Global Economy Entry by Foreign Firms

Question: Discuss about a Case Study on Entry by Foreign Firms? Answer: In an integrated global economy, the fortunes of national economy are no longer driven by internal factors but are increasingly being dominated by external factors especially global shocks. This is particularly so for developing countries whose extent of capital inflows and outflows especially in the emerging equity markets is severely dependent on the underlying macroeconomic strength of the developed nations particularly US and Eurozone. As a result the domain of economic policy making is increasingly becoming more challenging as the monetary and fiscal policies typically tend to become reactive to the global happenings which have profound impact on the domestic economy. This leads to enhanced level of vulnerability for the emerging economies which is most evident in the frequent fluctuation of exchange rate which to a large extent is driven by global factors. In this background, the aim of this essay is to explore the impact of international capital inflows on exchange rate determ ination in the context of emerging economies and thus comment on the implications for policymakers of these economies. In order to analyse the above thesis, it is quintessential to define the various constituents of capital inflows which are of significance for the discussion with regards to exchange rate. There are primarily four types of capital inflows that are likely to have an impact on the exchange rate namely Foreign Direct Investment (FDI), Foreign Institutional Investors (FII i.e. who invest money in domestic securities), remittances and raising debt or equity capital from abroad for domestic consumption by corporate and governments. In the period leading up to 2008 i.e. the global financial crisis, there was a substantial amount of capital inflows that were being invested in emerging economies particularly the BRICS nations on account of their superior growth prospects and sound economic fundamentals which is apparent from the graph shown below. Source: IMF (International Monetary Fund) There have been a plethora of studies which have tried to analyse the impact of FDI inflows on the domestic currency in the context of emerging markets. In an influential study conducted by Chakrabati and Scholnick (2002), it has been found that FDI inflows tend to result in the appreciation of currency in the short run. This is clearly on expected lines as FDI inflows would enhance the demand for domestic currency (as investment in the recipient nation can be only made in domestic currency) and thus the domestic currency would appreciate against the given foreign currency. However since FDI is typically meant to make a productive investment in the recipient country, the concerned money is not hot money and hence used for acquiring tangible assets which could further be used in production of a particular good or delivering a service. As a result, this does not cause much volatility in the exchange rate regime as FDI outflows are not very frequent as liquidation of existing assets is not easy (Campa, 1991). Additionally as is evident from the graph shown above, even at the peak the total FDI in emerging economies was $ 350 billion out of which nearly 33% was received by China alone. Since China has a pegged currency hence the huge FDI inflows do not have any measurable impact on Chinese currency while the remaining quantum of funds is not huge considering the size of emerging economies. Therefore in the short run, FDI do not contribute much to the volatility and determination of exchange rate in the emerging economies and hence do not contribute significantly to currency vulnerability (Chakrabati and Scholnick, 2002). In the aftermath of the 2008 global economic crisis, the West led by the US adhered to a exceptionally loose monetary policy with near interest rates along with pumping money into the system in the name of quantitative easing (QE). As a result of this ample liquidity available in the system, huge investments in the securities market of emerging economies were witnessed as these were much more resilient than the weak economies of the West (Fillingham, 2013). In this regard, it is prudent to take the example of India which is one of the largest emerging economies, placed just after China. The FII investment in the Indian capital markets is summarised in the data shown below. Source: SEBI Annual Reports (All figures are in INR crores) It is apparent from the above graph, that the highest FII inflows in the Indian stock market was witnessed in the year 2009-2010 and 2010-2011 i.e. in the aftermath of the global financial crisis due to ample liquidity available in the system with lack of attractive investment avenues. In this background, it is prudent to represent that currency movement of INR (Indian Rupee) with respect to USD which is depicted in the graph shown below. Source : Trading Economics Website From the above graph, it is apparent that as the global financial crisis reached its peak in 2008-2009, the FII which are primarily based in the West started liquidating their portfolios and pulling out money from emerging economies which is apparent in negative FII inflow in India. As a result there was a depreciation of Indian Rupee (INR) as is apparent from the graph shown since the demand for USD increased against INR thus causing appreciation of USD (Morgan, 2011). However after the central banks in the western countries intervened to pump huge liquidity in the system, then this cheap money started getting invested in emerging economies security market in the year 2010-2011. As a result the demand for the domestic currency increased, which was accompanied by a depreciation of USD and an appreciation of the domestic currency which is also apparent from the above graph where in the year 2010 and 2011, the INR has appreciated against the INR. Due to this appreciation the central ba nks in the emerging economies had to make regular intervention so as to assure that the interests of the exporters were safeguarded since global demand was also low (Gagnon et. al, 2011). Hence in Indias case RBI had to sterilise this massive inflows of USD by buying USD from the open markets. Further starting from 2013 onwards, the US economy has shown signs of recovery due to which the Federal Reserve in a systematic manner has reduced the support in the form of quantitative easing which officially ended in October 2014 (Monaghan, 2014). As a result of this, the supply of fresh dollars in the market has decreased which has caused an appreciation of USD and corresponding decline in the other currencies. Further since the macroeconomic fundamentals are improving in the USA, the foreign investors are withdrawing their money from emerging economies by liquidating their portfolios so as to invest money in the US economy. This has increased the supply of the currency of emerging economies and is causing their depreciation in the last 2-3 years which is quite evident from the graph of four currencies (i.e. Indian Rupee, South African Rand, Russian Rouble, Brazilian Real) of biggest economies. From the period beginning in 2013 to the present all these currencies have differentia ted by more than 20% and in some cases up to 40% (Kaltenbrunner, 2014). Source: Trading Economics Website Source: Trading Economics Website Source: Trading Economics Website Clearly this sudden depreciation of currency in a short span of time is a worrying signal for the central banks of these emerging economies and thus this issue was even raised in the G-7 summit in 2014. Most of these emerging economies (except China and Russia) run a sizable trade deficit and hence depreciation of currency further widens that trade deficit by making imports dearer and thereby is deteriorating the fiscal position of some of these emerging economies which further puts pressure on the currency to depreciate further and thus spiral into a vicious circle like situation which needs to be prudently managed (Kaltenbrunner, 2014). Another component of foreign capital inflow which can potentially impact the currency rate is the remittances particularly that which is made by the diasporas living abroad. India and China have the most widespread diasporas and hence receive the highest remittance. While fundamental principles of microeconomics may suggest that this inflow would cause appreciation of the local currency due to the increasing demand for the local currency. However the more prominent impact of remittances is primarily indirect and the direct impact is rather negligible. As a result of this money sent by diasporas, the amount of money with the domestic population increases which results in increased spending and demand for various products and services which fuels inflation. This inflation tends to cause depreciation of the domestic currency vis-a-vis the foreign currency especially if the inflation differential between the nations is significant (Chami et. al., 2008). For countries like India and China, the remittances despite being large are only a fraction of GDP and thus are absorbed by the economy without causing any inflation and hence the impact on the currency is minimal. However for smaller economies such as Vietnam, Cambodia where remittances as a % of GDP are significant, the economy cannot absorb the money and hence thus causes inflation which has significant depreciating effect on the economy (Ekanayake Halkides, 2008). Further with regards to capital inflows in the form of either government or corporate borrowings, usually the quantum of these are not large to impact currency rate and also they are usually regulated by the central banks and the government especially after the ill effects of the Asian economic crisis in 1997 caused primarily due to full capital convertibility of their corresponding currencies. It can be inferred from the above that for emerging economies that capital inflows does have a significant impact on the currency rate and thereby presents a challenge to regulators and exporter/importer due to increased vulnerability and underlying currency volatility. However for most emerging economies, capital inflows in the form of portfolio investments or FII route is the troublesome component since this is essentially hot money whose directional flow is more dependent on the global factors rather than domestic factors as has been witnessed in the aftermath of 2008 global economic crisis which has significantly enhanced bidirectional volatility in the underlying currency of all emerging economies. As a result going forward, it is imperative that the central banks and regulators need to augment their foreign reserves so that the currency exchange rates may be managed and thus kept in a range in the short run so as to not impact the interests of the economy in an adverse manner. Additionally reasonable restrictions on capital flows may also be placed in the interest of domestic currency stability but the same should be done so as not to adversely impacting the inflow of foreign capital which has a critical role to play in the economy of these emerging economies. References Campa, J.M. 1993. Entry by Foreign Firms in the United States under Exchange Rate Uncertainty, Review of Economics and Statistics, Vol. 75, No. 3, pp. 614-622. Chakrabarti, R. Scholnick, B. 2002. Exchange Rate Expectations and Foreign Direct Investment Flows, Weltwirtschafiliches Archives, Vol. 138, No.1, pp. 1-21. Chami, R., Barajas, R., Cosimano,T., Fullenkamp, C., Gapen, M. Montiel,P. 2008, Macroeconomic Consequences of Remittances, IMF Occasional Paper No. 259, International Monetary Fund, Washington Ekanayake, E.M. Halkides, M. 2008. Do remittances and foreign direct investment promote growth? Evidence from developing countries. Journal of International Business and Economics,Vol. 13, No.1, pp. 23-32 Fillingham, Z. 2013. Quantitative Easing and Emerging Markets: A Crisis in the Making?, Geopolitical Monitor, Available Online from https://www.geopoliticalmonitor.com/quantitative-easing-and-emerging-markets-a-crisis-in-the-making-4885/ (Accessed on August 29, 2015) Gagnon, J., Raskin, M., Remache, J. Sack.B. 2011. The Financial Market Effects of the Federal Reserves Large-Scale Asset Purchases. International Journal of Central Banking Vol.7, No.1, pp. 343. Kaltenbrunner, A. 2014. Volatile international capital flows in emerging economies, The Broker, Available Online from https://thebrokeronline.eu/Blogs/Employment/Volatile-international-capital-flows-in-emerging-economies (Accessed on August 27, 2015) Monaghan, A. 2014. 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