Friday, January 18, 2013

Currency appreciation : Is the fear of floating real?

Most of the currency in emerging economies appreciated in 2012 , specially after the Quantitative easing policy approach spread out to majors Central Banks. Huge amount of additional currency depreciate them and the counterpart, is the appreciation of the rest of trade currencies . Additional reasons for this situation are the capital flow to emerging countries, the less risk averse behavior ,interest rate differential, and better performance of these economies which has improved expectations for foreign investment . Implications : a.- Currency appreciation is good for consumers, inflationary expectation , foreign investment returns, and growth when it is based on domestic consumption. Not that much so, when it is based on exports with high price elasticity .Keep in mind that low price elasticity exports , such as high valued added goods, appreciation means huge profits for theirs exporters . b.- Currency appreciation means an incentive for foreign investment to stay in and reinvest profits, which keep economic growth pace on track. Besides, lower interest rate associated with it, decrease financial cost which boost up economic expectations even further . It follow that Currency appreciation, has a positive distributive effect which is not neutral for growth and welfare level . Then, why is there such a worry with the issue? a.- Exports have indirect and direct effect on employment .It is not just growth what it is hurt by appreciation , but also net jobs.(job creation because of appreciation ,might be lower than jobs destruction because of it). b.- As much as capital flow goes in , it might also either stop suddenly or start to flow out back to where it came from. Either case , mean costly downward adjustment in the spending path. c.- Import growth , increase the deficit in the trade account , which can be a threat for a country solvency status whether it goes beyond some reasonable rate(3-4% of GDP), no matter whether it is because of new investment or higher consumption (Investment might fail, and the multiplier effect of it , take consumption down ), the fact in this case is that Spends Grow rate, is higher than income grows. d.- Domestic currency can get out of its long run fundamental. Thus, over appreciation (Dornbusch effect), might induce a corrective market reaction, which as the Asian crisis taught us can be hard to control and of severe consequences .- Some analyst think that as long as Central Banks partially created all of this, they are called to solved it with some policy decisions which are not neutral, but on the risk balance scenario, in some cases (only in scenario (d)) can be an useful tool when it is properly designed and rightly applied. In such case (d), the fear of floating explain itself.