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euro Exchange Rates and International Trade I. INTRODUCTION Objective The general objectives of this study are to describe recent trade problems and examine why these problems are related to, and affected by exchange rates. The study first examines the exchange rate and how it is determined. The study will explore, in detail, the agencies that determine these rates. This study will also present the pros and cons of different prices of goods and services in different countries. Specifically, this paper: (1) defines recent trade problems and how they are affected by the exchange rate; (2) describes the steps taken within the agencies that determine the exchange rates; (3) examines the impact of these rates, both good and bad; (4) analyzes the costs of similar goods in the U.S. and in foreign markets; (5) discusses the pros and cons of the exchange rate and how it affects trade; (6) examines various exchange rate systems: floating, fixed, and dirty floating. Limitations of the Study The topics of exchange rate and trade both have a variety of factors that cause changes. As with any study that attempts to explore current developments in the economy, it is hard to keep information current. It is also virtually impossible to report on the status of every single government that is involved in the exchange market. One of the limitations of this study is to report on up-to-date values of currency while choosing a sample of governments that accurately represent the world economy. Therefore, the solution was to use stastical figures from magazine articles and books that were written within the previous year. Also, the countries that were chosen to be studied are considered to play a significant role in the exchange rate market. Plan of the Paper This study first examines the relationship between the exchange rate and trade. This examination includes a definition of the exchange rate, an explanation of how the rate is determined, and a detailed description of the agencies involved in determining the exchange rate, including the United States Treasury and the Federal Reserve Bank (the Fed). The next section defines and evaluates three different exchange rate systems - the fixed, the floating and the dirty floating. The third section defines trade problems, how they are affected by the exchange rate, and also how trade is affected by the exchange rate. Finally, this study analyzes foreign cost in terms of the costs of similar goods in foreign markets and how similar costs are possible. II. FOREIGN EXCHANGE RATE Definition of the Exchange Rate The foreign exchange rate is the price relationship between the currencies of two countries. How the exchange rate is determined, the agencies involved in determing the rate, and different exchange rate systems are outlined throughout this paper. Determining the Exchange Rate The exchange rate is determined by the supply and demand of services and goods traded between countries. Various agencies monitor the rate and intervene when needed, in order to counter disorderly market conditions. Intervention involves buying dollars and selling foreign currency, coming from the Exchange Stabilization Fund (ESF) of the Treasury, to support the dollar’s price against another currency. Conversely, the Fed will sell dollars and buy foreign currency to increase the strength of the dollar. The United States Department of Treasury, the Federal Reserve, and central banks are the primary agencies that become involved if intervention is needed.1 Although the U.S Treasury has been assigned primary resonsiblity for international financial policy by Congress, the Treasury usually works alongside the Federal Reserve System when deciding to intervene. These interventions do not occur often. Rather, they are implemented as an attempt to shift supply and demand on a long-term basis. Agencies Involved in Determining the Exchange Rate The Federal Reserve Bank and the United States Department of Treasury are primarily resonsible for keeping records on the Balance of Payments, which relates directly to the determination of the exchange rate. These agencies are responsible for keeping track of the flow of money that is used to purchase merchandise, securities, and services, as well as payments made to other countries by the United States. In addition, these agencies are responsible for determining when to intervene in the exchange rate. The International Monetary Fund (IMF) also attempts to intervene when the exchange rate needs to be stabilized. During the Asian currency crisis of 1998, the IMF attempted to intervene using common tactics such as devaluing currencies, pushing up interest rates and cutting public spending. Although opinions vary, some believe that the IMF’s intervention actually made the crisis worse. Why? The high interest rates and cheap currencies had self-defeating consequences. For example, Korea now has to buy $60-$65 worth of goods from abroad in order to export $100. These Korean companies cannot afford to buy imports and therefore also cannot take advantage of the cheaper labor that was a result of the intervention.2 Balance of Payments and the Exchange Rate The most important factor in determining the exchange rate is the Balance of Payments, which is an accounting record of all international transactions for a particular country during a specified time period. The Balance of Payments is figured using two primary accounts: the current account and the capital account. The current account is further subdivided into four accounts: Merchandise Trade, Services, Income Receipts, and Unilateral Transfers. The Capital Account is also further divided into four accounts: Direct Foreign Investment, Portfolio Investment, Bank Related Flows, and Official Reserve Transactions. In theory, the current account and the capital account should balance and the sum of the balance of payments should be zero. However, due to statistical discrepancies, accounting conventions, and exchange rate movements that change the recorded value of transactions, the balance is typically a deficit or surplus. Some of the factors that can affect the Balance of Payments occur when, for example, the United States buys more goods and services than it sells, and must finance the difference by borrowing, or selling more capital assets than it buys. Any transaction that causes money to flow in or out of a country is included in the Balance of Payments. Because the exchange rate is determined by the supply and demand of a country’s currency, it is directly related to the Balance of Payments. To help clarify the format for which the Balance of payments is determined, the 1993 U.S. Balance of Payments statement is included on the next page. III. EXCHANGE RATE SYSTEMS Fixed Exchange Rate In 1944, a group of representatives from throughout major industrialized countries, met in Bretton Woods, New Hampshire and established the fixed rate exchange system, known as the Bretton Woods Account. This system was developed as an entirely new international financial system as an attempt to curb fluctuations in currency values. The exchange rates were fixed using the U.S. dollar as the official reserve currency, and a country’s central bank had to buy or sell supplies of its currency using dollars, in the event that the exchange rate strayed from the pre-determined rate. 3 Floating Exchange Rate The Bretton Woods fixed exchange system stayed in effect until the early 1970’s, when it collapsed and was replaced with the floating exchange rate. This system did not impose a pre-determined exchange rate. Instead, the exchange rate is allowed to change and fluctuate as individuals, businesses, banks, and governments buy and sell the currencies of other countries. This creates a rate that is constantly changing - not only by the day or by the hour, but by the minute. Dirty Floating Exchange Rate The floating exchange rate can be further divided into two forms: clean or dirty floating. Clean floating refers to a rate in which the central bank does not intervene to affect the exchange rate. Dirty floating, which is more commonly practiced than clean floating, involves intervention from the central bank to influence the exchange rate. One of the advantages of a floating exchange rate is that although an internal crisis is possible, there will never be a foreign exchange crisis.4 IV. TRADE PROBLEMS Definition of Trade Problems As mentioned earlier, when the Bretton Woods system failed, the United States established a floating exchange rate, although many economists feared that a floating rate would be harmful to the operation of international trade. A floating rate was viewed as highly unstable and it was thought that the indirect effects of this instability would limit stimulation of trade. Without stability in trade, the supply and demand required to keep the rate at equilibrium would be disrupted and create an exchange crisis. Trade Problems as a Result of the Exchange Rate The exchange rate creates a problem in trade when a currency becomes overvalued, either as a result of the inflation rate remaining higher than that of its trading partner, or because the currency to which it is adjusted is rising and dragging the lower currency up. This overvalue leads to poor comptetitiveness - resulting in a loss of trade. In 1998, United States exports declined in almost all product groups, including agricultural items, industrial materials, capital goods, and even exports of services. To compound this problem, the U.S. experienced an increase in the number of imports. These two factors are crucial when explaining the U.S. trade deficit; however, the shifting of exchange rates has also played a part in the erosion of the United States competitivness in the global economy. In light of these problems, the dollar still remains strong. Trade problems are not only a result of situations in the United States, but as a result of the stability (or instability) of the exchange rate in other countries as well. A floating exchange rate works well in the U.S. because of the strength of the dollar. However, some countries have attempted to use an “adjustable peg” system, in which their currency is adjusted to that of a larger economy, with the option to adjust when underlying conditions change. This system has not proven to be beneficial, as in the cases of Brazil and Russia in 1998-99. Both of these countries experienced exchange-rate overvaluations and were forced to abandon their current exchange system. 5 This trend can be seen in the chart below. The economic crisis in Russia began to unfold in August of 1998, at the same time that the Ruble was decreasing in value. As the Ruble became increasingly overvalued, the Russian economy experienced more strain. This kind of economic crisis leads to an increase in imports from these countries and a decrease in exports. Source: 1999 Country Report on Economic Policy and Trade Practices Exchange Rates and Their Affect on Trade The exchange rate is one of the leading factors when countries decide what products and services to import and what products and services to export. While it is not the only factor that is considered, the exchange rate affects the ratio of the prices and allows countries to decide whether it would be profitable or not to import or export certain goods. For example, if the United States was considering trade with the U.K., four factors would be considered when determining which products would be imported and which products would be exported: 1) the price of the goods in U.S. dollars, 2) the price of the goods in U.K. pounds, 3) the U.K. price in dollars at the exchange rate, and 4) the ratio of the U.S. price to the U.K. price. The following chart illustrates the hypothetical cost to sell soybeans, gloves, and stereos in the U.S. compared to the U.K. Using the current exchange rate converts the cost of the goods into a common denominator, and allows each respective country to figure price differentials that are in their favor. It is assumed that there is a competitive market. (The prices and exchange rate used are hypothetical - not the actual current rates.) Price and Cost Differences As the chart above shows, when comparing soybeans and gloves, the price of gloves in the U.S. are half the price of gloves in the U.K. The price of soybeans is similar. The price of stereos, however, are in favor of the U.K., since the cost 300 dollars in the U.S. and would cost 180 dollars in the U.K. As a result of these differences, the U.S. would be more likely to export gloves and soybeans, and to import stereos from the U.K.6 If the exchange rate were to change, the prices of goods in dollars would also change, possibly creating change in the desire for countries to import or export certain goods. For example, if the exchange rate between the U.S. and the U.K. grew to $10 per pound, than the cost of goods in the U.K. would become very expensive, and the U.S. would want to export all goods to the U.K. The Exchange Rate and the Strength of the Dollar Another factor when examining the effects of the exchange rate on trade is the strength of the dollar. Economists have varying opinions on the pros and cons of a strong dollar and a weak dollar. Some experts believe that a weak dollar could be the first step toward financial market stability. They believe that an orderly decline in the dollar accomplishes several things crucial to getting the global econom back on its feet. This includes lifting price power and boosting exports in the manufacturing sector, relieving pressure on economies with dollar-pegged exchange rates, lifting the export competitiveness of emerging Asian nations by providing a currency advantage over Japan, and help redirecting capital to non-dollar investments, which is a crucial step in restarting hurting economies.7 Those with opposing viewpoints note that a weakened dollar creates inflation, which leads to a variety of problems. Inflation causes the price of all products to increase - including materials exported from other countries. As inflation increases, products that the U.S. exports do not bring in as much money, which conversely affects trade. How Economic Crisis in Another Country Affects the United States Earlier in this paper, the negative impact of the exchange system on the Brazilian and Russian economy was explored. While this impact was critical from an internal standpoint, the effects of these countries financial crisis on the United States can also be examined. The economic crisis in Brazil is a good example of how problems with the exchange rate in any particular country creates problems in economies across the world. In the past, U.S. banks have lent Brazil money. Outstanding loans to Brazil made by U.S. banks and companies total over $27 Billion. U.S. companies have more invested in Brazil than anywhere, other than Canada and the U.K. (405 of the Fortune 500 companies have Brazilian subsidaries) However, the crisis does not only affect the banks and companies that loaned Brazil money. The effects filter down into the American public - in their 401(k) plans and their paychecks. Essentially, because of the interconnectedness of the world economy, consumers end up paying for a portian of Brazil’s debt (albeit how small). 8 V. THE TRADE DEFICIT: PROS AND CONS Benefits of the Trade Deficit While the trade deficit is generally seen as a negative, many economists, as well as members of the Clinton administration, are aware of the benefits of a trade deficit. The primary reason that these people believe that the trade deficit can be a pro, not a con, is that they have concluded the trade deficit has nothing to do with how competitive American business is. They realize that the trade balance is not a function of how good our products are, but rather of the gap between how much we save and how much we invest. In today’s economy, private savings remain low and corporate investment has increased tremendously. These investments have to be financed in some way, usually in the form of a loan from someone else’s savings. (foreign money). 9 A second factor that can be examined is the fact that the activity of exchange rates and interest rates in other countries can affect U.S. exports and imports. In Asia, during their currency crisis, their currencies sank and interest rates rose. Investors become cautious, and choose to invest in safer economies, such as that found in the U.S. As Asian currency becomes further devalued, the dollar becomes stronger and imports are less expensive, creating a desire to buy U.S. imports. This can cause a rise in the trade deficit. However, a closer examination of the deficit reveals that although the deficit is indeed higher, the gap in imports and exports is largely due to an export drop, rather than an import surge. Negative Impacts of the Trade Deficit Benefits of the trade deficit can be found, and the thought that a large trade deficit is a problem is not entirely correct, there are also valid reasons as to why the trade deficit is not entirely beneficial. The Organization for Economic Cooperation and Development estimates that by the year 2000 the U.S. trade deficit will grow to almost $200 billion. One of the principal disadvantages of the deficit is that the deficit is often blamed for loss of jobs. In 1996, $1 Billion value added to U.S. manufacturing cost 14,000 jobs nationwide. Also, the trade deficit supposedly leads to greater international liabilities. As the U.S. funds their saving with foreign money, they become more reliant on those countries. VI. DIFFERENT EXCHANGE RATE SYSTEMS Analyzing the Cost of Similar Goods in Foreign Markets There are quite a few variables that can be analyzed when looking at the cost of goods in foreign markets. Not only does the exchange rate vary the costs of trade, but every country has different tariffs, trade sanctions, and barriers that they choose to impose on their import and export markets. For example, the import and export market in agriculture between Japan and the U.S., and China and the U.S. has undergone numerous changes in the past few years, including the import of rice. China, which describes its exchange system as a managed float, continues to impose barriers on the importing of U.S. good and services. In 1996, China announced a new tariff that would apply to agricultural items, such as rice. However, as of late 1998, they had still not announced the specifics of this tax, which complicates trade in these goods. Japan has also imposed tariffs and barriers to restrict trade. While it has reduced many of its formal tariffs, Japan still maintains control by imposing nontariff barriers. Japan has also begun to import rice into it’s country. However, rather than introducing the rice to the country’s consumers, the rice is stockpiled for food aid to third world countries. VI. CONCLUSION The exchange rate is one of the primary factors in the business of international trading. While there have been system changes in the United States, from the Bretton Woods to the present floating rate; and there are differing systems that are implemented throughtout the world, the fact remains that the exchange rate is the basis for an amazing amount of financial decisions - including trade. Economists will argue over which system is best, but there is not doubt that whatever system is chosen will still have to be able to withstand the constant fluctuations in supply and demand. In the past few years, the world has seen supposed stable markets plummet after an overvaluation of their currency. Brazil and Russia are just a few of the countries that were affected - Mexico, Asia,Thailand, Malaysia, the Philippines, and Indonesia are other countries who have had to overhaul their exchange system. Right now the dollar remains strong. However, the plight of these countries not only creates an internal crisis, but it creates a small amount of panic throughout the world. Investors who are cautious become concerned and quickly shift their investments. This movement creates a domino affect through the exchange rate, interest rates, and trade balances between countries Bibliography:

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