Exchange rates Paper 2

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South Africa’s grain millers oppose corn tariff

  1. A battle is taking place between South African corn farmers and the corn millers who process corn. Grain South Africa (Grain SA) is the organization that represents the interests of corn farmers. It has asked the country’s International Trade Administration Commission (ITAC) to protect local corn farmers from low global corn prices by imposing a tariff on corn imports.
  2. South Africa’s corn millers are opposing the request by Grain SA to implement the tariff on corn imports. The corn millers argue that a tariff will cause a burden for consumers and cattle farmers. In South Africa, corn is an essential food and also a source of feed for livestock.
  3. According to Reuters news service, South Africa is “Africa’s largest corn producer and is relied upon by neighboring Sub-Saharan nations to [reinforce] their own corn supplies and feed their people.” A drought in South Africa has dramatically increased the price of corn. In addition, the reduced supply has prompted the need for imports. “South Africa [has traditionally been] a net exporter of corn … [but] for the second year in a row, [the economy] will become a net importer of corn.” The need to import corn has shocked both the corn farmers and the government.
  4. The United States (US) is the world’s largest corn producer. An unusually large harvest has increased US supply and more than halved the price of US corn to its current price of US$145 a ton. However, in South Africa, because of the drought, prices for domestically produced corn have more than doubled to reach an all-time high of US$348 a ton. The low import prices of US corn have made it very difficult for South African corn farmers to earn sufficient income to survive the drought, which is why they have asked ITAC for protection.
  5. However, a spokesperson for the corn millers said “we are strongly opposed to any attempt to apply a tariff. Why do we need protection for a commodity in which we are so self-sufficient?” However, Grain SA have claimed that corn farmers cannot compete with the big corn-exporting countries, such as the US and Mexico, because their governments are subsidizing corn farmers. According to Grain SA, South African farmers get almost no assistance. This is why they have requested that ITAC implement the tariff to protect corn farmers from these unfair trade practices.
  6. According to economists, South Africa will probably need to import about 970 000 tons of corn this year and a further 3.8 million tons in the following 12 months. To make matters worse, the rand (South Africa’s currency) has experienced a sharp depreciation against the US dollar. Combined, the need to import corn and the depreciation are likely to negatively impact South Africa’s current account.

Question

Define the term depreciation indicated in bold in the text (paragraph [6]).

▶️Answer/Explanation

An explanation that it is a decrease in the value of one currency (in terms of another currency) plus one of the following :

  • in a floating exchange rate system
  • as a result of a movement in market forces

South Africa’s grain millers oppose corn tariff

  1. A battle is taking place between South African corn farmers and the corn millers who process corn. Grain South Africa (Grain SA) is the organization that represents the interests of corn farmers. It has asked the country’s International Trade Administration Commission (ITAC) to protect local corn farmers from low global corn prices by imposing a tariff on corn imports.
  2. South Africa’s corn millers are opposing the request by Grain SA to implement the tariff on corn imports. The corn millers argue that a tariff will cause a burden for consumers and cattle farmers. In South Africa, corn is an essential food and also a source of feed for livestock.
  3. According to Reuters news service, South Africa is “Africa’s largest corn producer and is relied upon by neighboring Sub-Saharan nations to [reinforce] their own corn supplies and feed their people.” A drought in South Africa has dramatically increased the price of corn. In addition, the reduced supply has prompted the need for imports. “South Africa [has traditionally been] a net exporter of corn … [but] for the second year in a row, [the economy] will become a net importer of corn.” The need to import corn has shocked both the corn farmers and the government.
  4. The United States (US) is the world’s largest corn producer. An unusually large harvest has increased US supply and more than halved the price of US corn to its current price of US$145 a ton. However, in South Africa, because of the drought, prices for domestically produced corn have more than doubled to reach an all-time high of US$348 a ton. The low import prices of US corn have made it very difficult for South African corn farmers to earn sufficient income to survive the drought, which is why they have asked ITAC for protection.
  5. However, a spokesperson for the corn millers said “we are strongly opposed to any attempt to apply a tariff. Why do we need protection for a commodity in which we are so self-sufficient?” However, Grain SA have claimed that corn farmers cannot compete with the big corn-exporting countries, such as the US and Mexico, because their governments are subsidizing corn farmers. According to Grain SA, South African farmers get almost no assistance. This is why they have requested that ITAC implement the tariff to protect corn farmers from these unfair trade practices.
  6. According to economists, South Africa will probably need to import about 970 000 tons of corn this year and a further 3.8 million tons in the following 12 months. To make matters worse, the rand (South Africa’s currency) has experienced a sharp depreciation against the US dollar. Combined, the need to import corn and the depreciation are likely to negatively impact South Africa’s current account.

Question

Using an exchange rate diagram, explain how “the need to import corn” will affect the value of the South African rand (paragraph [3]).

▶️Answer/Explanation

For drawing an exchange rate diagram showing an increase in supply of the rand and a fall in the exchange rate and for an explanation that the increase in imports of corn would result in selling the rand (to buy US dollars), thus increasing the supply of the rand and lowering its exchange rate.

Bank of Canada raises interest rates for the first time in seven years

  1. For seven years Canada’s central bank, the Bank of Canada, kept its official interest rate at 0.5 %. This period of easy monetary policy may be coming to an end. The Bank of Canada has just raised its official interest rate from 0.5 % to 0.75 %, claiming that there is new confidence in the Canadian economy. Figures show that the 3.5 % growth in gross domestic product (GDP) in the first quarter of 2017 is above its potential. In addition, the Bank of Canada expects growth in consumer spending, exports and business investment to stimulate economic growth in the months ahead. Such factors might contribute to inflationary pressure in the future.
  2. One of the issues that might have delayed the interest rate increase in Canada is that the inflation rate is still low and falling. Central banks typically raise interest rates when inflation is rising. That is not the problem in Canada, where the consumer price index (CPI) has been rising at well below the Bank of Canada’s 2 % inflation target. However, the governor of the Bank of Canada says that he is looking at forecasts of future inflation rates, noting that the data suggest the interest rate increase is necessary. An official statement from the Bank of Canada notes that growth is increasing across all industries and regions and that the economy has started to improve. There is no longer a need for the low interest rate.
  3. Positive economic growth figures, the optimism shown by the Bank of Canada, and the recent interest rate increase have caused a rapid appreciation of the Canadian dollar against the United States (US) dollar over recent months. There are now expectations that the Bank of Canada will raise the interest rate once or possibly twice more before the end of the year, as signs continue to point to a healthy economy. This would likely cause further strengthening of the Canadian dollar against the US dollar.
  4. An economist has said that the gain in the Canadian dollar against the US dollar may have a large effect on importers and exporters, although it will likely be months before consumers see the effects. She further noted that the effects would vary across different industries. There is some concern about the consequences for the Canadian current account. Currently the current account deficit is at 3.6 % of GDP.
  5. A stronger currency is also likely to encourage more Canadians to travel south to the US.

Question

Using an exchange rate diagram, explain one reason for the appreciation of the Canadian dollar (paragraph [3]).

▶️Answer/Explanation

For drawing an accurate, labelled demand and supply diagram for the Canadian dollar showing an increase in demand for the Canadian dollar and an increase in the exchange rate AND an explanation that:

  •  positive growth figures and/or the confidence expressed by the central bank means that international investors will have a greater willingness to invest in Canada

OR

  • a higher interest rate will provide more incentive for international savers (foreign investors) to save in Canadian banks.

OR

  • anticipation of future appreciation (speculation).

To carry out either of these transactions, there will be an increase in demand for the Canadian dollar and therefore an appreciation of the dollar.

Bank of Canada raises interest rates for the first time in seven years

  1. For seven years Canada’s central bank, the Bank of Canada, kept its official interest rate at 0.5 %. This period of easy monetary policy may be coming to an end. The Bank of Canada has just raised its official interest rate from 0.5 % to 0.75 %, claiming that there is new confidence in the Canadian economy. Figures show that the 3.5 % growth in gross domestic product (GDP) in the first quarter of 2017 is above its potential. In addition, the Bank of Canada expects growth in consumer spending, exports and business investment to stimulate economic growth in the months ahead. Such factors might contribute to inflationary pressure in the future.
  2. One of the issues that might have delayed the interest rate increase in Canada is that the inflation rate is still low and falling. Central banks typically raise interest rates when inflation is rising. That is not the problem in Canada, where the consumer price index (CPI) has been rising at well below the Bank of Canada’s 2 % inflation target. However, the governor of the Bank of Canada says that he is looking at forecasts of future inflation rates, noting that the data suggest the interest rate increase is necessary. An official statement from the Bank of Canada notes that growth is increasing across all industries and regions and that the economy has started to improve. There is no longer a need for the low interest rate.
  3. Positive economic growth figures, the optimism shown by the Bank of Canada, and the recent interest rate increase have caused a rapid appreciation of the Canadian dollar against the United States (US) dollar over recent months. There are now expectations that the Bank of Canada will raise the interest rate once or possibly twice more before the end of the year, as signs continue to point to a healthy economy. This would likely cause further strengthening of the Canadian dollar against the US dollar.
  4. An economist has said that the gain in the Canadian dollar against the US dollar may have a large effect on importers and exporters, although it will likely be months before consumers see the effects. She further noted that the effects would vary across different industries. There is some concern about the consequences for the Canadian current account. Currently the current account deficit is at 3.6 % of GDP.
  5. A stronger currency is also likely to encourage more Canadians to travel south to the US.

Question

▶️Answer/Explanation

Using information from the text/data and your knowledge of economics, discuss the possible effects on the Canadian economy of the strengthening of the Canadian dollar against the US dollar.

Responses may include:
A definition/explanation of a “stronger currency”.

Economic growth:

  • The strong Canadian dollar may cause a decrease in demand for exports and an increase in demand for imports, resulting in a fall in net exports and a decrease in AD. This may hinder economic growth, which has been increasing (paragraph [2]).

Low unemployment:

  • The stronger Canadian dollar may result in a decrease in demand for exports and an increase in demand for imports, thus raising unemployment in export industries and industries that compete with imports.
  • The need to cut costs may result in structural unemployment.
  • If demand for exports is relatively inelastic, as in the case for commodities (with reference to Table 1), there may be little effect on unemployment.
  • If demand for exports is relatively elastic, as in the case for manufactured goods (with reference to Table 1), there could be an increase in unemployment in this sector.
  • A stronger Canadian dollar makes it more attractive for Canadians to travel to the US, rather than travel in Canada, which may damage the Canadian tourism sector (paragraph [5]) and may lead to unemployment.

Low and stable inflation: 

  • The stronger Canadian dollar will make imported factors of production less expensive, resulting in an increase in SRAS and a fall in possible inflationary pressure.
  • The stronger Canadian dollar may also present a risk of increased deflationary pressure from lower priced imports and reduction in net exports (paragraph [2]).
  • The strong Canadian dollar may cause a decrease in demand for exports and an increase in demand for imports, resulting in a fall in net exports and a decrease in AD, thus a reduction in demand-pull inflationary pressure (paragraph [1]).
  • The effects depend on the PED for exports and imports.

Current account:

  • The current account deficit is a concern at 3.6 % of GDP (paragraph [4]), and a stronger Canadian dollar could lead to an increase in the deficit on the current account balance.
  • The effect depends on the PED for exports and imports.
  • The vast majority of Canada’s exports go to the US (Table 2), so the effect of the appreciation of the Canadian dollar against the US dollar is likely to be significant.

Standard of living

  • Consumers will gain from lower prices of imports, including effectively cheaper holidays in the US (paragraph [5]).

Argentina’s currency keeps falling

  1. The year 2018 started badly for Argentina when the worst drought in 50 years negatively affected its export revenues from maize and soybeans, both important exports. The economy suffered several additional problems: a stronger United States dollar (US$), international investors selling Argentinian assets due to a lack of confidence in the economy, rising inflation from 25 % to nearly 50 % (Figure 1) and a significant depreciation of the peso, Argentina’s currency.
  2. When Argentina’s president was elected in 2015, inflation was at 25 %. He gave the central bank freedom to raise interest rates, which encouraged foreign investors to buy government bonds. The government had borrowed a lot of money from overseas to finance the persistent budget deficit, but by 2018, foreign investors were interested in other markets.
  3. As the peso was overvalued in 2015, it kept demand for imports high and made it hard for exports to compete. The current account deficit rose to more than 5 % of gross domestic product (GDP) but slowly narrowed in 2018, because the president allowed the peso to float freely.
  4. In May 2018, in an attempt to control the inflation rate and stop the fall in the peso’s value, the Argentinian central bank raised interest rates to 40 %. In addition, it started selling foreign currency reserves. However, there were concerns that if the selling of foreign currency reserves continued, they would be depleted quickly. To address this concern, the president negotiated a US$50 billion loan from the International Monetary Fund (IMF). Yet the peso continued to fall. The IMF loan means that most of Argentina’s debt-servicing requirements are covered until 2020. However, under IMF loan conditions, the budget deficit must be cut by postponing infrastructure projects, subsidies must be cut, and government jobs must be cut.
  5. A spokesperson from the IMF said “Argentina has a floating, market-determined exchange rate, and the IMF fully supports that. The exchange rate should continue to be determined by market forces.”
  6. The peso’s weakness causes imported oil prices to go up, further raising inflation. The falling real incomes of households combined with higher interest rates will affect the economy negatively, possibly leading to a recession. Interest rates will remain high for some time, discouraging investment. Economists expect Argentina to fall into recession, for the fifth time in a decade.

Question

Using an exchange rate diagram, explain how raising interest rates would “stop the fall in the peso’s value” (paragraph [4]).

▶️Answer/Explanation

An exchange rate diagram showing a shift of the demand curve of the peso to the right and an increase in the exchange rate AND for an explanation that an increase in the interest rate could attract foreign financial investors to buy Argentinian bonds or save in Argentinian banks, which would increase the demand for pesos, stopping the fall in the peso’s value.
OR
An exchange rate diagram showing a shift of the supply curve of the peso to the left and an increase in the exchange rate AND for an explanation that an increase in the interest rate would discourage investors from selling Argentinian financial assets, which would decrease the supply of pesos, stopping the fall in the peso’s value.

Argentina’s currency keeps falling

  1. The year 2018 started badly for Argentina when the worst drought in 50 years negatively affected its export revenues from maize and soybeans, both important exports. The economy suffered several additional problems: a stronger United States dollar (US$), international investors selling Argentinian assets due to a lack of confidence in the economy, rising inflation from 25 % to nearly 50 % (Figure 1) and a significant depreciation of the peso, Argentina’s currency.
  2. When Argentina’s president was elected in 2015, inflation was at 25 %. He gave the central bank freedom to raise interest rates, which encouraged foreign investors to buy government bonds. The government had borrowed a lot of money from overseas to finance the persistent budget deficit, but by 2018, foreign investors were interested in other markets.
  3. As the peso was overvalued in 2015, it kept demand for imports high and made it hard for exports to compete. The current account deficit rose to more than 5 % of gross domestic product (GDP) but slowly narrowed in 2018, because the president allowed the peso to float freely.
  4. In May 2018, in an attempt to control the inflation rate and stop the fall in the peso’s value, the Argentinian central bank raised interest rates to 40 %. In addition, it started selling foreign currency reserves. However, there were concerns that if the selling of foreign currency reserves continued, they would be depleted quickly. To address this concern, the president negotiated a US$50 billion loan from the International Monetary Fund (IMF). Yet the peso continued to fall. The IMF loan means that most of Argentina’s debt-servicing requirements are covered until 2020. However, under IMF loan conditions, the budget deficit must be cut by postponing infrastructure projects, subsidies must be cut, and government jobs must be cut.
  5. A spokesperson from the IMF said “Argentina has a floating, market-determined exchange rate, and the IMF fully supports that. The exchange rate should continue to be determined by market forces.”
  6. The peso’s weakness causes imported oil prices to go up, further raising inflation. The falling real incomes of households combined with higher interest rates will affect the economy negatively, possibly leading to a recession. Interest rates will remain high for some time, discouraging investment. Economists expect Argentina to fall into recession, for the fifth time in a decade.

Question

Using an AD/AS diagram, explain how the peso’s weakness is “raising inflation” (paragraph [6]).

▶️Answer/Explanation

An AD/AS diagram showing a shift of the AS/SRAS curve to the left and an increase in price level.
AND
An explanation that a weak peso makes imports more expensive (imported oil prices go up), which increases the costs of production, shifting SRAS to the left/up, further raising inflation.

The fall of the Indian rupee

  1. Over the past year, India’s current account deficit widened as the 14 % increase in export revenue could not offset the rise in import expenditure. Over the same period, the value of the rupee (India’s currency) has fallen by 13 %.
  2. The rise in import expenditure was in part caused by higher oil prices following production cuts by the Organization of the Petroleum Exporting Countries (OPEC). Another reason for the increase in import expenditure was the higher spending on machinery and capital goods needed to achieve economic growth.
  3. Exports of services, especially software services, have helped to boost export revenue. However, one critical weakness in India’s exports of services is the lack of diversification. Exports of software services account for more than 41 % of India’s total service exports and more than 90 % of its software service exports are restricted to the United States and the European Union.
  4. The depreciation of the rupee, one of the steepest seen in recent years, has resulted in fears of high inflation. An economist at the Reserve Bank of India (India’s central bank) has warned that the increase in oil prices and consumers’ expectations of rising inflation could worsen inflationary pressures.
  5. Despite calls for an increase in interest rates in order to protect the rupee from further depreciation, the Reserve Bank of India has chosen to keep interest rates unchanged. The combined effect of a fall in confidence and higher interest rates would dampen economic growth. 

Question

▶️Answer/Explanation

Using information from the text/data and your knowledge of economics, discuss the possible economic consequences on the Indian economy of a depreciating rupee.

Benefits of the depreciation may include:

  • The depreciation would help close the current account deficit (paragraph [1]) by making imports more expensive and exports cheaper
  • Exported services would become cheaper in foreign currency terms which may lead to higher demand (but will not encourage diversification of exports (paragraph [3]))
  • The cheaper export services might help capture other markets (in addition to US and Europe) (paragraph [3])
  • Other currencies have also depreciated and hence the depreciation keeps Indian exports competitive (paragraph [5]).

Limitations/disadvantages of the depreciation may include: 

  • The depreciation would make imported oil even more expensive. Given that demand is likely to be inelastic and since rising oil prices are already a contributor to the current account deficit (paragraph [2]), that would worsen the deficit
  • Higher prices for imported capital goods and oil would worsen cost-push inflation (paragraphs [2] and [4])
  • Higher prices for imported capital goods may reduce imports of such goods and slow down potential growth (paragraph [2])
  • The inflation rate has risen between 2017 and 2018 (Table 1) and hence the depreciation would only lead to further increase in prices 
  • With the current high growth rate (Table 1), an increase in exports could lead to further demand-pull inflation.

China and global trade

  1. On 15 January 2020, the United States (US) and China signed a deal that reduced some tariffs and required China to buy more from US producers. This was a first step towards resolving a trade war, which had reduced bilateral trade flows by 9 % and investment flows by 60 %. However, critics argued that the deal left most tariffs unchanged and did not deal with deeper disagreements.
  2. The US, the European Union (EU) and Japan are calling for tougher World Trade Organization (WTO) rules on government support for firms that manufacture items such as steel or solar panels. The support, which is often in the form of subsidies, has allegedly undermined competing firms overseas, either by promoting exports or by decreasing imports, and therefore distorted global trade. Other governments also give subsidies, but there are claims that China uses them more extensively.
  3. The proposed WTO rule change would require governments to prove that subsidies do not give domestic firms an unfair advantage over foreign firms and that they do not lead to excess supply in the global market. If the rules are implemented, the WTO may regain some of the authority that it has lost in recent years.
  4. One of the US government’s goals when imposing huge tariffs on Chinese-made goods was to bring back manufacturing jobs to the US. Therefore, despite the new deal, the 25 % tariff on Chinese-made furniture will stay. As a result, many US furniture firms that had used overseas factories to make their US company-branded products have reduced their imports of Chinese-made furniture.
  5. Meanwhile, Vietnam, Cambodia and Bangladesh are benefitting because US manufacturers of wood furniture are setting up factories there. Therefore, some other US producers are asking for the tariff on Chinese-made wooden furniture to apply to all wooden furniture imported into the US, regardless of where it is manufactured.
  6. China is becoming less dominant as an exporter and more integrated into the global trading system. Its current account surplus was over 10 % of gross domestic product (GDP) in 2007, but it declined to just 0.4 % in 2018. Chinese producers are increasingly buying raw materials and other inputs from overseas producers. Although most electronic devices sold in the US are assembled in China, Chinese firms are often dependent on foreign suppliers. If the US and China tried to be less interdependent, it would take more than 10 years for China to become self-sufficient in the production of computer semiconductors and for the US to shift to other suppliers of electronic devices.

Question

▶️Answer/Explanation

Using a foreign exchange diagram, explain the possible effect of China’s large current account surplus in 2007 on the exchange rate of China’s currency (the renminbi) (paragraph [6]).

For drawing a correctly labelled exchange rate/foreign exchange diagram, with the demand curve shifting right (or the supply curve shifting left) and the equilibrium price of the renminbi rising AND for an explanation that the surplus could mean an extra demand for the currency due to more exports/greater inflows (or a reduced supply of the currency due to fewer imports/fewer outflows) which causes the exchange rate to rise/appreciate.

South Korea’s exchange rate and central bank intervention

  1. From mid-2017 until mid-2019, there was a downward trend in the exchange rate of the South Korean won (South Korea’s currency), and some commentators suggested that it was being deliberately undervalued. Despite the lower exchange rate, however, the value of South Korean exports declined by 10.3 % during 2019.
  2. The main reason for the decline in the value of exports was the weak market for semiconductors. Lower global prices of semiconductors, the largest single export item for South Korea, led to a drop of 25.9 % in the value of exports, despite an increase in their volume. Evidently, price competitiveness of exports from South Korea is not as significant as before, because its exports are now mainly luxury or high-technology items.
  3. In November 2019, South Korea’s current account surplus reached US\($\)5.97 billion, more than 4 % of gross domestic product (GDP). The financial account in the balance of payments had a net outflow of US\($\)5.34 billion, which was mainly due to a net outflow of US\($\)4.01 billion in foreign direct investment (FDI). There was also a net outflow of US\($\)1.07 billion in portfolio investment, because domestic residents increased their financial assets overseas while inward flows declined.
  4. The Bank of Korea (South Korea’s central bank, BoK) had reduced interest rates to record lows in October 2019, which partly accounted for the large portfolio investment outflows. Monetary policy is likely to continue to be expansionary through 2020, with the possibility of another interest rate reduction, because economic growth is forecast to be low, at less than 2.5 %. The forecast for inflation is that it will be below 1.5 %, while the unemployment rate is expected to continue to rise to over 4 %.
  5. While the BoK is not targeting a specific level for the exchange rate, it seems determined to intervene when the market is unstable. Its actions, however, have contributed to South Korea being accused by the United States (US) of changing the value of its currency to gain an export advantage. If the US concludes that South Korea has been manipulating its exchange rate unfairly, it could impose trade barriers on imports from South Korea.
  6. However, through the last six months of 2019, the South Korean won started to rise against the US dollar (US$). The appreciation was partly due to speculation and expectations of a rise in demand for semiconductors. Moreover, in August 2019, the BoK sold US dollars in order to prevent the South Korean won from depreciating again. Overall, the central bank’s foreign exchange intervention has been aimed at restraining the South Korean won’s depreciation or stabilizing the market rather than at trying to promote exports.

 

Question

▶️Answer/Explanation

Using an exchange rate diagram, explain the effect on the South Korean won’s exchange rate of South Korea’s central bank selling US dollars (paragraph [6]).

For drawing a correctly labelled exchange rate diagram for the South Korean won, with the demand curve shifting right and the equilibrium price of the South Korean won rising AND for an explanation that when the central bank sells US dollars, it will buy won, causing an increase in its demand and an increase in the value/appreciation/revaluation of the won.

Question

Using an exchange rate diagram, explain how capital flight may increase the overvaluation of the franc (Text D, paragraph 6).

▶️Answer/Explanation

For an exchange rate diagram showing a fixed exchange rate and an increase in supply due to the capital flight AND an explanation that the capital flight implies that more francs are sold on the international market, which worsens/causes the overvaluation.

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