reduction in the exchange rate of the currency relative to other currencies. The objective of devaluing a country s currency is to make exports cheaper and imports expensive, by reducing the prices of exports to foreign buyers, in foreign currency terms, and increasing the price of imports in terms of the domestic currency. If, for example, Zambian Kwacha to the US Dollar is devalued from $1 = K3.2 to K4, then foreign consumers and firms will be encouraged to switch to Zambian goods because with the same $1, they will be able to purchase more Zambian goods E.g. more Zambian Copper. They are able to purchase K4 worth of goods instead of K3.2 worth of goods. In addition local consumers and firms will be discouraged from imports because they will need to have K4 to purchase $1 worth of goods whereas before devaluation they were needed K3.2 to buy $1 worth of foreign goods. Hence depreciation in the kwacha exchange value should help boost the overseas demand for Zambian exports because Zambian firms will be able to supply more cheaply on the international markets. Requirements For A Successful Depreciation The Elasticity approach emphasizes the relative price effects of depreciation and suggests that depreciation works best when demand elasticities are high. The Absorption approach deals with the income effects of depreciation; the implication is that a decrease in domestic expenditure relative to income must occur for depreciation to promote payments equilibrium. The Monetary approach stresses the effects depreciation has on the purchasing power of money and the resulting impact on domestic expenditure levels (Kemp Donald, April 1975) Page 10

11 The Elasticity Approach Elasticity of demand refers to the responsiveness of buyers to changes in price. It indicates the percentage change in the quantity demanded stemming from a 1 percent change in price. Mathematically, elasticity is the ratio of the percentage change in the quantity demanded to the percentage change in price. Suppose the Zambian kwacha depreciates by 10 percent against the dollar. whether the Zambia trade balance will be improved depends on what happens to the dollar in payments for Zambia's exports as opposed to the dollar out payments for its imports. This, in turn, depends on whether the overseas demand for Zambian exports is elastic or inelastic and whether the Zambian demand for imports is elastic or inelastic. Depending on the size of the demand elasticities for Zambian exports and imports, Zambia's trade balance may improve, worsen, or remain unchanged in response to the kwacha depreciation. The general rule that determines the actual outcome is the so-called Marshall-Lerner condition (ibid P445). The Marshall-Lerner condition states: (1) Depreciation will improve the trade balance if the currency-depreciating nation's demand elasticity for imports plus the foreign demand elasticity for the nation's exports exceeds 1. (2) If the sum of the demand elasticities is less than 1, depreciation will worsen the trade balance. (3) The trade balance will be neither helped nor hurt if the sum of the demand elasticities equals 1. The Marshall-Lerner condition may be stated in terms of the currency of either the nation undergoing the depreciation or its trading partner J-CURVE EFFECT: TIME PATH OF DEPRECIATION A basic problem in measuring world price elasticities, however, is that there tends to be a time lag between changes in exchange rates and their ultimate effect on real trade. It takes time for movements in the exchange rate to affect trade flows. In the short run, demand for imports is likely to be fairly inelastic, Page 11

12 while exporters would be unlikely to increase the output to meet the increase in demand due to the depreciation of the currency there is likely to be an initial worsening of the current account because volumes are fixed. In the long run, demand and supply become more elastic with production and the volume of exports rising such that imports can be substituted and their volumes can fall. The time path of the response of trade flows to a currency's depreciation can be described in terms of the j-curve effect, so called because the trade balance continues to get worse for awhile after depreciation (sliding down the hook of the J) and then gets better (moving up the stem of the J). This effect occurs because the initial effect of depreciation is an increase in import expenditures: The home-currency price of imports has risen, but the volume is unchanged owing to prior commitments. As time passes, the quantity adjustment effect becomes relevant: Import volume is depressed, whereas exports become more attractive to foreign buyers. Fig 1.1 THE J CURVE EEFCT OF A CURRENCY DEPRECIATION Balance 0 Time (years) The J-curve analysis assumes that a given change in the exchange rate brings about a proportionate change in import prices. In practice, this relationship may be less than proportionate, thus weakening the influence of a change in the exchange rate on the volume of trade. The extent to which changing currency values lead to changes in import and export prices is known as the exchange rate pass-through relationship. Passthrough is important because buyers have incentives to alter their purchases of foreign goods only to the extent that the prices of these goods change in terms of their domestic currency following a change in the exchange rate. Complete(partial) pass-through occurs when a change in the exchange rate Page 12

13 brings about a proportionate (less than proportionate) change in export prices and import prices. Empirical evidence suggests that pass-through tends to be partial rather than complete.(ibid) The Absorption approach This emphasizes the income effects of currency depreciation. According to this view, a depreciation may initially stimulate a nation's exports and production of import-competing goods. But this will promote excess domestic spending unless real output can be expanded or domestic absorption reduced. The result would be a return to a payments deficit. (Ibid P457) The Monetary approach According to the elasticities and absorption approaches, monetary consequences are not associated with balance-of-payments adjustment; or, to the extent that such consequences exist, they can be neutralized by domestic monetary authorities. The elasticities and absorption approaches apply only to the trade account of the balance of payments, neglecting the implications of capital movements. The monetary approach to depreciation addresses this shortcoming. (Ibid ) According to the monetary approach, currency depreciation may induce a temporary improvement in a nation's balance-of payments position A depreciation of the home currency would increase the price level-that is, the domestic-currency prices of potential imports and exports. This increase would increase the demand for money, because larger amounts of money are needed for transactions. If that increased demand is not fulfilled from domestic sources, an inflow of money from overseas occurs. This inflow results in a balance-ofpayments surplus and a rise in international reserves. But the surplus does not last forever. By adding to the international component of the home-country money supply, the currency depreciation leads to an increase in spending (absorption), which reduces the surplus. The surplus eventually disappears when equilibrium is restored in the home country's money market. The effects of depreciation on real economic variables are thus temporary. Over the long run, currency depreciation merely raises the domestic price level. (Humphrey Thomas, July-August 1978.) Page 13

14 Deflation/ Fiscal Policy This is contraction of the domestic economy. Deflationary measures are aimed at reducing aggregate demand and this can be achieved by either increasing interest rates to discourage borrowing or increasing tax rates in order to reduce consumption expenditure. The government can also reduce its expenditure. Some of the overall trade deficit is due to the strength of domestic demand for goods and services. If the economy enters a slowdown phase, the growth of imports falls and this should provide an element of correction for the trade deficit Direct Controls These are direct controls mentioned under protectionism. A government can impose trade restrictions like quotas, import duties, exchange controls health and safety regulations etc. to cut down imports and by increasing exporters competitiveness on the international market by subsidizing exporters. It may also adopt policies to promote exports e,g by zero rating VAT on exports, export credit guarantee etc. This will eventually result in more exports. Raising Interest Rates High interest rates are likely to make Zambia attractive to foreign investors and encourage inward investment and inflow of foreign currency. Higher interest rates act to slowdown the growth of consumer demand and therefore lead to cutbacks on the demand for imports Page 14

15 REVIEW QUESTIONS FOR UNITS 1 1) What is meant by the balance of payments? 2) What economic transactions give rise to the receipt of dollars from foreigners? What transactions give rise to payments to foreigners? 3) Why does the balance-of-payments statement "balance"? 4) From a functional viewpoint, a nation's balance of payments can be grouped into several categories. What are these categories? 5) What financial assets are categorized as official reserve assets for the Zambia? 6) What is the meaning of a surplus (deficit) on the a. merchandise trade balance b. goods and services balance, and c. current account balance? 7) Why has the goods and services balance sometimes shown a surplus while the merchandise trade balance shows a deficit? 8) What does the balance of international indebtedness measure? How does this statement differ from the balance of payments? 9) Indicate whether each of the following items represents a debit or a credit on the Zambian balance of payments: a. A Zambian importer purchases a shipload of French wine. b. A Japanese automobile firm builds an assembly plant in Livingstone c. A Japanese manufacturer exports machinery to Zambia on a U.S. vessel. d. A Zambian. college student spends a year studying in South Africa. e. Zambia charities donate fuel to people in fuel short Malawi. f. Japanese investors collect interest income on their holdings of Zambian government securities. g. A German resident sends money to her relatives in the Zambia h. Goldman Insurance of Lusaka sells an insurance policy to a South African business firm. i. A British resident receives dividends on her CEC stocks. Page 15

16 UNIT 2 : FOREIGN EXCHANGE MARKETS AND EXCHANGE RATE DETERMINATION THEORIES This unit introduces the student to foreign exchange markets and their dynamics. The student should be able to understand the various foreign exchange markets operations and transactions and the involved calculations and graphical illustrations. The student should be able to understand explain some of the exchange rate determination theories THE FOREIGN EXCHANGE MARKET The foreign exchange market is the organizational; framework within which individuals, firms and banks buy and sell foreign currencies. For any currency the market refers or is composed of all locations average of the locations world wide where dollars are bought and sold for other currencies. By far the principal function of the foreign exchange market is the transfer of funds or purchasing power from one nation and currency to another. Other functions are to provide short term credits to finance trade and the facilities for avoiding foreign exchange rate risks or hedging. Only a small fraction of daily transactions in foreign exchange actually involve trading of currency. Most foreign-exchange transactions involve the transfer of bank deposits. A typical foreign-exchange market functions at three levels: 1) in transactions between commercial banks and their commercial customers, who are the ultimate demanders and suppliers of foreign exchange; 2) in the domestic interbank market conducted through brokers; and 3) in active trading in foreign exchange with banks overseas. In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a "commission" or in some other way. Page 16

17 Foreign Exchange Rates The foreign exchange rate is the domestic currency price of the foreign exchange. This exchange rate is kept the same in all parts of the market by arbitrage which refers to the purchasing foreign currency when its price is low and selling it when and where the price is high. An exchange rate is usually quoted in terms of the number of units of one currency that can be exchanged for one unit of another currency - e.g., in the form: ZMK 4.5 /US$. In this example, the US$ is referred to as the "quote currency" (price currency, payment currency) and the ZMK is the "base currency" (unit currency, transaction currency). A rise in the exchange rate refers to a depreciation or a reduction in the value of the domestic currency. Since a nation s currency can depreciate against some currency and appreciate against others, an effective exchange rate is usually calculated. This is a weighted average of the nation s exchange rates Foreign Exchange Arbitrage The exchange rate between the kwacha ( the domestic currency) and the Rand refers to the Kwacha required to purchase one Rand or K/$. If this rate is K4.98 in Lusaka and K5.00 in Johannesburg, foreign exchange arbitrageurs will purchase Rands in Lusaka and resell them on Johannesburg, making a profit of 2 ngwee on each Rand. As this occurs, the price of Rand in terms of the kwacha rises in Lusaka until they are equal, say at K5/R in both places. At this instance the possibility of earning a profit disappears and arbitrage comes to an end. If through time, the exchange rate rises form K5 to K5.10 in both Lusaka and J/burg it is said that the kwacha has depreciated with respect to the Rand because more kwacha is needed to purchase each Rand. On the other hand when the rate falls the Kwacha appreciates. This is equivalent to the depreciation of the Rand. Page 17

18 Types Of Foreign-Exchange Transactions When conducting purchases and sales of foreign currencies, banks promise to pay a stipulated amount of currency to another bank or customer on an agreedupon date. Banks typically engage in three types of foreign-exchange transactions: spot, forward, and swap. Spot Transactions (Spot Rates) A spot transaction is an outright purchase and sale of foreign currency for cash settlement not more than two business days after the date the transaction is recorded as a spot deal. The 2-day period is known as immediate delivery. By convention, the settlement date is the second business day after the date on which the transaction is agreed to by the two traders. The 2-day period provides ample time for the two parties to confirm the agreement and arrange the clearing and necessary debiting and crediting of bank accounts in various international locations. Forward Transactions Hedging Since foreign exchange rates usually fluctuate through time, anyone who has to make or receive a payment in a foreign currency at a future date runs the risk of having to pay more or receiving less in terms of the domestic currency than originally anticipated. These foreign exchange risks can be avoided or covered by Hedging. This involves an agreement today to buy or sell a certain amount of foreign exchange at some date usually 90 days from to date at a rate agreed upon today (the forward exchange rate) This is known as a forward transaction. Forward transactions differ from spot transactions in that their maturity date is more than two business days in the future. A forward-exchange contract's maturity date can be a few months or even years in the future. The exchange rate is fixed when the contract is initially made. No money necessarily changes hands until the transaction actually takes place, although dealers may require some customers to provide collateral in advance Suppose that Zambian firm owes $1,000 dollars to a Chinese exporter payable in three months. At todays exchange rate or Spot rate of K5/$, the Zambian firm owes an equivalent $5,000,000. If the spot rate in three months rose to K5.50, Page 18

19 the Zambian firm would have to pay an equivalent K 5,500,000 or K500,000 more. But if a three month forward rate were K5.10 the Zambian firm would buy today $1,000 at K5.10 per $ for delivery in three months and avoid paying for any further foreign exchange risk. After three months when the payment is due, the Zambian firm would get the $1,000 it needs for K5.10 per $ regardless of what the spot rate is at that time. Similarly if a Zambia exporter is to receive $1,000 in three months, he or she can sell this $1,000 for delivery in three months at todays three month forward rate Trading foreign currencies among banks also involves swap transactions. A currency swap is the conversion of one currency to another currency at one point in time, with an agreement to reconvert it back to the original currency at a specified time in the future. The rates of both exchanges are agreed to in advance. Swaps provide an efficient mechanism through which banks can meet their foreign exchange needs over a period of time. Banks are able to use a currency for a period in exchange for another currency that is not needed during that time. For example, Bank A may have excess balances of dollars but needs pounds to meet the requirements of its corporate clients. At the same time, Bank B may have excess balances of pounds and insufficient amounts of dollars. The banks could negotiate a swap agreement in which Bank A agrees to exchange dollars or pounds today and pounds for dollars in the future. The key aspect is that the two banks arrange the swap as a single transaction in which they agree to pay and receive stipulated amounts of currencies at specified rates. Speculation Speculation is the opposite of hedging because while hedging seeks to avoid risk or cover foreign exchange losses, the speculator accepts or even seeks a foreign exchange risk or an open position in the hope that he will make a profit. If the speculator correctly predicts the market, he or she will make a profit otherwise he will incur a loss. Speculation usually occurs in the forward exchange market. Page 19

20 For example if the forward rate on dollars for delivery in three months is K5 and a speculator believes that the spot rate of the dollar in three months will be K5.50, he can enter today into a forward contract to buy $1,000 in three months at K5 per $. After three months he will pay K5,000,000 for the $1,000 and if at that time the spot rate for the dollar is indeed K5.50 as anticipated, he can then, resell the $1,000 at the spot market and for K5.50 and earn a K500,000 on the transaction. But if, on the other hand, his expectations prove wrong and the spot rate of the dollar after three months is K4.5 instead, he will have to pay K5,000,000 for the $1,000 that he receives on the matured forward transaction but can only resell this $1,000 for K4.5 in the spot market, thus losing K500,000 on the transaction. Interest Arbitrage Covered Interest arbitrage refers to the transfer of liquid funds from one monetary center to another to take advantage of higher rates of return (interest rate). The resulting foreign exchange risk is usually covered or hedged by a forward sale of the foreign currency to coincide with the maturity of the foreign investment. There is an incentive for covered interest arbitrage as long as the positive interest differential in favour of the foreign monetary center exceeds the forward discount on the foreign currency. For example If the return on three-month treasury bills in 12% yearly in Lusaka and 8% in Jo/burg, a South African resident can exchange his Rands for Kwacha at the current spot rate and invest them in Lusaka where he earns 4% more per year or 1% per quarter. However, in three months, the South African resident may want to reconvert the Kwacha into Rands and collect the extra interest earned. But in three months, the spot rate of the Rand with respect to the kwacha may be lower and the extra interest gained may be wiped out or more than wiped out. To cover this exchange risk at the same time that the South African investor exchanges Rands for Kwacha to invest in Lusaka for three months, he or she will also engage in a forward sale of an equal amount of Kwacha, plus the amount of interest to be earned, for Rands for delivery in three months. If the forward discount on the Kwacha is 1% on a yearly basis she will lose of 1% for the quarter on the foreign exchange transaction, but Page 20

21 will gain an extra 1% interest for the quarter, for net riskless return of on 1% on the foreign investment (Salvatore Dominic, International Economics1990) However, as covered interest arbitrage proceeds, the positive interest differential in favour of Lusaka tends to decline while the forward discount on the Kwacha tends to increase, until they are equal or until there is interest parity. At interest parity, there is no further possibility of gain and covered interest arbitrage comes to an end. Interbank Trading All banks are prepared to purchase or sell foreign currencies for their customers. Bank purchases from and sales to consumers are classified as retail transactions when the amount involved is less than 1 million currency units. Wholesale transactions, involving more than 1 million currency units, generally occur between banks or with large corporate customers. Bank transactions with each other constitute the interbank market. It is in this market that most foreignexchange trading occurs. Foreign-exchange departments of major commercial banks typically serve as profit centers. A bank's foreign-exchange dealers are in constant contact with other dealers to buy and sell currencies. In most large banks, dealers specialize in one or more foreign currencies. The chief dealer establishes the overall trading policy and direction of trading, trying to service the foreign-exchange needs of the bank's customers and make a profit for the bank. Banks that regularly deal in the interbank market quote both a bid and an offer rate to other banks. The bid rate refers to the price that the bank is willing to pay for a unit of foreign currency; the offer rate is the price at which the bank is willing to sell a unit of foreign currency. The difference between the bid and the offer rate is the spread that varies by the size of the transaction and the liquidity of the currencies being traded. At any given time, a bank's bid quote for a foreign currency will be less than its offer quote. The spread is intended to cover the bank's costs of implementing the exchange of currencies. The large trading banks are prepared to "make a market" in a currency by providing bid and offer rates on request. Page 21

22 Equilibrium Exchange-Rate Determination Like other prices, the exchange rate in a free market is determined by both supply and demand conditions. A nation's demand for foreign exchange is derived from, or corresponds to, the debit items on its balance of payments. For example, the Zambian.demand for dollars may stem from its desire to import dollar denominated goods and services, to make investments in foreign countries, or to make transfer payments to residents abroad. Like most demand schedules, the Zambian demand for dollars varies inversely with its price; that is, fewer dollars are demanded at higher prices than at lower prices. This relationship is depicted by line Do in Figure 2.1. As the kwacha depreciates against the dollar (the kwacha price of the dollar rises), foreign goods and services become more expensive to Zambian importers. This is because more kwacha is required to purchase each dollar needed to finance the import purchases. The higher exchange rate reduces the number of imports bought, lowering the number of dollars demanded by Zambian residents. In like manner, an appreciation of the kwacha relative to the dollar would be expected to induce larger import purchases and more dollars demanded by Zambian residents. The supply of foreign exchange refers to the amount of foreign exchange that will be offered to the market at various exchange rates, all other factors held constant. The supply of dollar, for example, is generated by the desire of foreign residents and businesses to import Zambian goods and services, to lend funds and make investments in Zambia, to repay debts owed to Zambian lenders, and to extend transfer payments to Zambian residents. In each of these cases, the foreign economies offer dollars in the foreignexchange market to obtain the kwacha they need to make payments to Zambian residents. Note that the supply of dollars results from transactions that appear on the credit side of the Zambian balance of payments; thus, one can make a connection between the balance of payments and the foreign exchange market. The supply of dollars is denoted by schedule So in Figure 2.1. The schedule represents the number of dollars offered by the foreign economies to obtain Page 22

23 kwacha with which to buy Zambian goods, services, and assets. It is depicted in the figure as a positive function of the Zambian exchange rate. As the kwacha depreciates against the dollar (kwacha price of the dollar), the foreigners will be inclined to buy more Zambian goods. The reason, of course, is that at higher and higher kwacha prices of dollars, the foreign economies can get more Zambian kwacha and hence more Zambian goods per dollar. Zambian goods thus become cheaper to the foreign economies, who are induced to purchase additional quantities. As a result, more dollars are offered in the foreignexchange market to buy kwacha with which to pay Zambian exporters. Fig 2.1 Exchange rate Determination Kwacha Depreciation Kwacha Appreciation Kwacha Per dollar Millions Of Dollars The equilibrium exchange rate is established at the point of intersection of the supply and demand schedules of foreign exchange. The demand for foreign exchange corresponds to the debit items on a nation's balance-of-payments statement; the supply of foreign exchange corresponds to the credit items. As long as monetary authorities do not attempt to stabilize exchange rates or moderate their movements, the equilibrium exchange rate is determined by the market forces of supply and demand. In Figure 2.1 exchange-market equilibrium occurs at point E, where So and Do intersect. $3 Million will be traded at a price of K2000 kwacha dollar The foreign-exchange market is precisely cleared, leaving neither an excess supply nor an excess demand for dollars Given the supply and demand schedules of Figure 2.1 there is no reason for the exchange rate to deviate from the equilibrium level. But in practice, it is unlikely Page 23

24 that the equilibrium exchange rate will remain very long at the existing level. This is because the forces that underlie the location of the supply and demand schedules tend to change over time, causing shifts in the schedules. Should the demand for dollars shift rightward (an increase in demand), the kwacha will depreciate against the dollar; leftward shifts in the demand for dollars (a decrease in demand) cause the kwacha to appreciate. Conversely, a rightward shift in the supply of dollars (increase in supply) causes the kwacha to appreciate against the dollar; a leftward shift in the supply of the dollar (decrease in supply) results in a depreciation of the kwacha. EXCHANGE RATE DETERMINATION THEORIES Determining Long-Run Exchange Rates Changes in the long-run value of the exchange rate are due to reactions of traders in the foreign exchange market to changes in four key factors: relative price levels; relative productivity levels; consumer preferences for domestic or foreign goods; trade barriers Table 2.1 below summarizes the effects of these factors Table 3.1 : Determinants of the Kwacha Exchange Rate in the Long Run Factor Change Effect On The Kwacha s Exchange Value Zambian Price Level Increase Depreciation Decrease Appreciation Zambia Productivity Increase Appreciation Decrease Depreciation Zambian Preferences Increase Depreciation Decrease Appreciation Zambian Trade Barriers Increase Appreciation Decrease Depreciation To illustrate the effects of these factors, refer to Figure 3.2, which shows the demand and supply schedules of dollars. Initially, the equilibrium exchange rate is K1.50 per dollar. Each factor will be examined by itself, assuming that all other factors remain constant Page 24

25 (a) Relative Price Levels (b) Productivity Levels S1 Kwacha /$ 1.60 S0 Kwacha /$ S0 S D1 D D2 D0 6 Millions Of Dollars 6 Millions Of Dollars (c) Preferences for Domestic or foreign Goods (d) Trade Barriers Kwacha /$ 1.55 S0 Kwacha /$ S D D0 D0 D2 6 7 Millions Of Dollars Millions Of Dollars Fig 3.2: In the long run exchange rate between the kwacha and the dollar will reflect the price levels, relative productivity levels, preferences for foreign or domestic goods and trade barriers 5 6 Page 25

26 Relative Price Levels Referring to Figure 2.2 (a), suppose the domestic price level increases rapidly in the Zambia and remains constant in the overseas markets causing Zambian consumers to desire relatively low-priced foreign goods. The demand for dollar thus increases to D1 in the figure. Conversely, as the foreigners purchase less relatively high-priced Zambian goods, the supply of dollars decreases to S1. The increase in the demand for dollars and the decrease in the supply of dollars result in a depreciation of the kwacha to K1.60 per dollar. This analysis suggests that an increase in the Zambian price level relative to price levels in other countries causes the kwacha to depreciate in the long run. Relative Productivity Levels Productivity growth measures the increase in a country's output for a given level of input. If one country becomes more productive than other countries, it can produce goods more cheaply than its foreign competitors can. If productivity gains are passed forward to domestic and foreign buyers in the form of lower prices, the nation's exports tend to increase and imports tend to decrease. Referring to Figure 2.2 (b) suppose Zambian productivity growth is faster than that of the foreign trading partner. As Zambian, goods become relatively less expensive, the foreign trading partner will demand more Zambian goods, which results in an increase in the supply of dollars to S2, Additionally the Zambians demand fewer foreign goods, which become relatively more expensive, causing the demand for dollars to decrease to D2. Therefore, the kwacha appreciates to K1.40 per dollar. Simply put, in the long run, as a country becomes more productive relative to other countries, its currency appreciates. Preferences For Domestic Or Foreign Goods Referring to Figure 2.2 (c), suppose that Zambian consumers develop stronger preferences for foreign manufactured goods such as motor vehicles and electronic goods. The stronger demand for foreign goods results in Zambians' demanding more dollars to purchase these goods. As the demand for dollars rises to D2 the kwacha depreciates to K1.55 per dollar. Conversely, if foreign consumers demanded additional Zambian copper and agricultural products the kwacha would tend to appreciate against the dollar. It is concluded that an increased demand for a country's exports causes its currency to appreciate in Page 26

27 the long run; conversely, increased demand for imports results in a depreciation in the domestic currency. Trade Barriers Barriers to free trade also affect exchange rates. Suppose that the Zambian government imposes tariffs on foreign motor vehicles. By making motor vehicle imports more expensive than domestically produced ones (assuming Livingstone Motor assemblers were in production), the tariff discourages Zambians from purchasing foreign motor vehicles. In Figure 2.2 (d), this causes the demand for dollars to decrease to D2, which results in an appreciation of the kwacha to K1.45 per dollar. Simply put, trade barriers such as tariffs and quotas cause a currency appreciation in the long run for the country imposing the barriers. Inflation Rates, Purchasing Power Parity, And Long Run Exchange Rates The determinants discussed above are helpful in understanding the long-run behavior of exchange rates. It is now necessary to now focus on the Purchasing-Power Parity Approach and see how it builds on the relative price determinant of long-run exchange rates Law Of One Price The simplest concept of purchasing power parity is the law of one price. This asserts that identical goods should cost the same in all nations, assuming that it is costless to ship goods between nations and there are no barriers to trade. Before the costs of goods in different nations can be compared, prices must first be converted into a common currency. Once converted at the going marketexchange rate, the prices of identical goods from any two nations should be identical After converting francs into dollars, for example, machine tools purchased in Switzerland should cost the same as identical machine tools bought in the United States. (Carbaugh Robert J, International Economics 2005 P 398) In theory, the pursuit of profits tends to equalize the price of identical products in different nations. Assume that machine tools bought in South Africa are cheaper than the same machine tools bought in Zambia, after converting kwacha into Rands. South African exporters could realize a profit by purchasing machine Page 27

28 tools in South Africa at a low price and selling them in the Zambia at a high price. Such transactions would force prices up in South Africa and force prices down in the Zambia until the price of the machine tools would eventually become equal in both nations, whether prices are expressed in Kwacha or Rands. As a result, the law of one price would prevail. In practice, however, the law of one price does not always prevail. For example, tariffs and other trade barriers tend to drive a wedge between prices of identical products in different nations. Moreover, the cost of transporting goods from one nation to another restricts the potential profit from buying and selling identical products with different prices. (Carbaugh, 2005) Relative Purchasing Power Parity Rather than focusing on a particular good when applying the purchasing-powerparity concept, most analysts look at market baskets consisting of many goods. They consider a nation's overall inflation (deflation) rate as measured by, say, the producer price index or consumer price index. According to the theory of relative purchasing power parity, changes in relative national price levels determine changes in exchange rates over the long run. The theory predicts that the foreign exchange value of a currency tends to appreciate or depreciate at a rate equal to the difference between foreign and domestic inflation. As an example, if Zambian inflation exceeds South Africa's inflation by 4 percentage points per year, the purchasing power of the kwacha falls 4 points relative to the rand. The foreign-exchange value of the kwacha should therefore depreciate 4 percent per year. Conversely, the Zambian kwacha should appreciate against the rand if Zambia s inflation is less than South Africa s inflation. The purchasing-power-parity theory can be used to predict long-run exchange rates. As an example consider using the price indexes (P) of Zambia and South Africa. Letting 0 be the base period and 1 represent period 1, the purchasing power-parity is given as S1 = S0 where S0 equals the equilibrium exchange rate existing in the base period and S1 equals the estimated target at which the actual rate should be in the future. Page 28

29 For example, let the price indexes of the Zambia and South Africa and the equilibrium exchange rate be as follows: PZ0 = 100, PZ1 = 200, PSA0 = 100, PSA1 = 100, S0 = K4.50 Putting these figures into the previous equation, we can determine the new equilibrium exchange rate for period 1: S1 = K4.50 = K9.00 Between one period and the next, Zambia s inflation rate rose 100 percent, whereas South Africa's inflation rate remained unchanged. Maintaining purchasing power parity between the kwacha and the rand requires the kwacha to depreciate against the rand by an amount equal to the difference in the percentage rates of inflation in Zambia and South Africa. The kwacha must depreciate by 100 percent, from K4.50 per rand to K9 per rand, to maintain its purchasing power parity. If the example assumed instead that South Africa s inflation rate doubled while the Zambian inflation rate remained unchanged, the kwacha would appreciate to a level of K0.25 per rand, according to the purchasing-power parity theory. Determining Short-Run Exchange Rates: The Asset Market Approach It has been seen that exchange-rate fluctuations in the long run stem from volatility in market fundamentals including relative price levels (purchasing power parity), relative productivity levels, preferences for domestic or foreign goods, and trade barriers. Fluctuations in exchange rates, however, are sometimes too large and too sudden to be explained solely by such factors. For example, exchange rates can change by 2 percentage points or more in a single day. But variations in the determinants usually do not occur frequently or significantly enough to fully account for such exchange-rate irascibility, Therefore, to understand why exchange rates can fluctuate sharply in a particular day or week, we must consider other factors besides relative price level behavior, productivity trends, preferences, and trade barriers. We need to develop a framework that can demonstrate why exchange rates fluctuate in the short run Page 29