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There are different bases of classifying exchange rate. One of the bases is classifying the exchange rates according to the degree on which the government controls the rates. Examples of exchange rates that fall under this classification are fixed exchange rate, freely floating exchange rate, managed float exchange rate, and pegged exchange rate.
Fixed Exchange Rate
A fixed exchange rate embraces the approach of converting one currency to another directly. A good example of this exchange rate is the Bretton Woods, which demanded that countries should compare their exchange rates vis-à-vis the $US and should agree maintain to their currency rates at + or – 1%. In fixed exchange rate approach, the central government is expected to be committed and maintain a given exchange rate. This is so because the exchange rate aims at presenting a scenario whereby all member countries have the same or close inflation rates.
In addition to this, fixed exchange rate dictates that monetary policies of different member nations are subordinate to the general exchange rate policy. In the Bretton Woods system whenever the exchange rate was untenable, it was done away with and a new rate introduced. This new rate was the last resort and thus all member nations were expected to comply. Some other checks in this exchange rate include prohibition or restriction of some remittance types such as royalties or dividends, using the direct foreign investment system, overseas portfolio controls, and restrictions on imports. On the other hand, it required that hard currencies be surrendered to the central bank and limited prepayments on imports, and foreign borrowings were restricted to some given minimum and maximum maturity dates.
Fixed exchange rate had several advantages including:
- It provides international prices stability for trade conducts. The stability in prices reduces business risks as well as encouraging trade.
- It requires all its users to work within the bounds of restricted fiscal and monetary policies.
- This regime demands that the central bank retains high amounts of international reserves to enable it defend the rate.
- This regime is flexible and thus gives room for gradual changes.
Some disadvantages include:
- This regime is challenged by the emergence of complex derivatives in recent years.
- The regime has failed to the degree of a standard comparative advantage of the nations, and this has lead to inefficient resource allocation in different nations.
- The regime does not give room for automated correction of national imbalances.
- Floating Exchange Rate
This exchange rate assumes that market participants will adjust to changes in economic parameters. It insists that participants will adjust in their current currency as well as predicted or future currency, which will lead to a new equilibrium in case of disequilibrium. In addition to this, this regime expects the market rates to fluctuate unpredictably. Floating exchange rate can either be a managed floating or a pegged floating.
In managed floating, the rates exchange daily, but the Central Bank makes efforts to influence exchange rates in different countries through buying and selling local currencies. This is also called dirty float, and it is used in nations such as Singapore, India, and Thailand. On the other hand, in pegged floating, the currency is maintained within given fluctuation range around a common rate, which can be adjusted periodically. Some nations using this regime include China, Saudi Arabia, and Ukraine. This regime has advantages as well as disadvantages. Some advantages include:
- It has an automatic way of adjusting the balance of payment
- It has free internal policy
- So far, this system has not experienced any crisis.
- This regime is extremely flexible and thus, welcomes changes.
- It has a relatively low foreign exchange reserves.
Some disadvantages of this regime include:
- It has a lot of uncertainties because the currency changes day after day.
- The uncertainty, which is an inherent feature in this regime, has discouraged investors in countries using it as an exchange. Consequently, such countries register relatively low foreign investors.
- It lacks discipline as far as economic management is concerned.
Scandals in the Banking Sector
Since 2008, several banks in Britain, which have ever since been centres for world business, have faced several allegations of massive misbehaviour. This has lead to tarnishing of the banks’ reputation. The result of this poor conduct of the banks is tainted London reputation and thus it calls for strict regulatory measures.
Top on the misconduct list was the United Kingdom Barclay Bank. The bank management deliberately manipulated vital market interest rates. As a result, the chief executive officer of the bank, Bob Diamond was forced out of office after the British and the United States of America authority imposed a $453million charge for the misconduct. Some other banks were suspected of having taken part in this act, and thus investigations are still underway.
Another bank that exhibited misconduct was HSBC, a tremendously popular London bank that has had a good reputation over years. Allegedly, the bank took part in stopping the Mexican drug money laundering and as a result, it is facing a fine of more than $1billion. The financial report issued by JPMorgan Chase & Co. in May, 2008 disclosed that the bank had a trading loss of $2billion, which later rose to $5.8billion. This made the U.S. representatives; through the House Financial Services Committee conclude that seemingly, every large bank disasters occur in London. The Standard Chartered Bank, which is supposedly the most profitable bank in Britain, was also accused of laundering Iranian money.
Several banks in Britain are currently trying to find the solution to customer complaints to have wrongly bought payment protection insurance. Besides this, there is rising fear that the mis-selling scandal might arise again in the future. Other fears are rising due to the issue of mortgage loans, which do not attract monthly capital repayments from borrowers. Interest-only mortgages were exceedingly popular from mid 2000s to 2008 as banks tried to increase the cash homebuyers could get. Consequently, banks gave large amounts of loans to customers who could not pay the accumulated amount back. So far, there is remarkably little evidence that interest-only loans are being mis-sold due to the looming regulations that intend to encourage responsibility among lenders by ensuring that they own up in paying their loan interests.
Banks resorted to this form of financing because they had failed to obtain finances from credit markets. Initially, banks that were affected by this scandal were those that were engaged in home construction through mortgage lending. This system of financing through interest earned from mortgages plunged the banks into severe financial states since between 2007 and 2008; more than 100 mortgage lenders were bankrupt. This crisis hit its climax in September 2008 when several affected financial institutions were taken over by the government. For instance, the bank of America took over Merrill Lynch and the US treasury took over Fannie Mae and Freddie Mac. The government put these regulatory measures in place to prevent further crisis.
It is crucial to note that apparently, regulation of banks and other financial institutions is cheaper than monitoring efforts. Regulations subjects financial institutions to some restriction, guidelines, and requirements to encourage best practices. The government has a responsibility of ensuring that all banks within the country are regulated. However, some governments have found it exceedingly difficult to regulate the banks. This is because in some nations, some banks remit too much revenue to the government to an extent that if the banks quit the business then the government will face extremely hard economic times. Additionally, some senior politicians in some nations are shareholders of established banks. In such cases, regulating such banks becomes a problem because of the political influence.
Emerging Market Economy (EME)
EME is used to refer to an economy operating within a low to a middle per capita income. This economy grows at a faster rate than a high per capita income. This is because EME has a high potential to grow since it is in its transition stage from a closed market to an open economy.
Emerging markets have several common phenomena. In most cases, these markets have a lot of government regulations while their gross domestic product (GDP) is below average, that is, one-fifth of a developed nation’s GDP. Normally, there are limitations to ownership of shares by foreign investors and conduct their businesses at irregular trading hours. On the other hand, there are usually restrictions on dividends, interest income, or capital gains repatriation.
There are several emerging markets in the world including Brazil and China. This two contrasting emerging markets have different characteristics. China is the most populated country in the world and his confirms that there is a ready market for different commodities from investors. After introducing economic reforms in China in 1978, its market became the fastest growing globally. Presently, this market is the second-largest economy in both purchasing power parity and nominal total GDP, besides being the largest exporter and the second largest importer globally. On the other hand, the Brazilian economy is not as fast as that of Chinese. It is the seventh largest and the sixth largest growing market economy by purchasing power parity and nominal GDP respectively. To attain this level of economic growth, Brazil used economic reforms. Besides this, Brazil is one of the 17 Mega diverse nations and a home to spectacular natural environment and other natural resources in protected habitats.
Multinational companies should consider investing in emerging markets as a first priority. Just as, explained above, the upcoming of emerging markets has signalled a massive global market economy power shift after the industrial revolution. For instance, some of the current largest global markets were nowhere 20 years ago. Russia was fully under Iron Curtain while Brazil was literally an economic bucket, and China had just come out of Cultural Revolution 20 years ago, yet they are leading markets today. This, therefore, implies that there are several benefits of emerging markets over established markets. These benefits are:
Emerging markets grow at an exceptionally fast rate. At the start of the investments period, investors might have low profits, but in the long-run profits will rise drastically. Similarly, there might too much barriers in this market during the first stages of investments, but the challenges reduce gradually as the market grows in size. Secondly, emerging markets are destined to dominate the world economy. It is estimated that, in the next ten years, emerging markets will add more than one billion consumers to the world market. Thirdly, the fact that emerging markets grow at a remarkably fast rate proves that the GDP of the markets will increase at an equally faster rate. This only confirms that there will be ready and ever increasing market for the investors. In the next 30 years, the compounded GDP of emerging market economies will be much more than that of established markets in developed economies. It is also estimated that, in the next 50 years, emerging markets’ GDP will be twice as much as the GDP of today’s economy.
Besides the advantages of investing in emerging markets, there are several risks that investors face in these nations. Political instability in some of these nations is a substantial risk to any investment. Predicting what might happen in these nations as far as politics is concerned is an issue of serious concern. It is usually extremely difficult to of the future political state in these nations. Internal wars, as well as, external wars, political coups, and segregation along political lines are some of the common phenomena in many nations with emerging market.
On the other hand, some of these nations do not have stable economic policies. Different governments have come in with different economic policies to safeguard their interests. A government might decide to drop an economic policy used by the previous government and initiate a new approach without involving all the stakeholders, especially, the investors in the decision making. At the end of the day, foreign investors end up losing a lot since they have less control over policy making in the nations. These are some of the factors that companies have to consider before deciding to invest in any emerging market.