INDIVIDUAL ASSIGNMENT

IBF301_SU24

Class: IB18B

Lecture: Nguyen Thi Bich

Thuong

Full Name: Huynh Thi Quynh

Tram

Student ID: QS180055

Date: Summer 2024

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Question1: Conduct research to investigate how different exchange rate regimes (fixed,
floating, and managed float) impact a country's balance of payments. Use specific country
examples to illustrate your points.
The answer:
Exchange rates and trade balances are important indicators that have a significant impact
on the economies of countries around the world. The "exchange rate" is understood as the
rate at which one currency can be exchanged for another currency. Depending on market
demand and the policies of each country, exchange rates will vary, but they can be generally
categorized into three main types: fixed exchange rate, floating exchange rate, and managed
float exchange rate.
It is known that exchange rates and the balance of payments have a close and mutually
influential relationship, meaning that an increase or decrease in exchange rates affects the
balance of payments. So how do different exchange rates impact the balance of payments?
Below are the significant effects of different exchange rates on a country's balance of
payments, including:
I. Fixed Exchange Rate
The exchange rate is maintained at a fixed level for a long period with small allowable
fluctuations. In this system, the domestic currency has a fixed nominal value in terms of
another currency (foreign currency), and the government commits to buying and selling
foreign currency at the specified exchange rate when needed. The impacts on the balance of
payments are as follows:

1. Positive influence:
 Fixed exchange rates help limit arbitrary increases in the money supply, thereby
maintaining stability in the national financial system and preventing inflation.
 The volatility of fixed exchange rates is quite low so businesses can predict the selling
price of their goods in international markets.
 At the same time, using this exchange rate helps avoid risks caused by changes in
exchange rates caused by international trade and financial contracts signed in
currencies with fixed values.
2. Negative influence:

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  If this exchange rate regime is used over time, it will lead to an imbalance in the
import-export balance. Because the value of one country's currency will be closely
tied to another country's currency, it does not reflect the true state of that country's
economy. When a country's currency is overvalued compared to another country's
currency, that country's goods abroad become more expensive, causing a
disadvantage for the export of goods, leading to a trade deficit.
 To maintain a fixed exchange rate, the country must defend its derealistic exchange
rate, which means the central bank must regularly intervene in the market by buying
foreign currency. This can cause a payment imbalance when countries do not have
enough foreign currency reserves to meet the need to buy goods and services from
abroad.
3. For example in a specific country: Hong Kong
It is known that in 1983, Hong Kong applied a fixed exchange rate mechanism with
the US dollar, specifically at 7.80 Hong Kong dollars/USD. This brought many
positive aspects to Hong Kong's economy at that time, the fixed exchange rate
allowed free movement of capital, suitable for a small and open economy like Hong
Kong. The peg saved Hong Kong from financial ruin in 1983 and continues to
provide a stable exchange rate environment that has allowed the city to develop into
an international financial center.
However, this also brings disadvantages when Hong Kong is forced to import loose
monetary policy from the US. And even if the economies of the US and Hong Kong
have transitions and are not similar to each other, Hong Kong's interest rates still have
to adjust to the US. These things have led to pressure from investment activities when
inflation in Hong Kong is high and real estate prices in Hong Kong are rising hotly.
To protect the domestic currency exchange rate, Hong Kong's monetary authority
spent more than 1 billion USD and spent nearly 15 billion USD to buy back shares of
many businesses.

II. Floating exchange rate:

A country's currency exchange rate changes flexibly based on the supply and demand
relationship in the foreign exchange market. The effects of floating exchange rates on the
balance of payments are as follows:

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 1. Positive influence:
 It is possible to adjust the balance of payments to equilibrium, because if a
country's current account deficit causes the domestic currency to depreciate, a
floating exchange rate will promote exports and limit imports until the The
balance of payments becomes balanced.
 Clearly reflects the supply and demand situation and fluctuations of the foreign
currency market. Helps make the market more transparent and efficient. At the
same time, the application of floating exchange rates also contributes to stabilizing
the economy by fully adjusting the exchange rate according to the PPP mechanism
when foreign prices increase. Thereby avoiding risks, inflation and adverse
shocks.
 The monetary policy of a country applying a floating exchange rate will also be
more independent and proactive. The country also does not need to reserve a large
amount of foreign exchange because the central bank does not need to participate
in adjustments. exchange rate.
2. Negative influence:
 Floating exchange rates come with external fluctuations because this exchange rate
depends on many factors such as market price fluctuations, political issues, and
policies of countries. Therefore, it can lead to the prices of goods and assets
skyrocketing or hitting bottom in a short period of time, causing great risks in trade
and investment.
3. A specific example in one country: the United States
In 1971, the United States left the Bretton Woods system because the BWS limited
spending by the United States and countries around the world. The USD has been
devalued, inflation has increased rapidly and the US trade balance is in deficit.
To escape the difficult situation and improve the economy, the United States floated
the USD. Thanks to this, the US currency supply is controlled. Protect the US
economy from a balance of payments crisis because it has to import and perform
services in USD. The government may sometimes provide financial support when
there are trade and national budget deficits.

III. Managed floating exchange rate:

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 In this exchange rate mechanism, the currency exchange rate is floating but still subject to
the intervention of the state bank to ensure fluctuations in a direction beneficial to the
economy. The impacts of floating exchange rates on the trade balance are as follows:

1. Positive effect:
 This is a combination of fixed and floating exchange rates, thereby helping the
economy integrate into the world's common economy, while ensuring economic
stability and promoting development. import and export but still ensure the
independence of each currency.
 Besides, the government can also participate in adjusting exchange rates when
necessary to protect the trade balance from financial shocks.
2. Negative influence:
 To maintain this exchange rate mechanism, the central bank must keep a strong
enough foreign currency balance and must consider intervening in the market at the
right time to stabilize the balance of payments as well as the market, otherwise it will
easily become a fixed exchange rate mechanism.
3. Example of the impact of floating exchange rate adjustments on the balance of
payments: Vietnam - 2023
At the beginning of the first half of 2023, the exchange rate did not fluctuate much
and reached about 23,690 VND/USD right at the beginning of the year. Then it
fluctuated slightly in the range of 23,700 to under 24,000 (selling exchange rate of
commercial banks) and around 23,600 to 23,700 (central exchange rate)

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 However, in the next 6 months of 2023, the exchange rate will begin to fluctuate strongly.
It is known that in August, the exchange rate at commercial banks increased to 23,850
VND/USD, and the peak at the end of October exceeded 24,000 VND/USD, falling around
24,760 VND/USD.

The reason for the devaluation of Vietnam's exchange rate is that at this time many
countries around the world are facing crises such as inflation, raw material prices, conflicts...
causing exchange rates to tend to decrease. Especially because the US Federal Reserve (Fed)
has raised interest rates to solve the problem of inflation, increasing yields on US bonds,
making the USD more attractive in the eyes of investors. And Vietnam is a country with a
monetary policy that is in contrast to the US (Fed) and some other countries, so according to
the general trend of world conditions, VND has also been devalued.

Thanks to the improvement in production and exports in the first months of 2023 and the
total capital from 2022, the state bank has the ability to participate in timely market and
exchange rate navigation. Specifically, from September 21 to November 8, the state issued
361,000 billion VND of T-bills with an average interest rate of 1.04%/year to maintain
256,000 billion VND of T-bills in circulation. Thanks to that, our country's interest rates are
narrowed compared to the USD, reducing external impacts.

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 By the end of 2023, activities in the foreign exchange market will be more active, the
central exchange rate is at 23,866 VND/USD; Listed and traded exchange rates on the market
increased by about 2.9%, compared to exchange rates in the Vietnamese region that are
considered to be kept quite stable.

→ Data from the Department of Statistics shows:

In the 11 months of 2023, our country's total import-export turnover of goods is 619.1
billion USD, down 8.3% over the same period last year. Specifically, reaching 322.5 billion
USD in export turnover, down 5.9% compared to 2022, and reaching 296.6 billion USD in
import turnover (down 10.7%). Vietnam's export market Nam has a significant decline, even
negative growth, but in October 2023 there was a positive trend.

At the same time, in December the trade surplus reached 2.28 billion USD, bringing the
total trade surplus for the whole year 2023 to 28 billion USD (the previous year's trade
surplus was 12.1 billion USD). Thanks to that, the economy changes for the better, greatly
affecting the balance of payments.

Question 2: The following quotes

a. Determine if IRP is holding between the United States and Singapore

b. If IRP is not holding, explain in detail how you would realize a certain profit in U.S dollar
terms. Assuming that you are authorised to work with $1,000,000, the arbitrage profit in
dollars S.

c. Explain how IRP will be restored as a result of covered arbitrage activities.

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The answer:
S($/S$)= 1/1.3497
F3($/S$)= 1/1.3515
i$= (4.0%/12) x3 = 1.0%
iS$= (4.5%/12) x3 = 1.125%
a. According to the topic:
1 + i$= 1+1.0% =1.01
F3/S x (1+ iS$)= (1.3497/1.3515) x (1+1.125%)= 1.0099
Thus, IRP is not holding between the United States and Singapore
b. If IRP is not held, this is for a certain profit in US dollars and the arbitrage profit:
1. Borrow S$1,349,700 at a 4.5% interest rate/year in Singapore
CF0= S$ 1,349,700 → CF1= S$ 1,364,884,125
2. Convert S$1,349,700 at spot change rate S$1,3497$
CF0= -1,349,700 → CF1= $1,000,000
3. Lend $1,000,000 with interest rate of 4.0%/year
CF0= -$1,000,000 → CF1= $1,010,000
4. Exchange $1,010,000 to S$ at the forward exchange rate
$1= s$1.3515 → $1,010,000 = S$1,365,015
Thus, profit = S$1,365,015 - S$ 1,364,884,125
= S$130.875
Profit in dollar $ = 130.875/1.3515=$96.8386
c. The way in which the IRP will be recovered due to covered arbitrage activities.
+ Interest rates will increase in Singapore
+ Interest rates will fall in the United States
+ The US dollar will increase in price in the market
+ The US dollar will lose value in the market

IV. References

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