Tag: Economic Theory

Currency Crisis Cause and Resolution

Currency Crisis

Currency crises are rapid and unpredictable decline in the value of the currency of a nation. The crises are often more severe if the country involved uses a fixed exchange rate than if the country has a flexible exchange rate since the monetary authority will be forced to abandon the fixed rate. Currency crises usually increase by selling pressure of a currency and can only be remedied through devaluation or establishing a new exchange rate at a sufficiently depreciated level. Several countries have experienced currency crises which are caused by different factors. One of the most severe currency crisis occurred in Mexico between 1994 and 1995. The crises led to huge massive economic crises that forced the Mexican government to seek assistance from the United States and the International Monetary Fund (IMF) (Carbaugh, 2016). The essay herein will, therefore, examine the sources of currency crises in Mexico and the specific resolution and also including some other countries that have experienced currency crisis such as Russia and Turkey.

Mexico Currency Crisis (1994-1995)

Before the 1994 Mexico currency crises, the central bank of Mexico maintained the value of peso within a depreciated band of four percent every year against the U.S. dollar. In 1994, the Central bank decided to issue debt that is linked to the US dollar as a way to reduce interest rates on debts. The debts kept rising until it exceeded the central bank’s falling foreign exchange reserves which led to the currency crises. Despite the government responding by devaluing the currency by 15 percent, the crises continued until 1995. The continued selling pressure on the currency forced the monetary authorities to withdraw support in foreign exchange markets as foreign reserves of the Bank of Mexico fell. Although the severity of the Mexican currency crisis in 1994 was unprecedented, Mexico’s history on exchange rate policy has been characterized by the duration of both fixed exchange rate and flexible exchange rates (Ötker et al., 1995). The devaluation registered by Mexico is the largest depreciation of the currency of a country within one year.

When the currency crises occurred, there was little information about the possibility of its occurrence. The crises were somehow similar to the debt crisis that occurred between 1982 and 1983. Several assessments have been conducted to establish the main cause of the situation, and most of them reveal that it was contributed by the exchange rate policy of Mexican monetary authorities. The other cause identified through the assessment is the excessive use of short maturity tesobonos for deficit financing. Tesobonos is a peso-dominated bond which is issued by the government of Mexico and the coupons associated with it are indexed to the United States dollar. The Mexican government issued the tesobonos as a way to convince the international investors to buy Mexican debt that is exempted from risks associated with currency exchange. The investors are therefore immune to the effects of changes in the dollar value of the peso between the period of purchase and redemption. The risk associated with the change of currency is therefore carried by the Mexican government and not the investors. For instance, if the value of peso depreciated during the period of purchase and redemption, the Mexican government and the taxpayers would be liable for the losses.

According to the international economic statistics that were available before the crises, the Mexican government had the chance to evade the crises if the monetary authorities had information about the actual state of Mexican reserves. At the beginning of 1994, the Mexican reserves were at around $25 billion, but towards the ends of the year, the reserves had reduced to about $5 billion (Tavlas, 1997). The existing reserves were insufficient to meet the existing financial obligations. Furthermore, a default was considered to be a perilous move for the stability of the international financial markets. The deficit, therefore, led to the currency crisis. The International Monetary Fund (IMF) failed to provide the Mexican authorities with information about the decline in the reserves. Following the crisis, the IMF has resolved to closely monitor the financial reserves of developing countries to avert the occurrence of a currency crisis. The IMF has also resorted to providing early warning indicators to avoid the occurrence of a currency crisis in any nation.

Currency Crisis
Currency Crisis

Mexico has a great deal of the forms of direct capital investment in 1994, but it was not sufficient. The government was receiving massive amounts of money through stock-brokers who were motivated by the quick returns which were about 20 percent annually. The investment bankers and the stock-brokers were ready to exit Mexico as soon as the crisis begun thereby increasing the magnitude of economic damage. The troubles of Mexico extended from insufficient reserves, inability to service the debts, and incapability to generate profits on the equity capital. The crises also contributed to other social and political problems such as the Chiaspas rebellion at the beginning of 1994 (Tavlas, 1997). The political issues made the foreign investors take their money out of Mexico thereby broadening the implications of the crisis. The implications of the crises forced the Mexican government to seek assistance from the International Monetary Fund and the United States government.

According to Gil-Diaz (1998), the currency crisis in Mexico was contributed by the execution of the privation of the public enterprises and the deregulation of the Mexican banking sector. He concluded that the confiscation of the banking sector followed by subsequent privatization in 1991-1992 is the cause of the currency crisis. The Mexican monetary authorities made the deregulation of the banking sector without due consideration about the implications that it would have on the federal reserves. The decision later resulted in an increase in unpaid debts to the banks. The currency was then triggered by the Mexican government in 1994 because of the economic decisions. The crisis was determined by the fragility of the banking system and not the macroeconomic factors as indicators by other researchers. Three years before the crisis, the Mexican peso was overvalued which also resulted in economic pressure. The monetary policy that was passed by the Mexican authorities was inappropriate because the Federal Reserve was raising the interest rate while the Bank of Mexico maintained the existing rates. It, therefore, made the investors leave increasing pressure on the reserves.

The Mexican currency crisis had a regional effect through a contagion in various markets such as Brazil, Argentina, Asia, and Thailand; the effect was referred to as the “Tequila effect.” The crisis affected both the stock market and the foreign exchange market. Only the countries that had high economic fundamentals were exempted from the effects of the crisis. The Mexican government responded to the adverse situation by requesting for loans from different countries and international bodies among them being the United States, the International Monetary Fund, and the Bank for International Settlements. In the end, Mexican government managed to secure a loan totaling to $50billion that was used to meet the financial obligations. However, the move by the government to ask for loans received criticism from some of the European authorities that considered the move to be a moral hazard.

The Mexican government continued to resolve the crisis by implementing a severe adjustment program. Some of the strategies in the program included reducing the public spending, increasing the value added tax from 10 percent to 15 percent, and raising the prices of all the public goods and services. The program worsened the situation in Mexico as the Gross Domestic Product dropped by 6.5 percent and inflation increased by 50 percent. Furthermore, the banking system collapsed thereby forcing the government to use public funds in the rescue. The government also changed the exchange rate from fixed to flexible. Later, a law was passed that would only allow the government budget to be approved if the deficit is zero to prevent further lending. The initiative had positive implications in the GDP because of the increased exports of products to the United States. Through the Banking Fund for the Protection of Savings, the government was able to bail out the banking system that had collapsed.  Years later, the government decided to sell the Mexican banks to the international financial groups. Presently, there is only one Mexican bank as foreign investors own the rest.

One of the international institutions that played a role in rescuing Mexico was the International Monetary Fund. The IMF is responsible for providing loans to nations that are in financial deficit. The loans are usually issued following an agreement between the nation and IMF. The IMF responded to the crisis by providing a loan to the Mexican government through the U.S Treasury as a way to protect the foreign banks and other existing financial institutions. The various government also played a vital role in rescuing the currency crisis among them being the United States and Canada. The U.S. has had a long outstanding relationship with Mexico, and it is also the largest trading partner. Although the Federal Service Bank contributed to the crisis by increasing the interest rate, the United States assisted the Mexican government with loans to end the crisis. On the other hand, Canadian government through the North American Framework Agreement (NAFA) contributed funds beyond what had been collected at the time of occurrence of the crisis.

Russia Currency Crisis (1998)

Russia was severely hit by a currency crisis in 1998 that left both the economic and financial system in crisis. According to Gerry & Li (2002), the financial crisis begun in August 1997 when the Russian government defaulted on its domestic financial and economic systems. The duration was characterized by an increase in inflation, high levels of unemployment, and shanking of the economy. Although the crisis lasted for a short period, Russian who was living in the urban areas were severely hit. Globalization and uncontrolled speculation in the financial markets is one of the leading contributors to a currency crisis in the developing countries. The rise in the amount of capital that is flowing in the international financial systems as a result of globalization has had negative impacts on the economies of different countries. The crisis is caused by failures of certain sectors of the economy in the countries involved which later spreads to other countries through contagion and spill-over effects. For instance, the Asian currency crisis spread through contagion and spillovers to other countries such as Thailand in 1997 and later to Russia in 1998. Therefore, Asia is one of the causes of the Russian crisis although research shows that there is a little linkage between the crises that hit the two countries.

The Russian crisis can also be attributed to both political and economic factors. The Russian government triggered the crisis by selling the GKOs and OFZs which denominated debt instruments and coupon bonds after the fall of USSR. The Russian government then started experiencing problems that had negative implications on both the financial and the economic systems. The Russian government responded by converting the Ruble dominated instruments into US dollar-dominated Eurobonds to alleviate the risks involved. The Russian government continued borrowing from external sources that later raised concerns of its default exposure as foreign investors decided to cut their connection with the Russian debt, equity, and commodity market because of lack of confidence. The withdrawal of investors from Russia economy reduced the government capability to finance the debts thereby causing a currency crisis. According to the reports provided by the Economic Intelligence Unit (1998) in 1998, 30 percent of the Russian expenditure was used to service the short-term debts that the government had secured from other governments and international institutions. Therefore, high levels of debts are one of the causes of a currency crisis in Russia.

Russian Currency crisis was also caused nu the fall in the value of the Rule, weak banking system, and the reduction in the level of the foreign reserves. The Russian government tried to remedy the situation through the Central Bank by pegging the Russian Ruble to the US dollar with a narrow band. Several other studies have been conducted to establish the causes of the Russian financial crisis which had serious consequences to the economic and financial systems of other countries such as Turkey, Ukraine, and Moldova. The devaluation of the Russian Ruble also had negative implications on the Russia banks regarding assets and liabilities. There was also a reduction in the foreign exchange contracts because of the increase in the value of liabilities. Furthermore, the Russian government debts such as bonds and treasury bills that were used assets were reduced to worthless assets because of the defaults. As a result, most banks were closed which made a majority of the Russians to lose their savings. Lastly, the crisis caused political fallouts and frequent demonstrations of workers who were demanding a pay rise (Margolin, 2000).

The Russian currency crisis was resolved after intervention by the International Monetary Fund (IMF) which has the mandate of monitoring the economic and development policies enacted by various nations. The other responsibilities of the international body are to lend money to countries that are experiencing financial challenges and provision of technical assistance regarding research and training to countries that are in need. The IMF intervened in the Russian crisis by lending money that would help the government to escape the financial collapse. Despite the IMF lending money to the Russian government, the situation was already out of control since the money could only be used to take care of the short-term debts but not offer a permanent solution to the difficult situation.

For a country to survive a financial crisis, it requires a plan for the aid to be used in a manner that will help escape the situation. It is an excellent idea for the international body to issue financial aid, but the Russian government was not prepared to use the funds to evade the crisis. The government had lost control of the situation, and therefore it required more than financial aid to help the situations. The Russian government responded by coming up with a plan that would ensure the crisis does not happen again. The funds issued by the IMF were used in rescuing the banking system which plays a vital role in maintaining economic growth in a nation.

Conclusion

A currency crisis is one of the challenges that has been experienced by several countries especially the developing countries. Among the countries that have been affected by currency crisis include Mexico between 1994 and 1995, Russia in 1998, and Thailand in 1997. The crisis has severe implications on the economic and financial systems of an economy. The causes of the crisis vary from one nation to another, for instance, the crisis in Mexico was caused by reducing the level of Federal Reserve while excessive borrowing caused the Russian crisis. Once the countries are caught in such difficult situations, it the responsibility of the international bodies and other government to assist in escaping the situation. International Monetary Fund played a vital role in helping the above-discussed countries escape the harsh implication of currency crisis. The United States and Canada through the North American Framework Agreement (NAFA) assisted Mexico financial aid in helping rescue the situation.

References

Carbaugh, R. (2016). International Economics. Boston, MA: Cengage Learning.

Economist Intelligence Unit (1998). Russia: Country Report. London. pp. 42.

Gery, C. J. & Li, C. A. 2002. Vulnerability to welfare change during economic shocks: evidence from the 1998 Russian Crisis. Working Paper. University of Essex, Department of Economics, Discussion Papers.

Gil-Díaz, F. (1998). The Origin of Mexico’s 1994 Financial Crisis. Cato Journal, 17 (3), pp. 303-313.

Margolin, R. (2000). The Russian Financial Crisis: from craze to crash. The Stern Journal, New York University.

Ötker, I., Pazarbaşioğlu, C., International Monetary Fund, & International Monetary Fund. (1995). Speculative attacks and currency crisis: The Mexican experience. Washington, D.C.: International Monetary Fund, Treasurer’s Dept. and Monetary and Exchange Affairs Dept.

Tavlas, G. S. (1997). The Collapse of Exchange Rate Regimes: Causes, Consequences and Policy Responses. Boston, MA: Springer US.

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Did you find any useful knowledge relating to currency crises in this post? What are the key facts that grabbed your attention? Let us know in the comments. Thank you.

Negative Interest Rates

Discuss the macroeconomic effects of negative official interest rates. What relevance, if any, do the macroeconomic models have in explaining this phenomenon and predicting its likely consequences?

The negative interest rate is a recent phenomenon emerged from the global financial crisis in 2008. The negative official interest rate has become worldwide phenomenon and a part of policy initiatives by central banks around the world (Collignon, 2012) to deal with the problems of low rate of economic growth, massive unemployment and disinflation by injecting some easy money in search of some viable solution for economic recovery.

The interest rate is most crucial variable for financial industry as it has widespread effects on share prices, exchange rate and income distribution between exporting firms and consumers. IMF (2012) has mentioned the negative effects on insurance and savings in form of pension funds and financial stability is threatened in case of persistent negative interest rates. This policy can have negative consequences for growth and independence of central banks in the hands of irresponsible government decisions (White, 2012).

Money market suffers as important intermediaries like money market funds could be compelled out of business because of lost profitability that shift the interest of investors to more profitable market oriented business.

The consumers also suffer from negative interest rate in form of high global commodity prices. The reason behind this phenomenon is the changing interest and speculative behaviour of investors into high yielding assets like oil and food. The increased inflation rate results in lower purchasing power of consumers that hindered the economic recovery (Belke et al., 2010).

The negative interest rate dampen saving as it encourage people to spend more rather to save, this has long term negative effects for the people who are dependent on interest income. On the other hand the savings are not properly used for investment because of deteriorating investment efficiency.

The benefit of low interest rate includes the increasing capacity of banks to lend as a major problem the banks faced during the financial crisis was undercapitalization that restricted their capacity to make loans for recovery.

Negative Interest Rates
Negative Interest Rates

The negative interest rate can increase the wealth of households in form of higher asset prices and lower the capital cost for making investments but at the same time it gives rise to additional borrowing that increases the debt levels.

Negative interest rates can be explained in terms of Keynes theory of interest rate and theory of speculative demand for money. According to Keynes the equilibrium interest rate is the rate that equates money supply and money demand. Keynes began by asking “why an individual would hold any money above the needed for transaction and precautionary motives when bonds pay interest and money does not.” Keynes believed that such an additional demand for money exists because of uncertainty about future interest rates and the relationship between changes in the interest rate and the price of bonds. As there is an inverse relation between bond price and interest rate, Keynes speculative demand for money is the money held in anticipation of a fall in bond prices and a rise in interest rates (Froyen, 2005).

Here we observe a phenomenon of liquidity trap. It is the situation at a very low interest rate where the speculative demand for money schedule becomes nearly horizontal as shown in figure.

One implication of negative interest rates could be the liquidity trap which can lead to deep recession with deflation. It can be explained with the help of an example. In the 1990s, the interest rate in Japan was the lowest in the world and in 1998 the interest rate on Japanese six month treasury bills turned slightly negative. In such a situation Japan experienced prolonged recession accompanied by deflation which is the negative inflation rate (Mishkin, 2007). Usually it is believed that the low interest rates are a good thing because they make borrowing cheaper. But the case of Japan shows that low and negative interest rates were a sign that Japanese economy was in real trouble with falling prices and contracting economy.

Secondly, it is not attractive for the lenders to lend below 0%, as that will guarantee a loss, and a bank offering a negative deposit rate will find few takers, as savers will instead hold cash.

Countries like Denmark and Sweden introduced negative interest rates in recent years on temporary basis. In Denmark the purpose of adopting negative interest rate was to limit an unwanted rise in its currency. For this they moved to negative deposit rates. It did not cause any financial meltdown nor did it cause any noticeable change in the interest rate charged by banks for bank loans. Recently, European Central Bank has adopted the negative interest rates of -0.1% on Eurozone banks to encourage them to lend to small firms rather than to hoard cash. It is meant to boost the economy by increasing the lending to consumers and businesses.

Consequences of adopting Negative Interest Rates

  1. This development can have unpredictable consequences. Those consequences may include the possibility that banks will pass on to customers the costs for depositing money with the ECB.
  2. Also the negative return on keeping funds with the central bank might encourage banks to invest in riskier assets to secure a return.
  3. As an alternative investment, banks may increase their purchases of government bonds and it would have potentially serious consequences if banks are holding bonds to such an extent that government borrowing costs are artificially low. If a financial shock occurs, the banks and governments could find themselves so intertwined and interdependent that they drag each other and the economy down.

References

Belke, A., Bordon, I. G., & Hendricks, T. W. (2010) ‘Global Liquidity and Commodity Prices–a Co-integrated VAR Approach for OECD Countries’. Applied Financial Economics, 20(3), 227-242.

Collignon, S. (2012) ‘Fiscal policy Rules and the Sustainability of Public Debt in Europe’. International Economic Review, 53(2), 539-567.

Froyen, R.T. (2005) Macroeconomics: Theories and Policies (8th ed.). Prentice Hall: Upper Saddle River.

International Monetary Fund Staff (2011) ‘Global Financial Stability Report: Durable Financial Stability: Getting There from Here’. International Monetary Fund.

Mishkin, F. S. (2007) The Economics of Money, Banking, and Financial Market. (sixth ed.). Pearson Education.

White, W.R. (2012) ‘Ultra Easy Monetary Policy and the Law of Unintended Consequences; Federal Reserve Bank of Dallas’. Globalization and Monetary Policy Institute.

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Economics Dissertation Topics

Economics Dissertation Topics

Writing an economics dissertation can prove to be a tough task and quality economics dissertation topics are hard to come by. The dissertation in hand allows you to investigate your ability for, and interest in doing economic research. Economics is not the easiest of subjects but it is one of the most interesting. Economics touches nearly every aspect of business and economic theory has been taught for centuries. Economics is seen as the analysis of production, consumption, distribution of wealth and allocation of limited resources to satisfy the needs of people and business. Nowadays, economics extends across national boundaries in the form of international business and global fiscal policy; this is noticeable with the formation of the European Union and flow of international finance.

Your economics dissertation is likely to be the biggest project you undertake at university or college. It can consist of anything between 10,000 to 15,000 words for a typical undergraduate dissertation and will involve in-depth research, time and dedication, you must organize your own time effectively in order to make it a success and set realistic goals. Here we have given a few thoughts and some advice on planning, researching and writing your dissertation. You will see a list of economics dissertation topics further on in this post.

Economics Dissertation Topics
Economics Dissertation Topics

Before you begin your economics dissertation, you must decide on an appropriate economics dissertation topic and title. Your dissertation should focus on a specific issue try to avoid generalizing as you may write a fragmented and disjointed piece of research. The topic should be interesting, something that can uphold in-depth research.

Choosing an economics dissertation topic and getting started

  • What is your topic question?
  • Do you have adequate background research?
  • Stay focused on it

In previous posts, I always stress to keep the research up to date and to engage the reader. There is no real benefit in writing an economics dissertation on outdated theory or defunct policy.

Choose a topic from an area you are familiar and comfortable writing about. Remember that this is a large project that will keep you engaged for most of your final year. It is advisable to revisit topics you have already covered on your degree as this may lead you to elaborate and base your dissertation on a project you have already completed. Writing your economics dissertation will be the ideal opportunity for you to use your intellect, skills, creativity, and economics training.

Economics Dissertation Advice

  • For empirical papers: Where will you get your data? How will it help answer your question?
  • What statistical techniques will you be able to use? Will you be able to identify causation or only correlation?
  • Theory papers typically are not just informal discussions. They tend to involve more mathematics than empirical ones, not less.
  • If you are having trouble understanding a topic, a good place to start is to look in several relevant textbooks to see how they handle it.

Economics is a specialized and scientific subject that involves equations, mathematics, figures and tables, economic theory is often underpinned by statistics and you need to be mindful of this. The field of economics differs vastly from other business subjects such as marketing, strategy and information management. These subject areas tend not to rely heavily on statistics or equations to strengthen findings and recommendations.

Below is a list of economics dissertation topics that will help you

Economics Dissertation – Economic Deflation Concerns in the United Kingdom

Economics Dissertation – Macroeconomic Factors Affecting Exchange Rates

Economics Dissertation – Relationship Between Stock Price And Market Efficiencies

Economics Dissertation – Determinants Of Bank Performance In China

Economics Dissertation – Importance of Economic Integration for Developed Economies

I hope you have benefited from reading this post. Feel free to add comments or suggests that I may have left out. These will be considered and added to this post.

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Multi-Asset Portfolio Dissertation

How The Role Of Property In A Multi-Asset Portfolio Has Been Affected By The Credit Crunch

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The existing literature argues property’s role in a multi-asset portfolio to be a means of risk reduction opposed to a method of returns. However, with the recent credit crunch having an adverse effect on the property market, this study will look into the affect it has had upon property’s role. To reach this finding, a combination of primary and secondary data will be used.

The secondary data was obtained through a literature review and the primary data from interviews and a questionnaire. The findings were that the credit crunch has left the UK property in a position where it can offer investors opportunity to make capital gains and a secure income through rents. This has led to property’s role now being mainly focused on returns but still included as a means of risk reduction.

Multi-Asset Portfolio Dissertation
Multi-Asset Portfolio Dissertation

In a multi-asset portfolio an investor will likely include property to diversify and better their overall returns. However, with property values falling, it is likely investors were wishing to pull out of this asset class, cut their losses and venture elsewhere due to their risk adverse attitudes. A negative correlation when comparing property with stocks and bonds makes the later pair appears the way forward. Reason being; they should theoretically be outperforming the current property market rectifying diversification in a multi-asset portfolio.

If investors make this decision and reduce the amount of real estate, levels of diversification will decrease, increasing specific risk. The chance of disposing their property is extremely slim however because of property’s liquidity being further extenuated by a market downturn. Property is evidently not offering the attributes investors’ want, yet they are unable to dispose of this unwanted asset. This puts investors in a very difficult situation of being left with a depreciating asset in their multi-asset portfolio.

A possible solution to this would be identifying potential emerging markets, such as Latin America and India, which may offer the desired benefits currently unattainable in the UK. So with property still existing among UK fund managers’ portfolios the role it now offers must be determined. This dissertation will be based on three key assumptions namely:

  • Investors’ main reason for including property in a multi-asset portfolio is to reduce risk
  • Due to the poor performance of property in recent years, investors are reducing the property exposure in a portfolio and replacing it with more traditional methods such as bonds
  • Even with the recession being a global problem, certain investors feel there are still benefits from international property investment

The opening chapter of this dissertation has been produced to give readers an understanding of the overall study and what the upcoming chapters will be exploring. Chapter two will be a literature review analysing applicable company publications and academic literature, relating to the use of property within a multi-asset portfolio. It will clarify why various investors wish to include property, its characteristics, alternative assets to invest in and overseas investment.

Each of these points will be tackled in their own independent section. The following chapter (three) will exhibit clearly the use of methodologies used throughout the dissertation to find out how the actions of investors has changed towards property during the credit crunch. Within the chapter it will also justify why these research methods were best suited for this field of research. The fourth chapter will bring together the results from the literature review, interviews and online questionnaire, clearly explaining what has been identified.

The final chapter of the dissertation shall be the conclusion. It will summarise the key findings answering the aims and objectives outlined at the start of the paper, identifying how the role of property within a multi-asset portfolio has been affected by the credit crunch. It will also make clear the limitations of the study and recommendations for similar studies in the future.

This research will help support many other studies that have been carried out over the years in regard to property’s role within a multi-asset portfolios. This paper will differ to previous studies, carried out by the like of Bryne and Lee, as it is primarily focusing on an economic downturn opposed to data over long periods with varying market conditions. There is a distinct lack of existing literature on this matter. By shedding light on this aspect, it will give an investor’s insight on how property is best used in a multi-asset portfolio during a struggling market.

If you enjoyed reading this post on multi-asset portfolios, I would be very grateful if you could help spread this knowledge by emailing this post to a friend, or sharing it on Twitter or Facebook. Thank you.

Economics Essay Monetary Union

Balance of Advantages of the UK Joining the EMU and/or Using the Euro as a Functional Currency

Introduction

The Economic and Monetary Union is an agreement between participating European nations to share a single currency, the Euro and a single economic policy with set conditions of fiscal responsibility. There are currently 27 member-states of varying degrees of integration with the EMU.

Currently there are 16 member states who adopted the Euro: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia, Spain, Cyprus, Malta and Slovakia. Further 3 countries including United Kingdom, Denmark and Sweden did not join the EMU even though they had an option to do so. Main reason for the UK not to join the Euro was the strength of the Pound and the British economy against the countries in the Euro zone. Joining EMU was predicted to cause economic problems in the country as European Central Bank would seize full power over the monetary policy in the UK including for instance setting benchmark interest rates. Economists are therefore divided into two groups: pro and cons the EMU. Aim of this report is to show on the example of invented for the purpose of the report Multinational Corporation (Insomnia plc) the influence of UK joining the EMU and/or using Euro as a functional currency.

History of Insomnia PLC

Insomnia plc is a UK based Multinational Corporation with their headquarters in Aberdeen, Scotland. The company was founded in 1987 by Mira Stavika. Insomnia designs, produces and sells luxurious clothing, shoes and accessories for adults and kids. The company has internationalized through subsidiary undertakings in Italy, Spain, Germany and France as well as international trade with India, where the clothing is manufactured and exported to UK. The special packaging for cloths is produced in Slovakia. Since 2001, the company is listed on the London Stock Exchange and the largest German stock exchange in Frankfurt (FWB Frankfurter Wertpapierborse). The corporation owns approximately 60% of each subsidiary.

Scope of Business

After importing clothing to the UK, Insomnia stores it and resells majority part of it to their subsidiaries at the 20% mark-up. The remaining part is being sold in the UK. Subsidiaries and parent trade the clothing in the Insomnia branded shops. Apart from the payments for the import of clothing, foreign entity has to pay to its UK parent the management fee for the administrative and managerial services it provides. Out of the profit the foreign entities obtain, 70% is re-invested in their business; the remainder is paid to shareholders in form of dividends. Almost 40% of Company’s debt is denominated in Pound Sterling where the remaining part (60%) is in Euro. Revenue of the company comes in 70% from Euro and 30% from UK braches in Pound Sterling.

Parent company uses Pound Sterling as a functional and reporting currency, whereas all of the subsidiaries occupying in the Euro zone, use Euro as a functional and reporting currency.

Monetary Union
Monetary Union

Current Exposures in  a Monetary Union

Insomnia plc trades mainly in the foreign markets. This exposes the company into a series of uncertainties mainly regarding the exchange rate of the currencies. Exchange rates cannot be predicted with the ideal accuracy, but companies can at least forecast their exposure to exchange rates fluctuations which comes in three types.

Transaction Exposure

Transaction exposure is the degree to which the short–to–medium term cash flows denominated in foreign currencies are affected by the exchange rate fluctuations. This type of exposure has direct and large effect on the value of the company’s earnings.

Insomnia is highly affected by this type of exposure due to majority of its operations denominated in foreign currency. Buying clothing from the manufacturers in India and selling these to their foreign subsidiaries highly exposes company. Depending on the economic conditions, value of Indian Rupee and Euro can change rapidly within short period of time (Even as much as 10% within a year; Madura, 2007). Invoicing of clothing imported from India is denominated in Rupee, so if the value of this currency appreciates against the Pound, payables of UK company will increase and adverse. Similarly sales of the clothing to subsidiaries are invoiced in foreign currency, the Euro, which can affect cash flow in the adverse way to Rupees. Transaction exposure affects debt as well. Due to the Euro/Sterling exchange rate increase by 16.3% in 2009, debt of the company increased significantly last year as 60% of debt is denominated in Euro.

Economic Exposure

Extent to which present value of company’s future cash flows are affected by the exchange rate fluctuations is referred as economic exposure. ‘All types of anticipated future transactions that cause transaction exposure also cause economic exposure because these transactions represent cash flows that can be influenced by exchange rate fluctuations. Economic exposure includes transaction exposure and indirect effects on revenue and cost. ’ (Madura, 2007)

Insomnia is exposed as well to the economic exposure. If the Indian Rupee appreciates against the Pound as in previous example, the company may need to increase the price of clothing sold in the UK and price of goods sold to subsidiaries as will have to pay more for the supplies. In this case, customers might shift their purchases to the cheaper clothes’ retailers both in the UK and Euro zone which will decrease export of cloths to subsidiaries and result in the reduction of the future revenues of the corporation. If Pound appreciates, home sales are expected to decrease due to the foreign competition as well. Basically, increase in value of Pound will result in a decrease in both cash inflows and outflows, and adverse. (Madura, 2007)

Translation Exposure

How does this affect a wider monetary union? Subsidiaries have their own accounting records, but in reality parent fully controls the entities. Parent company has to show its own and subsidiaries’ accounts in a consolidated manner through consolidated financial statement. To do so, there is a need to translate financial statements of all subsidiaries of different currencies into reporting currency of the parent, which is Pound Sterling.

As exchange rates vary over time, the translation of the foreign entity’s accounts is exposed to exchange rate movements called translation exposure.

Insomnia plc has to translate the Euro denominated financial statements of its subsidiaries to the Pound Sterling, which is governed by the Financial Reporting Standards (FRS 23) and the International Accounting Standards (IAS 21). Assets and liabilities should be translated at the closing date; whereas income and expenses at the exchange rates at the transaction dates (average rate for the period is allowed, if reasonable).

Translation exposure does not affect the cash flow directly, but investors base their decisions on the consolidated financial statements. When in 2005 Insomnia announced that its consolidated earnings will be negatively affected by the translation exposure to Euro, investors responded very fast by selling their shares of the company, which led to decline in value of the stock by 5%.

Hedging

What is the impact of hedging on a wider monetary union? Exchange rate fluctuation exposures affect the cash flows of the entity in a direct or indirect way. The main aim of hedging is to minimize the effects and the uncertainty of the exchange rates fluctuations. Hedging may as well reduce agency costs, expected tax liability, and the cost of financial distress. Insomnia uses forward contracts to secure the exchange rate of their transactions and thus minimize the transaction exposure. For payables it negotiates the forward contract to buy foreign currency, for receivables – contract to sell foreign currency. The company, being risk averse, uses forward contracts to minimize the economic and translation exposure as well. To minimize the cost of hedging, company first calculates the net transactions exposure in each currency for each of the subsidiaries, then hedge against this balance. Additionally, company invoices the exports to its subsidiaries in the same currency in which they will pay management fees and dividends to a UK parent. It cannot be done for the transactions with the suppliers in India and Slovakia.

Effects of the UK Joining EMU on Insomnia Plc

Creating single market forming free flow of goods, capital, services and people within the European Union was the main objective of creating the EMU. To adopt Euro, countries need to fulfill “Convergence Criteria” set out by the Maastricht Treaty, but benefits outweigh the hard to accomplish objectives of price, exchange rate and fiscal stability as well as interest rate convergence and an impact on a wider monetary union.

Cost Savings on Cross-Border Transactions

Increase in trade within the European Union is one of the main objectives of the EMU. It is supposed to increase the consumption possibilities. According to Rose (2000) trade within domestic economy is far higher than international. Joining EMU and having single market with other EU countries will significantly increase the trade by making it domestic. It could be a great advantage for the Insomnia. It is thought to be achieved through cost savings on the cross-border transactions. Trading across Euro zone is much cheaper due to no need for exchanging money to foreign currency, hedging or keeping high reserves of foreign exchange. This will speed up the transactions and decrease its cost. Insomnia will benefit from this as company already trades with the subsidiaries from the Euro zone. Joining EMU will decrease costs of trading with them, whereas leaving problem of high costs of trade with India unsolved. Staying outside the EMU could be a big disadvantage in case of Pound appreciation. Shall this happen, export and sales in foreign countries will decrease as price of company’s goods will be higher. If joining EMU, Euro fluctuations would not have an effect on the exports to subsidiaries.

So far, strength of Sterling against Euro has already resulted in the reduced UK exports, which in turn forced foreign investors to pull out of the UK (Gillette, Siemens) and many more threat to pull out if UK will not adopt Euro. For the economy it is a disadvantage, but it is in favour of Insomnia plc, as it will reduce the competition. However, today’s situation is not positive for the company as “investors come here [to UK] because we have lower taxes and less regulation than the Euro-zone.” (Dominic Cummings, F/T; 12/06/01)

Stability of Prices

Stability influences monetary union, one of the advantages of joining EMU according to the European Commission is having more stable prices due to anti-inflationary regulations by European Central Bank. It is to be done by setting benchmark interest rates (according to the Fisher Effect) and exchange rate. It will affect Insomnia indirectly. In the event of the crisis in one of the EMU countries it is very possible that ECB will adjust interest rates in all other countries regardless the domestic conditions of single states. UK economy then may become unstable and collapse unfavourably affecting cash flows of the company. The risk of this happening is large due to high Euro volatility comparing to Dollar and Pound since it was introduced.

However, price stability can bring more advantages than the disadvantages to the Insomnia. Creditors being sure that prices will remain stable in the future are more willing to lend at lower interest rate which encourages domestic investments. Historically, UK interest rates have been higher than in the Euro-zone. In case of higher interest rates in the country, it may attract foreign investors in putting funds into Insomnia, but customers are more willing to save money rather than spend on clothing. Controlled inflation, stabilized prices and elimination of exchange rate fluctuations result in the ease of making long term investment decisions, planning and borrowing for Insomnia. (“Stability: Why is it important for you?”; ECB, 2009)

Price Transparency in a Monetary Union

Price transparency of a monetary union is driven by the price stability. When joining EMU, costs of the same goods across the whole Euro-zone will be much easier to compare. Prices of the Insomnia plc are relatively more expensive than the competitors, revealing it will lead customers to shift their purchases to different retailers. This might effect in the downwards pressure on prices and make it harder to keep different pricing policies on similar quality and use products. It is a big advantage for customers, but not for the Insomnia businesses. On the other hand, price transparency might help the company to find and work with the new, cheaper suppliers of clothing’s packaging. In addition, if Insomnia wants to set up a new subsidiary in the Euro-zone country, can easily compare costs of doing so among various locations. Stock prices of EMU countries are more comparable and prices are more stable as well, so it is easier and safer for the foreign investors to chose and invest in stock of Insomnia. Although, highly correlated markets decrease the diversification of the European investor.

Other Effects

Joining Euro will effect in long-term savings on the book-keeping. The Company has to hire people and keep tracks of costs, expenditures, margins etc. in various currencies. These costs will be reduced due to single currency used by the parent and subsidiaries. On the other hand, the disadvantage of one currency would be the cost of change over. This will require staff training, new tills software as well as labelling. Using Euro by UK might make company’s products more attractive to Euro zone customers due to easier purchases of goods online with no exchange rate uncertainty.

However, contrasting to the UK, in the Euro zone there is a VAT fee on children clothing, which will increase the price of such company’s items. It is a disadvantage for the clothing company. (Stephen Castle, the Independent, 15/07/03)

The level of hedging in Insomnia will be significantly decreased. Due to having Euro as a functional currency, company’s transaction exposure will be minimized drastically, due to having majority of transactions denominated in Euro. Insomnia will have to hedge only against the Indian Rupee. Economic exposure to exchange rate fluctuations will be decreased as well due to majority of the company’s operations based in the single, highly integrated market. Appreciation or depreciation of the Euro will not have an effect on the price of goods relatively to the competitors, trade or competition itself within the EMU. It will influence only trade with India and only Rupee will have to be hedged against. Translation exposure will be eliminated. As company needs to translate only the financial statements of its subsidiaries within the EMU, there is no need for this, therefore any need for hedging.

Using Euro as a Functional Currency of Insomnia Plc

“Functional currency is the currency of the primary economic environment in which the entity operates. The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash.”(IAS 21) Insomnia considers the choice of the functional currency based on the factors stated by the IAS 21:

  1. The currency: That mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services.
  2. The currency: That mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled).

According to the factors stated above, Insomnia should change its functional currency into Euro. The effect of this action will be similar to joining the EMU. Insomnia having Euro as a functional currency will benefit from the fixed exchange rate and reductions in cost of managing currency risk, speed of Euro transactions as well as price transparency. UK market will not be highly integrated with the Euro zone, as it would be in case of joining EMU. Insomnia would not be able to gain from the lower interest rates and stable prices. Obtaining cross-border funds will be easier when having Euro as functional currency, but due to prices being less stable, the cost of financing will be slightly higher than in the EMU. VAT on children clothing will not be introduced giving an advantage to Insomnia. Hedging will be decreased as well. Transaction exposure will be minimized, but by less than when joining EMU. There will be a need to hedge small amounts against receivables in Pounds and payables in Rupees as the majority of transactions are denominated in Euro. The company could easily reduce the exposure even more by invoicing in Euro, shifting this way the exposure down the supply chain. Economic exposure will be slightly decreased. In opinion of the report’s author, appreciation or depreciation of Euro throughout the EMU will not have an effect on the company or its competition. Although, UK will not be consistent with the single market, interest rates and inflation of the EMU zone, which may cause the differentiation in prices of the same goods (no price stability). Translation exposure will be shifted from translating from Euro to Pounds, to translation of Pounds to Euro. Exposure will be however decreased due to only 30% of revenue coming in Pounds.

On the other hand, it is argued (E. Christie; A. Marshall) that there is no connection in reduction in hedging with the decrease in risk. According to the article, the majority of UK MNCs using Euro as functional currency stated that there is no reduction in hedging. Author of the report argues with this opinion. It is probable that questioned companies had different levels of trade with the Euro zone states. Insomnia plc has its majority of operations focused within the EMU zone, therefore the advantages of reduced risk will benefit in lower incentives for hedging. Moreover, hedging policies could stay unchanged due to the different types of risk (non currency) faced by the companies. According to the article, using Euro did not encourage companies to expand internationally, which illustrates currency exchange risk as only one of the factors influencing investment decisions.

Conclusion

UK joining the EMU will bring Insomnia Plc lots of advantages. Stable prices, elimination of the exchange rate uncertainty leading to cost savings on the cross-border transactions, price transparency, possible growth, easier accessible borrowing, higher stock liquidity and decrease in hedging are just the major benefits to the company. However, there are factors which can influence the corporation in a negative way including not always favorable price transparency or additional costs of change over. Similarly, using the Euro as a functional currency involves its advantages and disadvantages, but the last have greater power than in the case of joining the EMU. It is decided that main exposures of the company involve the exchange risk; therefore reducing this uncertainty will be significantly beneficial to the Insomnia plc in the short and long term.

References

Anon, An Analysis on Whether UK Should Join the Euro

Artis, M., The call of a common currency, Europe without Currency Barriers, paper no. 3

Buckley, A., 2004. Multinational Finance. 5th ed. Edinburgh: Pearson Education ltd.

Castle, S., 2003. Britain fights EU plan for children’s clothing tax.

Christie, E., Marshall, A., 2001. The Impact of the Introduction of the Euro on Foreign Exchange Risk Management in UK Multinational Companies. European Financial Management, Vol. 7, No. 3.

Currie, D., 1997. The pros and cons of EMU

HM Treasury (1997), UK membership of the single currency: An assessment of the Five Economic Test

Rose, A.K., 1999. Does a Currency Union Boost International Trade?

International Accounting Standards. ,2009,IAS 21, The Effects of Changes in Foreign Exchange Rates

Madura, J., Fox, R., 2007. International Financial Management. London: Thomson Learning.

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