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How does foreign currency affect currency stability?

Running head: The Impact of Foreign Currency Inflows on Currency Stability and Economic Growth in Developing Asian Countries.

“The Impact of Foreign Currency Inflows on Currency Stability and Economic Growth in Developing Asian Countries”

TABLE OF CONTENTS

SECTION I: DEFINITION OF THE PROBLEM

Abstract………………………………………………………………………………….

Background……………………………………………………………………………...

Statement of the Problem………………………………………………………………..

Purpose of the Study…………………………………………………………………….

Research Questions……………………………………………………………………...

Definition of the Terms………………………………………………………………….

Limitations of the Study………………………………………………………………...

SECTION II: REVIEW OF THE LITERATURE

Introduction……………………………………………………………………………..

Summary………………………………………………………………………….........

SECTION III: METHODOLOGY

Data Collection Methods……………………………………………………………..

Data Analysis Methods………………………………………………………….........

Research Statement……………………………………………………………….......

SECTION IV: ANALYSIS OF DATA

Research Statement Analysis………………………………………….…………..…...

Data Analysis………………………………………………………………..………....

Summary……………………………………………………………………..………...

SECTION V: SUMMARY, CONLUSION, AND RECOMMENDATIONS

Summary………………………………………………………………………….…....

Conclusion…………………………………………………………………………......

Recommendations…………………………………………………..……………..…..

GARCH (p,q) Model……………………………………………………..……..…… .

References……………………………………………………………………..……….

Abstract

Currency crisis situation occur any time when foreign reserve is zero and it can be avoided when country have huge foreign reserve weight. The project “The Impact of Foreign Currency Inflows on Currency Stability and Economic Growth in Developing Asian Countries” essentially deals with studying the impact of most important variables, namely Foreign Direct Investment, Foreign Portfolio Investment, exchange rates and Short Term Lending on global currency crisis particularly in stock market and bank. Future Financial Crisis in banks and stock markets involve collapse of major banks those refinancing their cash flows in short term debt and stock market to get higher return. In recent days, financial crisis is a major economic crisis which involves the countries’ major banks and financial institutions have difficulties in refinancing their short term debt as well as those banks run on deposits. This project will help to Asian economies that how it can reduce threat by learning lessons from the European Economic crisis. The main cause of currency crisis can be economy and its policy. The next impact of currency crisis is because of the country’s monitory policy, fiscal deficits, exchange rate crisis and Inflation. There are some other factors that also affect currency crisis including speculators, exchange rate policy, political level of the country, corruption and other legal factors.

Asia’s financial crisis will results into certain important changes at international financial level. All countries try to improve balance of capital flows and instability as well as other risks in the highly capital movement. This paper is written to discuss lessons from the currency crisis and that will help to prevent or reduce the probability of future financial crisis. By doing this analysis, it will learn what happened in past and what we can learn from the crisis and what will happen next to Asian countries to find their path for economic growth and stability.

Background

Due to globalization, foreign investors are diverted towards developing countries like India, China, Russia and Brazil and invest their capital to get higher returns from developing countries. Developing countries have around three billion people that are just half of the world’s population, one-fourth of world’s area and more than 40% of the world’s knowledgeable people which can become biggest assets for such countries. According to various economist projections and Goldman Sachs report, from 2030 to 2050 China would be world’s biggest economy and by 2050 BRIC’s (Brazil, Russia, India and China) economies would be the richest economies in the world and hold a combined GDP in terms of PPP of 15.45 trillion dollars. Among them, India and China would be the dominant global suppliers in terms of manufacturing and service industries, whereas Russia and Brazil would be the biggest suppliers of raw materials to those countries. It would have a direct effect on the developed countries like the United States and the European countries in terms of unemployment, economic growth, real estate and lack of skilled jobs mainly in manufacturing sectors.

Statement of the problem

Evidence suggests the countries financial condition change according to the life cycle theory. The main cause of currency crisis is countries economy and its monitory policies. Currency crisis is not only created by speculators but on the other side insulting currency from crisis is to select exchange rate policy and appropriate monitory policy.

Purpose of the study

The purpose of this study is to know insight effect and factors affecting financial crisis due to foreign direct investment, foreign portfolio investment, currency fluctuation, countries culture and short term international lending in four developing countries. Also, knowing the currency fluctuations based on fundamental analysis would help me in future for trading currencies in global market.

To know Foreign Direct Investment, Foreign Portfolio Investment, currency fluctuation and Short Term Lending in the specified countries.

How foreign investments in developing countries negatively affect the developed countries currency?

To know capital flows and how to control flows over specified period of time and study the impact of capital controls on currency.

Research Questions

The objective of this study are to analyze the role of foreign direct investment, economic liberalized policies, foreign portfolio investments and short term lending, and the impact of these factors on a country’s currency and economy.

To what extent does an increase, or decrease, in money supply/demand affect the economy of developing countries?

What industries are primarily affected as a result of a currency crisis in Asian developing countries?

How and to what extent does a currency crisis affect the supply and demand of gold, silver and platinum?

How and to what extent does the decline in the value of a country’s currency affect its economy, and is the impact same for both emerging and developed economies?

How are a country’s capital outflows affected by selling off foreign reserves?

In times of financial currency crises, what are a developing country’s best options as related to devaluing its currency, or permitting it to float?

Limitations of the Study

There are several concerns relating to the limitations of this study. First, time limitations hindered the opportunity to do an in-depth evaluation of the problem statement. More time may have presented a greater opportunity to identify additional information and resources to better clarify and support the study. Second, secondary sources are used in this research study.

Section II: Review of the Literature

Introduction

2.1 SCENARIO IN EAST ASIAN COUNTRIES

http://www.imf.org/external/np/speeches/2009/101609.htm

It was too much written about Asian financial crisis and so many lesson learned from the financial sectors. The beginning of 1997 crisis was related on floating currency of Thailand, Thai Baht. It was devaluation of Thai Baht and slowdown in economic activities in ASEAN countries. After some period of time, countries found their GDP (Gross Domestic Product) rates slow down.

In that case, recession was the major players in the world economy and Consumers are the primary driver of global growth. Asian producers were trying to find out the replacements but lowering of economic growth rate in Asian countries would have environmental impact in the world market.

It has been very difficult time for Asia in this global financial crisis. The degree of downturn in Asian economies makes surprise that was larger than what was in historic growth between westernized countries and Asian countries. Until 1997, Asia attracted almost half of total capital inflow to developing countries. The economies of Southeast Asia in particular maintained high interest rates attractive to foreign investors looking for a high rate of return. As a result the region's economies received a large inflow of hot money and experienced a dramatic run-up in asset prices. At the same time, the regional economies of Thailand, Malaysia, Indonesia, the Philippines, Singapore, and South Korea experienced high, 8-12 percent GDP growth rates in the late 1980s and early 1990s. This achievement was broadly acclaimed by economic institutions including the IMF and World Bank, and was known as part of the Asian economic miracle.

Whatever the disputed causes, the Asian crisis started in mid-1997 and affected currencies, stock markets, and other asset prices of several South East Asian economies. Triggered by events in Latin America, particularly after the Mexican peso crisis of 1994, Western investors lost confidence in securities in East Asia and began to pull money out, creating a snowball effect.

In 1994, MIT economist Paul Krugman published an article attacking the idea of an Asian economic miracle. He argued that East Asia's economic growth had historically been the result of capital investment, leading to growth in productivity. However, total factor productivity had increased only marginally or not at all. Krugman argued that only growth in total factor productivity, and not capital investment, could lead to long-term prosperity. Krugman would be seen by many as prescient after the financial crisis became full-blown, though he himself claimed that he had not predicted it. http://web.mit.edu/krugman/www/myth.html

At the time Thailand, Indonesia and South Korea had large private current account deficits and the maintenance of pegged exchange rates encouraged external borrowing and led to excessive exposure to foreign exchange risk in both the financial and corporate sectors. In the mid-1990s, two factors began to change their economic environment. As the U.S. economy recovered from a recession in the early 1990s, the U.S. Federal Reserve Bank under Alan Greenspan began to raise U.S. interest rates to head off inflation. This made the U.S. a more attractive investment destination relative to Southeast Asia, which had attracted hot money flows through high short-term interest rates, and raised the value of the U.S. dollar, to which many Southeast Asian nations' currencies were pegged, thus making their exports less competitive. At the same time, Southeast Asia's export growth slowed dramatically in the spring of 1996, deteriorating their current account position.

Some economists have advanced the impact of Mainland China on the real economy as a contributing factor to their ASEAN nations' export growth slowdown, though these economists maintain the main cause of the crises was excessive real estate speculation. China had begun to compete effectively with other Asian exporters particularly in the 1990s after the implementation of a number of export-oriented reforms. Most importantly, the Thai and Indonesian currencies were closely tied to the dollar, which was appreciating in the 1990s. Western importers sought cheaper manufacturers and found them, indeed, in China whose currency was depreciated relative to the dollar. Other economists dispute this claim noting that both ASEAN and China experienced simultaneous rapid export growth in the early 1990s.

Many economists, like those within the Cato Institute, believed that the Asian crisis was created not by market psychology or technology (which actually represents a more efficient form of capitalism through the ability to acquire information cheaply and more quickly) but by macroeconomic policies that distorted information which in turn created the volatility that attracted speculators. What some have called "herd mentality" was merely the result of speculators behaving rationally, noting the fraudulent currency policies (Fixed exchange rates attempting to be defended by their government) which speculators assumed could not be sustained. Such economists believe that this crisis was the result of unsustainable macroeconomic/protectionist policies which create the very "market" imperfections they were originally designed to correct. http://worldeconomiccrisis.blogspot.com/2007/12/1997-east-asian-financial-crisis.html

Other economists, including Joseph Stiglitz and Jeffrey Sachs, have downplayed the role of the real economy in the crisis compared to the financial markets due to the speed of the crisis. The rapidity with which the crisis happened has prompted Sachs and others to compare it to a classic bank run prompted by a sudden risk shock. Sachs points to strict monetary and contractory fiscal policies implemented by the governments at the advice of the IMF in the wake of the crisis, while Frederic Mishkin points to the role of asymmetric information in the financial markets that led to a "herd mentality" among investors that magnified a relatively small risk in the real economy. The crisis has thus attracted interest from behavioral economists interested in market psychology. http://www.wordiq.com/definition/Asian_financial_crisis

The foreign ministers of the 10 ASEAN countries believed that the well co-ordinated manipulation of currencies was a deliberate attempt to destabilize the ASEAN economies. Malaysian Prime Minister Mahathir Mohamad accused currency speculator George Soros of ruining Malaysia's economy with massive currency speculation. http://en.wikipedia.org/wiki/1997_Asian_Financial_Crisis At the 30th ASEAN Ministerial Meeting held in Subang Jaya, Malaysia they issued a joint declaration on 25 July 1997 expressing serious concern and called for further intensification of ASEAN's cooperation to safeguard and promote ASEAN's interest in this regard. Coincidentally, on that same day, the Central Bankers of most of the affected countries were at the EMEAP (Executive Meeting of East Asia Pacific) meeting in Shanghai, and they failed to make the New Arrangement to Borrow operational. A year earlier, the finance ministers of these same countries had attended the 3rd APEC finance ministers meeting in Kyoto, Japan on 17 March 1996, and according to that joint declaration, they had been unable to double the amounts available under the General Agreement to Borrow and the Emergency Finance Mechanism. As such, the crisis could be seen as the failure to adequately build capacity in time, to prevent currency manipulation. http://worldeconomiccrisis.blogspot.com/2007/12/1997-east-asian-financial-crisis.html

2.2 IMF AND CONTROVERSY

The role of the International Monetary Fund (IMF) was very controversial during the crisis, causing many locals to call the crisis the "IMF crisis." To begin with, many commentators in retrospect criticized the IMF for encouraging the developing economies of Asia down the path of "fast track capitalism", meaning liberalization of the financial sector (i.e. elimination of restrictions on capital flows); maintenance of high domestic interest rates in order to suck in portfolio investment and bank capital; and pegging of the national currency to the dollar to reassure foreign investors against currency risk.

However, the greatest criticism of the IMF's role in the crisis was targeted towards its response. As country after country fell into crisis, many local businesses and governments that had taken out loans in US dollars, which suddenly became much more expensive relative to the local currency which formed their earned income, found themselves unable to pay their creditors. The dynamics in this scenario were similar to that of the Latin American debt crisis. http://worldeconomiccrisis.blogspot.com/2007/12/1997-east-asian-financial-crisis.html

In response, the IMF offered to step in the case of each nation and offer it a multi-billion dollar "rescue package" to enable these nations to avoid default. However, the IMF's support was conditional on a series of drastic economic reforms influenced by neoliberal economic principles called a Structural Adjustment Package (SAP). The SAP's called on crisis nations to cut government spending to reduce deficits, allow insolvent banks and financial institutions to fail, and aggressively raise interest rates. The reasoning was that these steps would restore confidence in the nations' fiscal solvency, penalize insolvent companies, and protect currency values. However, the effects of the SAP's were mixed and their impact controversial. Critics, however, noted the contradictory nature of these policies, arguing that in a recession, the traditional response is to increase government spending, prop up major companies, and lower interest rates. The reasoning was that by stimulating the economy and staving off recession, governments could restore confidence while preventing economic pain. They pointed out that the U.S. government pursued these expansionary policies when the U.S. itself entered a recession in 2001. These criticisms were informed from a Keynesian viewpoint.

2.3 WHAT IS CURRENCY CRISIS?

There is no universally accepted definition of currency crisis, but most would agree that they all involve one key element: investors fleeing a currency in masse out of fear that it might be devalued, in turn fueling the very devaluation they anticipated. When expectations of all the people are same, there is no speculation, it leads to currency crisis. Speculative activity takes place because of heterogeneity i.e. there is heading behavior, the difference in expectation is lost, everybody moves in the same direction. A currency crisis is one kind of financial distress.

A currency crisis is a particularly dramatic form of exchange rate volatility. Deeper integration and openness during the 1990’s has come hand in hand with numerous cases of outward oriented growth and prosperity abruptly reversed by currency crisis and speculative attacks on fixed rate regime. Examples abound Chile 1982, Mexico 1986and 1995, Argentina 1995, Thailand, Korea, Indonesia, Malaysia, and Philippines 1997 and 1998, Russia 1998 and episode in Brazil, Argentina and Uruguay. A sudden loss of confidence in the value leads to sharp depreciation, threat to bankruptcies, financial panic and at times severe recession. Between 1970 and 2000 more than 160 currency crashes occurred and it seems that have become a more frequent type of event in recent times. They usually have huge political and economic implications. Continuous crisis definition: It measures the crisis empirically. Currency crisis are not measured empirically under discrete crisis definition. Under discrete definition the answer is in yes or no form. Continuous crisis definition measures the currency crisis whether it is high, low or medium.

What were the cause of the Asia economic, currency and financial crises of 1997 – 98? Two main hypotheses and interpretations have emerged in the aftermath of the crisis. According to one view, sudden shifts in market expectations and confidence were the key source of the initial financial turmoil, its propagation over time and regional contagion. While the macro economic performance of some countries had worsened in the mid 1990s, the extent and depth of the 1997 – 98 crisis should not to be attributed to a deterioration in fundamentals, but rather to panic on the part of domestic and international investors, somewhat reinforced by the faulty policy response of the International Monetary Fund (IMF) and the International Financial community.

According to the other view – the crisis reflected structural and policy distortions in the countries of the region. Fundamental imbalances triggered the currency and financial crisis in 1997, even if, once the crisis started, market overreaction and herding caused the plunge of exchange rates, asset prices and economic activity to be more severe than warranted by the initial weak economic condition.

Macroeconomic imbalances in these countries are assessed within a board overview of structural factors: current account deficits and foreign indebtedness, growth and inflation rates, saving and investment ratios, budget deficits, real exchange rates, foreign reserve, corporate sector investment, measure of debt and profitability, indexes of excessive bank lending, indicators of credit growth and financial fragility, monetary stances, debt – service ratios, dynamics and composition of capital inflows and out flows, and political instability. A country could run very large and persistent current account deficits and remain solvent, as long as it can generate trade surplus (of the appropriate size) at some times in the future.

2.4 FEATURES OF THE CURRENCY CRISIS

A review of the Asian currency crises reveals that conditions leading up to the crises were not necessarily identical among the various affected countries. In particular, very significant differences in background conditions existed among the three most seriously affected countries of the crises i.e. Thailand, Indonesia, and the South Korea, which were forced to seek assistance from the IMF and the international community. It is notable that the Latin American debt crisis of the 1980s and the Mexican currency crisis of 1994 and 1995 (and its so-called "Tequila effect") had a minimal impact on the Asian economies. By contrast, the Asian crises spread very rapidly throughout Asia once the initial flame was ignited in Thailand. This fact points to the various characteristics, which are identified below as the defining features of the Asian currency crises.

WARNING INDICATORS AND THE 2008 FINANCIAL CRISIS IN ASIA

What industries are primarily affected as a result of a currency crisis in Asian developing countries?

http://www.unescap.org/55/e1123e.htm

The industries primary affected due to currency crisis is banking industry and stock market of the country. Not only in that country but around the world it has a large impact to the stock market

The global financial crisis, brewing for a while, really started to show its effects in the middle of 2007 and into 2008. Around the world stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems.

On the one hand many people are concerned that those responsible for the financial problems are the ones being bailed out, while on the other hand, a global financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world. The problem could have been avoided, if ideologues supporting the current economics models weren’t so vocal, influential and inconsiderate of others’ viewpoints and concerns.

In economic terms, financial crisis have varying effect on different industries. Export sectors hampered due to increase in the domestic price level caused by currency devaluation and increase business costs.

Decrease demand of the non essential goods like Auto mobile due the massive unemployment. Auto mobile industry at the developed countries relied on the parts and accessories from the developing countries.

Other industry also affected due the bankrupt financial institute due to large debts. Exports from the other countries suffer as they lose the competition from the crisis countries. For example, In 1999, financial crisis at Brazil affect

Impact of currency crisis on social and development sectors

Increase in poverty level and inequality in Asian countries

Increase or decrease, in money supply/demand affect the economy of developing countries

The role of monitory policy during currency crisis gained attention to the Asian Countries. It was a huge depreciation in Thailand, Korea, Indonesia and Philippines affected the banks and firms to large extend and that resulted large scale of downturn in banking sectors as well as economies. Higher interest rate support exchange rate by discouraging capital outflows and increasing cost of speculations while currency crisis. Studies prove that tighter monitory policy appreciates exchange rates. Another characteristic higher interest rates as a signal of monitory authorities supporting its currencies. In Asian countries, country which has a stable government, strong laws and high quality of bureaucracy will better able to serve their currency in the world market. As a result monitory policy has different effect on the exchange rate.

FDI

FII

Liberal Export Import rules & regulations

There are three different types of money supply which Federal Reserve uses to measure: “M1, a narrow measure of money’s function as a medium of exchange; M2, a broader measure that also reflects money’s function as a store of value; and M3, a still broader measure that covers items that many regard as close substitutes for money.” http://www.econlib.org/library/Enc/MoneySupply.html

Money definition is varies according to the time. In past centuries gold and silver were considered as money. After that paper money and check able deposit has been introduced. The main function of money is to virtually transactions and has a major impact to the economy. It is possible to increase in money supply by keeping interest rates lower and investment that has higher return by putting more money in the hand of consumers and keep them healthier to spend in the economy. Business always tries to ordering more raw materials to get higher production which leads to increase in the demand of labor and capital goods. If money supply continues to rise then prices begin to rise in the market. On the opposite side if the money supply falls then the growth rate is decline and that results into decreases in inflation in the economy.

Money supply in the economy means total amount of money available in an economy at a particular point of time. There is a strong relation between money supply growth and long term price inflation. There are two links between growth of the money supply and the inflation rate. First, increase in the Money supply cause to real production instead of inflation in recession, when resources are not fully utilized. Second, if the nominal GDP and money supply fluctuate and increase in money supply have no effect or unpredictable effect on the growth of nominal GDP. The government can prevent unwanted inflation and recession cycle by turning up the money supply and demand. The role of the Federal Reserve is to hold the money as a reserve from the commercial banks and financial institution as a deposit liabilities. Federal Reserve control reserve by lending money to financial institution and editing Federal Reserve rate on loans which were landed in the open market operations. Federal Reserve has a right to increase or decrease reserve in open market. To increase reserve Federal Reserve buys US treasury securities writing check. The seller of the treasury securities deposits that check in the banks and increase its reserves. At the same time central bank with fixed exchange rate allow economy to be eating into foreign reserve and allow the exchange rate to be fluctuating. The best solution to currency crisis is a foreign reserve with the country. When market is expected to be devaluating, downward pressure on the currency then it can be offset by increasing interest rate. When interest rate increases, central bank has to shrink money supply and that result into demand for the currency in the world market. The bank can do this by selling off foreign reserve to create capital outflow. When bank sells a part of its foreign reserves, bank receives money from the overseas market. Exchange rate cannot stable for long period of time that decline in foreign reserves as well as political and economic factors such as increasing unemployment. When currency is devaluate, the fixed exchange rate result into domestic goods become cheaper than foreign goods that increase the demand for workers and increase the outputs. In the short run devaluation also increase interest rates that can be offset by the central bank by increase in the money supply and foreign reserve. If he market expect the central bank to devaluate the currency that would result into increase the exchange rate and there is a possibility that foreign reserve can boost the demands. At that time central bank must use its foreign reserve to shrink the money supply and that increase domestic interest rate. When investors have sold their domestic currency as denominated investments that would convert the investment into foreign currency. It has an effect of exchange rate to be worse in run on the currency that can make it impossible for the country to finance its capital budgeting.

How and to what extent does a currency crisis affect the supply and demand of gold, silver and platinum?

http://goldnews.bullionvault.com/gold_currency_crisis_030120104

Increase poverty level and inequality in the countries

One of the more immediate effects of the financial crisis is lower labor demand which increase in the lay off. These is mainly due decrease in the demands of goods and services and downsizing of the corporate sectors.

High costs for basic necessities and commodities and this short run effect aggregate poverty. People are not able to find new jobs at urban areas so reverse migration start to the rural areas to reduce their expenses. Younger are more vulnerable social group as there are no jobs available after recent graduation that increase frustration in life.

Increase lay off due to recession

http://www.eadn.org/The%20Effects%20of%20the%20Asian%20Financial%20Crisis%20on%20the%20Philippines.pdf

http://www.endpoverty2015.org/files/Global%20Financial%20Crisis%20-%20Implications%20for%20India's%20Development.pdf

Industry

http://comingcurrencycrisis.blogspot.com/

http://www.shtfplan.com/forecasting/gerald-celente-predicts-us-dollar-currency-crisis-in-2010_11232009

http://www.huntingtonnews.net/columns/100801-mcgeehan-columnscrisis.html

For PPT

http://www.imf.org/external/np/speeches/2009/021409.htm

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