Economy Changing Paradigms In Global Financial Markets Finance Essay - Free Essay Example

Global financial melt down in the recent decade have forced the governments of the rest of the world to think outside of the Dollar and triggered the need for a new global non-dollar financial system. A number of factors like 9-11 attack, abnormally low interest rates causing sub-prime crisis, flaws in regulatory side- introduction of the market risk amendment in 1996 etc have highlighted how Americans economic problems wreck havoc on other nations globally. US was the significant contributor for this crisis yet US simply printed fiat currency and exports inflation to oil consumers by keeping dollar cheap while draining resources backwardly.. Barry Eichengreen (2009) says that inspite of this global credit crisis, the dollar has benefitted from it and has strengthened against virtually every currency. Countries with low interest rates benefitted from this volatility for carrying out trades as the borrowings were repaid. It also researches that investors got back to traditional dollar considering it to be safe haven currency. Considering the wide number of market participants using dollar, dollar would continue its dominance. On the other hand Dorothe Enskog (2009) research highlights that there is a visible impact that the declining wealth of creditors nations with major victims being China, Japan, OPEC, and the Asian NIEs. Central banks have incurred losses on their holdings of US securities and have accelerated the diversification of their dollar portfolio. As per Resenweig (2009) in November 2009 India purchased 200 tons of gold to its reserves fearing that the US dollar may weaken. China and Mexico followed India and replaced their US reserves by gold. Likewise global investors may also react in similar manner. And sooner or later there will be a drift away from dollar to any other currency. Given this volatility in financial economy, considerable research is being done in analyzing delineating from dollar and moving to a non dollar economy. The challenge is that there are other countries that are tightly coupled with the dollar that it will be extremely difficult and costly for them to decouple from dollar. This paper reviews the historic and current foreign exchange reserves, gross domestic product, foreign exchange rates, current account balances, portfolio investments and other economic factors to analyze the feasibility of this transition. Literature Review The historical evidences of how the combination of international economic political power and convenience of use have brought about the evolution of reserve currency status for any currency. Prior to 1870 gold and silver were used for international transactions. Post that Britain was the single most important single participant of capital account transactions and became the principal currency. However World War I brought about a fatal blow to sterlings reserve currency status and US dollar emerged as an alternative to Pound Sterling. In 1917 Britain suspended convertibility of sterling into gold. Post World War I, US emerged as a net creditor having large current account surpluses and recycled it though dollar dominated loans to foreign governments. Roubini, Nouriel (2009) study also includes the history of dominance of financial currency that started with the John Maynard Keynes proposing 60 years ago an international currency called Bancor, based on 30 representative commodities. After World War II, international financial system established the Bretton Woods in 1944, a fixed-exchange rate regime after which France decided to bring in the dollar as a global reserve currency. And since then dollar has been the worlds most widely used currency with US being the most dominant economies. In 1960s Western European countries restored convertibility of their currencies for current account transactions and started accumulating US dollars thus raising first question against dollars reserve status. This problem was covered by a study by Triffin who said that when the foreign holdings of dollar exceeds USs gold holdings, the credibility of US commitment to convert gold at fixed price will no longer hold valid. US will then be forced to adopt deflationary policies for dollar value preservance. This is known as Triffins Dilemna. Since then the US dollars reserve status has been questioned a number of times. In 1967 SDR[1]was created to solve the Triffins Dilemna and to support Bretton Woods system of fixed exchange rates to alleviate the shortage of U.S. dollar and gold reserves in the expansion of international trade. Zhou (2009) has emphasized on the creation of an international currency unit, based on the Keynesian proposal and stated that the scope SDR should be broadened to enable it to fully satisfy the member countries ´ demand for a reserve currency. International and Reserve Currency Dollar fulfills all the necessary roles of a reserve currency Medium of Exchange : Required by central banks to manage unwanted foreign exchange fluctuations of their domestic currencies caused by outflow and inflow of capital by private bodies Unit of account : Required by countries for managing inflation and domestic monetary policy Store of value: Acts as self insurance for any balance of payment crisis and exchange rate instability. Dollar also possesses the essential characteristics and conditions required for any currency to classify as the international currency Economic Size: Substantially large share of world output and trade. Creditor Status : Price stability and overall macroeconomic stability Developed Financial System Offers high liquidity and greater degree of financial market development Network Externalities : Self generating demand of the international currency Craig Elwell (2007) in its report to the US Congress suggested that all these factors would continue to exist for quite a sizeable period along with dollars global availability and full convertibility. Areas of concern Global financial turmoil has caused serious imbalances in the economic stability especially in the last decade. According to the US Congressional Budget Office, the US budget deficit is anticipated to triple from USD455 billion (bn) to USD1.75 trillion (tr) (or 13% of gross domestic product (GDP)) in the year ending in September 2009 (Source IMF). Consequently the financiers of US current account deficit i.e. Japan, Europe, China and now emerging countries have felt the need to explore alternatives to dollar. USDs share in total world foreign reserves has declined from 72.7 percent in end-June 2001 to 62.8 percent as of end-June 2009 (Source: Federal Reserve) Figure 1 Current composition of World Foreign Reserves, Source: IMF Philip D Wooldridges key emerging markets have accumulated vast stockpiles of foreign exchange reserves. Most are dollar-denominated and siphoned to US assets. Chinas alternative to US Dollar as a reserve currency Suzanne McGee (2009) , Humpage (2009) and Zhou (2009) said that China is considering the diversification of reserves away from the US dollar; convincing the rest of the world through political and economic agencies of adopting a new global currency; and encouraging the international use of their own currencies. US economy is under-going important structural changes, which adds haze and mist to the prognosis. US may experience higher inflation than the rest of the world, which erodes the dollars purchasing power Figure 2 -Foreign Reserves held by countries, Source: IMF Exploring Euro as an alternative Chinn, M., Frankel, J. (2008) analyzed the possibility of the Euro taking over dollar as the as Leading International Currency. They concluded that if dollar precipitates and looses it position as the leading international currency, globally banks would considerably loose considerably their current stand causing the end of economic and political development supremacy. All the current privileges like accepting short term deposits at low interest rates in return for long term investments (easy financing of large US deficits) and that too at reasonable higher than average rate of returns would also be lost. They have however suggested that when pound lost its stand to dollar in last century, there is a possibility that Euro may surpass dollar. Fritz, Ratto and Int (2008) analyzed the QUEST III model (Ratto M, Roeger W, int Veld an estimated DSGE model of the euro area with fiscal and monetary policy). They studied the macroeconomic effects of change in foreign reserves composition that indicated the deterioration in trade balance and also causes exchange rate effect on trade balance and wealth effect on private consumption. Is SDR a credit alternative? Agnes M. Yap (2009) investigated the need for moving from dollar to non dollar Economy and exploring SDR as an alternative currency. Agnes suggested that global monetary policies are forced to maintain a stable exchange rate with the US dollar. This makes them more vulnerable compared to the domestic economic problems of the US. US governments massive debt may erode the future value of the US dollar. This will debase the value of US dollar assets and the foreign exchange reserves of other countries. US dollars global reserve currency status has allowed it to have access to easy credit from other countries. This assisted FED in keeping low interest rates and encouraged excessive spending in the US-leading to the current crisis. Other Research Saul Islakes (2009) argues that there are factors that favor of continuing with dollar economy. Moving to a non dollar economy will cause a great disruption in the global marketplace. Major commodities, cross-border transactions and trade deals are denominated in US dollars. Also the cost of bringing about a new global reserve currency may require some countries to subsidize the cost of bringing buyers and sellers together, until a critical number of countries have adopted a new currency. However at the same time the stability of dollar asset markets especially short term government securities, high liquidity in the financial markets, reduced exchange rate risk and lower borrowing cost may be poise a challenge for some other currency against dollar. Emerging markets are exerting considered pressure on key agencies to adopt a new global currency and internationalize their own currencies; China is calling for a new global currency to replace the dominant dollar, showing a growing assertiveness on revamping the world economy. However the fear of a sudden collapse in confidence could lead to a devastating dollar run by other foreign investors. It may cause a rapid depreciation of the dollar and interest rates. This will force emerging markets to loose their current significant wealth owing to the disproportionately large chunk of dollar-based assets. John Greenwood in Global Economic Insight (Nov 2009) highlighted the insecurity in the international monetary system and dollar has led to calls for a new system with a new denomination. These are: Any existing national currency in wide spread use like Euro, RmB, Yuan or Pound Synthetic currency designated for the purpose like SDR. John studied various possible currencies and concluded that all other currencies have both pros and cons tagged with them that make them favorable and also unfavorable as a replacement for dollar. Synthetic Research Problem The recent global meltdown has shifted the global monetary axis to non-dollar zones specifically China. The economic balance of power has resulted in engineering a paradigm shift to a great deal because of the United States relative weakness and Chinas relative strength. The debate still continues that whether dollar will be able to maintain its strength as the global currency or would this be a short lived and temporary. The question is whether the dollars status as the invoicing currency for international trade, the currency of denomination for oil and other commodity prices, and the base currency for foreignÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ exchangeÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ market transactions will remain or be lost? The study will analyze various factors like out and trade, business confidence levels, size of financial markets and exchange rates in determining the stability and suitability of dollar maintaining its international currency status. Objective of the Study Different studies have been done so far on finding whether it is possible to detach the tag dollar economy from the global economy. Various researches recommend the possibility of different existing financial currencies to overtake dollar (like RmB, Euro or SDR) while other research focuses on coming up with a single reserve currency as a replacement for dollar. This study would research would extend done the research by some of those papers and explore the possibility of whether it will be possible to divorce from the dollar world towards a common currency area? Are the alternatives currently under the microscope feasible or would dollar continue as the reserve currency? Methodology Data Collection The data would be sourced from Bloomberg, Federal Reserve, Bank for International Settlements (BIS), European Central Bank (ECB), Eurostat, the International Monetary Fund (IMF), the Organisation for Economic Co-operation and Development (OECD), the United Nations (UN), and the World Bank (WB). There is no primary research included in this paper. The research done would be a secondary research. Foreign Exchange reserves Figure 3 Foreign Exchange Reserves Source: COFER Gross domestic product, constant prices Figure 4 GDP Source: IMF Business Confidence Figure 5- Business Confidence Source: OECD Foreign direct investments Figure 6- Foreign Direct Investments Source: IMF Export of Goods Services Figure 7- Export of Goods Services Source: IMF Import of Goods Services Figure 8- Import of Goods Services Source: IMF Current Account Balance Figure 9- Current Account Balance Source: IMF Foreign Exchange Rates Figure 10- Foreign Exchange Rates Source: COFER Currency composition of reserve portfolios FX market turnover by currency pair Data Cleansing The data is collected from various sources. The data format used from various sources may be inconsistent. Additionally there are certain missing data points for some specific time series / indicator. In case of missing data point linear interpolation technique with moving average will be used. Data Analysis Financial and GARCH time series tool box from MATLAB ® will be used for any matrix manipulations, algorithms like GARCH / EGARCH and plotting of functions and data. Some statistical analysis will also be done including regression, standard deviation, mean squared weighted deviation and correlation for verifying the analysis. GARCH GARCH (Generalized Autoregressive Conditional Heteroscedasticity) method assists in modeling the serial dependence of volatility of univariate time series data. Autoregressive provides a feedback mechanism that incorporates past observations into the present while Conditional implies a dependence on the observations of the immediate past. GARCH likelihood is a complicated and highly nonlinear function (Engle and Bollerslev, 1986) and provides an argument for the use of numerical derivatives. The basic GARCH(p,q) model is given by With constraints i = 1,2,3,ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦. p j = 1,2,3ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ÃƒÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦q For GARCH(p,q) the lag lengths p and q, as well as the magnitudes of the coefficients and , determine the extent to which disturbances persist. Stationarity constraints are necessary and the sign of the disturbance is ignored. GARCH Limitations GARCH Models are usually applied to return series and decisions are rarely based solely on expected returns and volatilities. GARCH models often fail to capture highly irregular phenomena and other highly unanticipated events that can lead to significant structural change. EGARCH (Exponential GARCH) EGARCH(p,q) model for the conditional variance of the innovations with leverage terms and an explicit probability distribution assumption is Where EGARCH(p,q) models are treated as ARMA(P,Q) models for . Thus, the stationarity constraint for EGARCH(p,q) models is included by ensuring that the eigenvalues of the characteristic polynomial are inside the unit circle. The standardized innovation makes EGARCH models fundamentally different from GARCH model that acts as the forcing variable for both the conditional variance and the error. GARCH model allow for volatility clustering (i.e., persistence) by a combination of the and terms, whereas persistence in EGARCH models is entirely captured by the terms. Research Findings Recommendation