Bharat SainiLast Updated on February 27, 2017 by Bharat Saini
A new research, by Jonathan Kearns and Nikhil Patel, economists of the Bank for International Settlements (BIS), concludes that a cheaper currency does not always boost economic growth. The research is based on a sample of twenty two emerging markets besides almost the same number of advanced economies to gauge the effect of changes in the exchange rate on the trade channel related to exports and imports and also on the financial channel related to price and availability of credit.
According to their findings via trade channels there is a negative relationship between changes in GDP and currency shifts, i.e. net trade adds to economic growth when the currency weakens and detracts from growth when it strengthens. This has been the belief of most of the exporters.
They also found via financial channel, an offsetting effect of currencies on financial conditions. As per their findings for thirteen of the twenty two emerging markets in the study, the financial effect dominates, i.e. a stronger exchange rate on balance speeds up the economy and a weaker one slows it down. And for advanced economies, the trade-channel effect is bigger than the financial-channel effect.
These researchers suggest that a cheap currency cannot be relied on to give a boost to a sagging economy, as their findings are that the financial channel works mainly through investment, which relies more on foreign-currency borrowing than consumer spending. Their results are sobering for emerging-market economies. More worrying still, the exchange rate might not always act as a shock absorber; rather it may, through the financial channel, work to amplify booms and busts.
While the trade channel indicates that exchange rate depreciation will stimulate domestic economic activity, the financial channel can have the opposite effect. When banks and non-banks have foreign currency liabilities, exchange rate depreciation has valuation effects that can lead to a tightening in domestic financial conditions. Using trade-weighted exchange rates and new BIS-constructed debt-weighted exchange rates to separate these influences, they find that the financial channel partly offsets the trade channel for emerging market economies but the effect is weaker for advanced economies.
The trade channel, underpins the effect of the exchange rate on economic activity. An exchange rate appreciation raises the international cost of exports, reducing both export demand and the domestic cost of imports, leading to substitution away from domestic production. Thus, an appreciation is contractionary for domestic economic activity, while depreciation is expansionary. However, the links between economies go beyond trade. Extensive financial connections, and in particular the large stock of foreign currency borrowing, provide another crucial means by which external conditions can affect an economy. An appreciation of the local currency can strengthen the balance sheets of domestic borrowers in foreign currency, easing domestic financial conditions. This financial channel of exchange rates can act as a potential offset to the trade channel, in that an exchange rate appreciation boosts domestic economic activity through easier financial conditions. Conversely, depreciation could negatively affect the economy by weakening domestic balance sheets.
(Explanations:
The Bank for International Settlements (BIS) is an international financial institution owned by central banks which “fosters international monetary and financial cooperation and serves as a bank for central banks”. The BIS carries out its work through its meetings programmes and through the Basel Process – hosting international groups pursuing global financial stability and facilitating their interaction. It also provides banking services, but only to central banks and other international organizations. It is based in Basel, Switzerland, with representative offices in Hong Kong and Mexico City.
Monetary policy is referred to as either being Expansionary or Contractionary, where an Expansionary policy increases the total supply of money in the economy more rapidly than usual, and Contractionary policy expands the money supply more slowly than usual or even shrinks it.
 Exchange rate (also known as a foreign–exchange rate, forex rate, FX rate or Agio) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.
When a Currency Appreciates it means it increased in value relative to another Currency; Depreciates means it weakened or fell in value relative to another currency.
GDP or Gross Domestic Product is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, GDP is usually calculated on an annual basis.)
