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Exchange rate: Who determines it - government or the market? Vote_lcap68%Exchange rate: Who determines it - government or the market? Vote_rcap 68% [ 178 ]
Exchange rate: Who determines it - government or the market? Vote_lcap18%Exchange rate: Who determines it - government or the market? Vote_rcap 18% [ 47 ]
Exchange rate: Who determines it - government or the market? Vote_lcap13%Exchange rate: Who determines it - government or the market? Vote_rcap 13% [ 35 ]

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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » Exchange rate: Who determines it - government or the market?

Exchange rate: Who determines it - government or the market?

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sriranga

sriranga
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by R.M.B Senanayake

The authorities are still keen to stabilize the rupee at a price they think is reasonable or justified judging from the statements of the powers that be and the actions of the two state owned banks which have become instruments of this thinking. So instead of the Central Bank intervening to defend the rupee we find the People’s Bank selling dollars from their position to keep the rate down. But for how long do they want to stabilize the rupee? Didn’t they announce that that the fixed exchange regime was given up because it is incomprehensible with low foreign reserves which are also borrowed and on which interest is payable to foreigners. It is also unsustainable, with macro-economic instability caused by budget deficits and money printing. (The Central Bank alone holds $240 billion of Treasury securities). The only way to have a fixed exchange rate regime is to link the money supply directly to the pegged currency as under a Currency Board which we had under the colonial regime and which Hong Kong still has.

Governments have multiple objectives in managing the economy. They want high economic growth, high employment and price stability or low inflation which economists think should be 3% or so. They are forced to also preserve balance in the Balance of Payments so that the Gross Official Reserves will not be driven to zero but maintained at an adequate level. But can a government achieve all these objectives at the same time? Economists say no. They say the number of policy instruments to achieve all these objectives is not available and Tinbergen (1956) taught that for economic policy to work, there needs to be at least as many policy instruments as there are policy goals. We must dedicate at least one instrument to each objective. So what instrument does the Government dedicate to restore balance in the balance of payments if foreign capital inflows don’t come in to offset the current account deficit?

A fluctuating exchange rate is one policy instrument dedicated to restoring balance in the balance of payments. It works but it takes time. If a country doesn’t have the time to allow it to work, then other direct measures like import controls and high tariffs are imposed. But such controls mean a reduced standard of living and a higher cost of living for the poor in particular. It is better to exhaust the possibility of exchange rate as a policy instrument to restore balance rather than clamp down controls. Both instruments raise prices and while in the former it is the consumers who decide which goods and services to buy with the higher prices for all imported goods, under the latter it is the government that decides what goods should be imported. I think the former which gives the choice to the public is better.

The Central Bank has also tightened monetary policy. The money market rates, or the inter-bank rates, have risen with the recent tightening of monetary policy. But its consistency is in doubt. Should it keep the interest rates high or reduce them? The effect of monetary policy is to reduce monetary expansion through the banking system. But should it increase the Reserve Money for that increases the banks capacity for lending and creating money through such lending. The Central Bank seems to be seeking the best of both worlds. It wants the banks to restrict credit (imposed a limit of 18% on the Aggregate Credit that when the rupee has already depreciated by 15-18% raising prices of imports by a similar amount and thus requiring more trade credit for imports); but at the same time it wants to keep the interest rates low for government borrowing through the issue of Treasury securities in the primary market.

So it rejects offers which are higher than the previous week at the primary auctions. Since the banks have excess reserves and they are restricted from lending to the private sector, they can only invest in Treasury securities even if the interest rates are not sufficient to give them adequate return after paying for deposits. But this excess money in the hands of the banks will also depress the exchange rate. The rupee- dollar exchange rate is a price and like all prices will be determined through supply and demand. When the banks find more rupees available to be used in the foreign exchange market they will offer more rupees to buy the dollars which will depress the rupee in the market. The Central Bank by cutting the net open positions of the banks has not helped the situation for they cannot anticipate a demand and buy and accumulate dollars.

So they buy when they have to deliver irrespective of the prevailing price of the dollars in rupees. With no holding capacity and flushed with rupees the banks will cover their requirements whatever the cost. In the short run markets overshoot and some intervention may be necessary to iron out excessive fluctuations- but not to keep the level unchanged or to attain a fixed target for the rupee. This is done through quantity based intervention rather than through price intervention. The factors that determine the short term market in foreign exchange are different from those that determine the exchange rate in the long run. Economists talk of the long term rate being determined by the purchasing power parity.

Exchange rate theory

Exchange rates are prices that are determined by supply and demand. It is the single most important price in the economy because it determines the international balance of payments. There is no general theory of exchange rate determination for the short term although there is the purchasing power parity theory for the long term exchange rate determination. The factors affecting the exchange rate in the short term are: parity conditions, institutional infrastructure, speculation, cross-border foreign direct investment and portfolio investment, and political risks. The authorities seem to think they know what should be the proper exchange rate. But if the foreign exchange market is free it is difficult to predict where it would settle.

The authorities think the depreciation is higher than what they consider appropriate and blame speculation. So they reduced the open net positions of the banks. But our foreign exchange market is small and the reduction in banks positions reduces the possibility of correcting when market overshoots. A large bill such as an oil bill de-stabilizes the market unless the banks accumulate foreign exchange to deal with such a bill. Or else the Central Bank will have to supply the dollars to meet the bill. There seem to be inadequate foreign capital inflows to the market and hence the supply of dollars does not increase relative to the demand increase. The exchange rate is a price and like other prices is determined by supply and demand.

When the supply of rupees is increased while the supply of dollars is not increasing then more rupees are available to be exchanged for dollars and the rupee may depreciate in the short term market. Of course economics doesn’t have a settled theory regarding the relationship between interest rates and the exchange rate. The theory is said to be non-monotonic which means it has to be refined through more empirical studies. Although no model has been consistent in predicting short-term foreign exchange rate behavior, there are several major concepts that play a role in determining the foreign exchange rates. The first is based on the idea that the current price of an asset reflects all available information; and therefore, only unexpected events cause exchange rates to fluctuate. (Levich, 2001). The effect it has on the exchange rate, whether the exchange rate will move immediately, or reach a new equilibrium, overreact, or continue to adjust is difficult to predict. The effect also depends on whether the change is temporary or permanent, whether it is anticipated or unexpected and what view the market players have of the views and expectations of the authorities. In the short term exchange rates also seem to be affected by news about fundamental economic events, such as the release of the first quarter external sector figures. The asset approach emphasizes the role of expectations. In the monetary approach, the exchange rate establishes a relative price between two currencies. But in the portfolio-balance approach, exchange rates reflect the relative risk and return of two currencies. (Levich, 2001). How do our market players assess the risk and return in holding rupees as against dollars? The Sunday Leader carried this risk perspective of an anonymous banker. According to him, "The business community is concerned about the stability of the economy but they don’t want to talk about it due to fears of being exposed". He says there is a contraction in demand for bank borrowings not due to high lending rates, but due to questions about the island’s economic stability besetting the minds of the local business community. He has also pointed out Sri Lanka has been virtually ostracized by its key export and tourism market, the West and its allies, due to allegations of war crimes committed during the closing stages of its recently concluded terrorist war. How does all this affect the risk return profile of the country?
http://www.island.lk/index.php?page_cat=article-details&page=article-details&code_title=54572

http://sharemarket-srilanka.blogspot.co.uk/

Redbulls

Redbulls
Director - Equity Analytics
Director - Equity Analytics

Good one to read.
Thanks for sharing.
Special thanks to R.M.B Senanayake.

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