IMPACTS OF EXCHANGE RATE FLUCTUATIONS ON DOMESTIC ECONOMY
- The fact that among the macroeconomic variables, exchange rates are perhaps the most closely monitored, analyzed and manipulated economic measure highlights the overwhelming importance of exchange rates in an economy. The unpredictability of the markets caused by exchange rate changes can profoundly influence the economy of countries.
- As a matter of fact, it is most likely that exchange rate fluctuations may determine a country’s economic performance. Knowledge about the possible effects of exchange rate fluctuations enables us to have an understanding of the appropriateness of exchange rate policy, especially in developing countries.
In the discussion that follows, we shall examine the impact of exchange rate fluctuations on the real economy.
The developments in the foreign exchange markets affect the domestic economy both directly and indirectly. The direct impact of fluctuations in rates is initially felt by economic agents who are directly involved in international trade or international finance. In judging the impacts of exchange rate fluctuations, it becomes, therefore, necessary to evaluate their effects on trade, investments, consumption output, economic growth and inflation.
(i) Exchange rates have a very significant role in determining the nature and extent of a country's trade. Changes in import and export prices will lead to changes in import and export volumes, causing changes in import spending and export revenue.
(ii) Fluctuations in the exchange rate affect the economy by changing the relative prices of domestically-produced and foreign-produced goods and services. All else equal (or other things remaining the same), an appreciation of a country’s currency raises the relative price of its exports and lowers the relative price of its imports. Conversely, a depreciation lowers the relative price of a country’s exports and raises the relative price of its imports. When a country’s currency depreciates, foreigners find that its exports are cheaper and domestic residents find that imports from abroad are more expensive. An appreciation has opposite effects i.e foreigners pay more for the country’s products and domestic consumers pay less for foreign products. For example; assume that there is devaluation or depreciation of Indian Rupee from $1=Rs 65/ to $1=Rs 70/.A foreigner who spends ten dollars on buying Indian goods will, post devaluation, get goods worth Rs.700/ instead of Rs 650/ prior to depreciation. An importer has to pay for his purchases in foreign currency, and, therefore, a resident of India, who wants to import goods worth $1 will have to pay Rs 70/ instead of Rs 65/ prior to depreciation. Importers will be affected most as they will have to pay more rupees on importing products. On the contrary, exporters will be benefitted as goods exported abroad will fetch dollars which can now be converted to more rupees.
(iii) Exchange rate changes affect economic activity in the domestic economy. A depreciation of domestic currency primarily increases the price of foreign goods relative to goods produced in the home country and diverts spending from foreign goods to domestic goods. Increased demand, both for domestic import-competing goods and for exports encourages economic activity and creates output expansion. Overall, the outcome of exchange rate depreciation is an expansionary impact on the economy at an aggregate level. The positive effect of currency depreciation, however, largely depends on whether the switching of demand has taken place in the right direction and in the right amount, as well as on the capacity of the home economy to meet the additional demand by supplying more goods to meet the increased domestic demand.
(iv) By lowering export prices, currency depreciation helps increase the international competitiveness of domestic industries, increases the volume of exports and promotes trade balance. However, a point to be noted is that the price changes
in exports and imports may counterbalance or offset each other only if trade is
in balance and terms of trade are not changed. In case the country’s imports
exceed exports, the net result is a reduction in real income within the
country.
(v) We have seen above that by changing the relative prices, depreciation may increase windfall profits in export and import-competing industries. However, depreciation may also cause contractionary effects. We shall see how it may happen. In an under developed or semi industrialized country, where - inputs (such as oil) and components for manufacturing are mostly imported and cannot be domestically produced, increased import prices will increase firms’ cost of production , push domestic prices up and decrease real output.
(vi) For an economy where exports are significantly high, a depreciated currency would mean a lot of gain. In addition, if exports originate from labour-intensive industries, increased export prices will have positive effect employment income and potentially on wages.
(vii) Depreciation is also likely to add to consumer price inflation in the short run, directly through its effect on prices of imported consumer goods and also due to increased demand for domestic goods. The impact will be greater if the composition of domestic consumption baskets consists more of imported goods. Indirectly, cost push inflation may result through possible escalation in the cost of imported inputs. In such an inflationary situation, the central bank of the country will have no incentive to cut policy rates as this is likely to increase the burden of all types of borrowers including businesses.
(viii) When a country’s currency depreciates, production for exports and of import substitutes become more profitable. Therefore, factors of production will be induced to move into the tradable goods sectors and out of the non tradable goods sectors. The reverse will be true when the currency appreciates. These types of resource movements involve economic wastes.
(ix) A depreciation or devaluation is also likely to affect a country’s terms of trade. (Terms of trade is the ratio of the price of a country’s export commodity to the price of its import commodity) Since the prices of both exports and imports rise in terms of the domestic currency as a result of depreciation or devaluation, the terms of trade of the nation can rise , fall or remain unchanged, depending on whether price of exports rises by more than , less than or same percentages as price of imports.
(x) The fiscal health of a country whose currency depreciates is likely to be affected with rising export earnings and import payments and consequent impact on current account balance. A widening current account deficit is a danger signal as far as growth prospects of the overall economy is concerned. If export earnings rise faster than the imports spending then current account will improve otherwise not.
(xi) Companies that have borrowed in foreign exchange through external commercial borrowings (ECBs) but have been careless and did not sufficiently hedge these loans against foreign exchange risks would also be negatively impacted as they would require more domestic currency to repay their loans. A depreciated domestic currency would also increase their debt burden and lower their profits and impact their balance sheets adversely. These would signal investors who will be discouraged from investing in such companies.
(xii) Countries with foreign currency denominated government debts, currency depreciation will increase the interest burden and cause strain to the exchequer for repaying and servicing foreign debt. Fortunately, India’s has small proportion of public debt in foreign currency.
(xiii) Exchange rate fluctuations make financial forecasting more difficult for firms and larger amounts will have to be earmarked for insuring against exchange rate risks through hedging.
(xiv) With growth of investments across international boundaries, exchange rates have assumed special significance. Investors who have purchased a foreign asset, or the corporation which floats a foreign debt, will find themselves facing foreign exchange risk. Exchange rate movements have become the single most important factor affecting the value of investments on an international level. They are critical to business volumes, profit forecasts, investment plans and investment outcomes. Depreciating currency hits investor sentiments and has radical impact on patterns of international capital flows.
(xv) Foreign investors are likely to be indecisive or highly cautious before investing in a country which has high exchange rate volatility. Foreign capital inflows are characteristically vulnerable when local currency weakens. Therefore foreign portfolio investment flows into debt and equity as well as foreign direct investment flows are likely to shrink. This shoots up capital account deficits affecting the country’s fiscal health. If investor sentiments are such that they anticipate further depreciation, there may be large scale withdrawal of portfolio investments and huge redemptions through global exchange traded
funds leading to further depreciation of domestic currency. This may result in
a highly volatile domestic equity
market affecting the confidence of domestic investors. Reduced foreign
investments also widen the gap
between investments required for growth and actual investments. Over a period of time, unemployment is likely to mount in the economy.With increasing dependence on imports, Indian economy has always felt the brunt of higher international prices of fuel impacting domestic transportation and overall cost of production which often triggered inflation, increase in oil and fertilizer subsidy bills, costly foreign travel, escalated foreign debt service payments and higher outstanding external commercial borrowings (or ECB) and government’s foreign debt.
The other impacts of currency depreciation are: (i) Windfall gains for export oriented sectors (such as IT sector, textile, pharmaceuticals, gems and jewelry in the case of India) because depreciating currency fetches more domestic currency per unit of foreign currency.
(ii) Remittances to homeland by non residents and businesses abroad fetches more in terms of domestic currency
(iii) Depreciation would enhance government revenues from import related taxes, especially if the country imports more of essential goods
(iv) Depreciation would result in higher amount of local currency for a given amount of foreign currency borrowings of government.
(v) Depreciation also can have a positive impact on country’s trade deficit as it makes imports more expensive for domestic consumers and exports cheaper for foreigners.
(vi) Depreciation also can have a positive impact on controlling spiraling gold imports (mostly wasteful) and thereby improve trade balance.
An appreciation of currency or a strong currency (or possibly an overvalued currency) makes the domestic currency more valuable and, therefore, can be exchanged for a larger amount of foreign currency. An appreciation will have the following consequences on real economy:
(i) An appreciation of currency raises the price of exports and, therefore, the quantity of exports would fall. Since imports become cheaper, we may expect an increase in the quantity of imports. Combining these two effects together, the domestic aggregate demand falls and, therefore, economic growth is likely to be negatively impacted.
(ii) The outcome of appreciation also depends on the stage of the business cycle as well. If appreciation sets in during the recessionary phase, the result would be a further fall in aggregate demand and higher levels of unemployment. If the economy is facing a boom, an appreciation of domestic currency would trim down inflationary pressures and soften the rate of growth of the economy.
(iii) An appreciation may cause reduction in the levels of inflation because imports are cheaper. Lower price of imported capital goods, components and raw materials lead to decrease in cost of production which reflects on decrease in prices. Additionally, decrease in aggregate demand tends to lower demand pull inflation. Living standards of people are likely to improve due to availability of cheaper consumer goods.
(iv) With increasing export prices, the competitiveness of domestic industry is adversely affected and, therefore, firms have greater incentives to introduce technological innovations and capital intensive production to cut costs to remain competitive.
(v) Increasing imports and declining exports are liable to cause larger deficits and worsen the current account. However, - the impact of appreciation on current account depends upon the elasticity of demand for exports and imports. Relatively inelastic demand for imports and exports may lead to an improvement in the current account position. Higher the price elasticity of demand for exports , greater would be the fall in demand and higher will be the fall in the aggregate value of exports. This will adversely affect the current account balance.
(vi) Loss of competitiveness will be insignificant if currency appreciation is because of strong fundamentals of the economy.
From the discussions in this unit, we understand that all countries would desire to have steady exchange rates to eliminate the risks and uncertainties associated with international trade and investments. However, nations may sometimes go in for tradeoffs with weaker exchange rate to stimulate exports and aggregate demand, or a stronger exchange rate to fight inflation. Learners may keep themselves well- informed on contemporary exchange rate developments and their implications on the economic welfare of countries.
