Task 3

Fluctuations in the value of a foreign currency can be explained by these

models which includes international parity conditions, balance of payment models,
and the asset market model. (Wikipedia, 2014) None of these models has succeeded
in proving the volatility of the foreign currency value in the long run because the
world currency market is always under a cloud of large and ever changing mix of
events. Supply and demand factors constantly shifts and the value of one currency in
relation to another also shifts accordingly to the events. There are no other markets
that includes as comprehensive as foreign exchange market of the worlds changes at
any given time. (Lyons, 2011)
The value of any foreign currency is not influenced by a single element rather
than several which can be classified into economic factors, political conditions, and
market psychology. Economic factors includes economic policy and economic
conditions. Economic policies are circulated by government agencies and the central
bank and it comprises government fiscal policy and monetary policy. While economic
conditions are revelations of the economy through economy reports and indicators
such as governments budget deficit or surplus, balance of trade levels and trends,
inflation level and trends, economic growth and health, and economy productivity.
Political conditions are those internal, regional, or international political events that
could have a profound effect on the value of currency. Political instability negatively
affects a currencys value, for example THB dropped 0.23% to 32.68 a USD in
December 2013, a four year low since June 2010 while the SET index also dropped
1.23% as the protest against Yingluck Shinawatra the Thai Prime Minister then, went
on. (Gayathri, 2013) Similarly, a rise in an opposition coalition with a better
promising ruling of the government can positively affect its value. Market psychology
affects the currency value in variety of ways such as flight to quality, which is a type
of capital flight to a perceived safe haven as a result of unsettling events. Besides,
traders also study long term trend of a currency by analysing longer term price trends
as a result of political or economic trends. (Murphy, 1999) Market also practice buy
the rumour, sell the trend which is a market truism where the currency tends to
reflect the impact before an event even occur and react oppositely when it passes,
hence causing the market being oversold or overbought. Also known as a cognitive
bias known as anchoring.
For better understanding lets create a scenario to assume that there is a simple
two way relationship between two major trading partners based in China with a MNC
from the US. The Chinese government has recently depreciated its currency to 6.1450
Yuan a dollar, down 1.5% since the beginning of the year, which has reversed the
long running trend of gradual appreciation towards the USD during the past eight
years. The reasons behind the PBoC engineered policy is to punish the speculators,
restrain huge capital inflow, and to assume some control over capital flows to
generate inflationary pressure. (Yan, 2014) For a multinational corporation that trades
by importing goods from China to the US, it is indeed a positive event for the
importer. If the supplier in China is being paid by Yuan, the depreciating Yuan means
the MNC costs of importing goods to the US has lowered, which will return higher
earnings for the MNC in US. The extent of the foreign earnings depends on the
volume of goods imported by the US Corporation, the higher the volume, the higher
the savings on cost. However, the sharp depreciation of a currency may not
immediately result in more savings on cost for the importer MNC as the importing
activity may come in a form of debt. If a MNC repaid their supplier later at a higher
appreciated exchange rate later, it shows that there is actually less savings than first
thought. Such event is an example of transaction risk exposed to MNC operating
internationally. (Giddy and Duffey, 1992) Transaction risks can be mitigated by
hedging.
Besides, fluctuations in exchange rate also affect a MNCs value other than its
earnings. Any assets and liabilities held in the denomination of Yuan by the US MNC
will be directly impacted by the depreciation. The depreciation of Yuan means that
the asset held by the US MNC in China will suffer a lost in their asset value. On the
other hand, the liabilities held by the US MNC in China will be valued less as Yuan
depreciates, hence it is a gain for the MNC. However, to decide whether the
depreciations will be a net gain for the MNC depends on whether the MNC holds
more liabilities than assets, or its opposite. For example, if the MNC is in the
banking sector, the weakening Yuan directly impacts the US banks assets and
liabilities denominated in foreign currency, off-balance sheet exposure and non-asset
based services. (Martin & Mauer, 2013) However as stated above, the direct effect
can only be seen if the amount of foreign currency assets and liabilities held differs.
Besides it also has an indirect effect for the MNC bank on its demand for loans,
competitiveness and also other banking aspects. When the exchange rate depreciation
has a positive impact on borrowers, the quality of the bank assets will not deteriorate.
However a depreciating exchange rate might adversely affect domestic firms instead
hence deteriorating the banks asset, causing insolvency due to credit risk and
liquidity risk. (Sahminan, 2004)
For the second scenario, lets assume that we are a MNC based in US looking
to venture into the Central and Eastern Europe (CEE) market. The CEE has always
been in a political turbulence since 1990. It is reflected by relatively frequent
government changes and shuffles, is strongly interrelated with the democratization
process which took off since 1990. (Gurgul & Lach, 2013) Generally, economists
usually stress that political stability may slow down economic growth through
investment and speed up inflation, as MNC opt to look elsewhere where the political
environment is safer and more stable. However, there is a silver lining behind this
political instability. There are a few reasons why the MNC can benefit from this
political instability in the CEE. First, the political turmoil in CEE is causing the local
currencies to weaken, hence providing a cheap opportunity for MNC to venture into
their market. (Bozadzhieva, 2012) With the local government also actively seeking
FDI, MNCs can expect to acquire more local assets at a discount. Besides, the local
government in the CEE is likely to push themselves out of the Eurozone crisis, which
is also the only way to push Europe out of the high debt low growth cycle. MNC can
also expect better support from the government and less strict regulations for FDI.
The political instability also provide consumer some breathing space by delaying high
taxes introduction. With a higher consumer spending power and a weakening inflation,
there is an opportunity in the fast moving consumer goods market for the MNCs to
venture.





References
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