FLOATING EXCHANGE RATE MECHANISM IN DEVELOPING ECONOMIES

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Globalization has been made possible through global exchange. Globalization is the direct offspring of foreign exchange, that is, the exchange of goods and services among countries across the globe. Therefore, through globalization, an important concept has evolved, which is exchange rate. Exchange rate is the rate at which foreign transaction is made. It is the rate at which a foreign a currency is converted into another currency.



INTRODUCTION

Globalization has been made possible through global exchange. Globalization is the direct offspring of foreign exchange, that is, the exchange of goods and services among countries across the globe. Therefore, through globalization, an important concept has evolved, which is exchange rate.
Exchange rate is the rate at which foreign transaction is made. It is the rate at which a foreign a currency is converted into another currency.



According to Investopedia “Exchange Rate is the price of a nation’s currency in terms of another currency”.
An exchange rate has two components.
The domestic currency and the foreign currency.
The base currency and the counter currency.
An exchange rate can be quoted either directly or indirectly. In a direct quotation, the price of a unit of a domestic currency is expressed in terms of the domestic currency.
In an indirect quotation the price of a unit of a domestic currency is expressed in terms of other currency. Let’s take the exchange rate between the Nigeria Naira (NGN) and the US dollar (USD) as an example.
N1: $0.0074
The above exchange rate means N1 is equivalent to $0.0074. That means the USD is higher in value compared to the naira (NGN).
In another case; it can also be expressed in terms of dollars.
$1: N335
This means that 1 USD is equivalent to N335 (NGN).



For exchange rate to be determined, there is need that the government of any nation to decide between one of the following exchange rate mechanisms. We have the fixed exchange rate mechanism, the floating exchange rate mechanism and the pegged exchange rate mechanism.
To fully understand the analysis of this article, it will be worthwhile to explain the three mechanisms.
The fixed exchange rate mechanism according to investopedia “a fixed exchange rate is a country’s exchange rate under which the government or central bank ties the official rate to another country’s currency or to the price of Gold”.
The exchange rate is fixed under this mechanism. For example,
N1: $100
Where the naira (NGN) is the base currency, the USD is the counter currency. The exchange rate will remain like that unchanged because the apex bank is guiding it.
According to investopedia “the purpose of a fixed exchange rate is to maintain a country’s currency value within a very narrow band”. The exchange rate is fixed because of the economic consequences of depreciation of currency.



A fixed exchange rate provides greater certainty for exporters, importers and also help the government to control inflation which in the long run have a positive multiplier effect on the economy i.e. the mechanism will keep interest rate low which will stimulate increase trade and investment.
The Floating Exchange Rate: According to investopedia “a floating exchange rate is a regime where the currency price is set by the forex market based on supply and demand compared with other currencies”.
The rate today can be $1: N345 and tomorrow $1: N400. It is highly fluctuating and unstable.
The forex market is the market for foreign exchange where foreign goods and services are exchanged. To buy a commodity from The United State to Ghana, the currency of Ghana which is Cedi must be converted at an exchange rate to the US dollar. It is only when this is done that exchange can take place between The United State of America and Ghana.



The Pegged Exchange Rate Mechanism: According to investopedia “A pegged exchange rate is a hybrid of fixed and floating exchange rate mechanism”. In this system, a certain range is set that the exchange rate between one currency and another cannot exceed.
For example:
$1 = N100 – N110
That is $1 will be exchanged between N110. That means that $1 cannot exceed N100 and N110 no matter how it fluctuates.
With this understanding of the exchange rate mechanism, we can now proceed to deeper analysis of the economy in regard to exchange rate.



THE CODITIONS UNDER WHICH A COUNTRY FLOATS THE EXCHANGE RATE.

Most developed economy operates a floating exchange rate because the demand for their currency is very high.
You know that the determining factor in floating exchange is the forces of demand and supply. In the developed economy where manufactured goods/products are made, where modern technology is applied to production, the demand for their commodities/products is very high than their demand for other country’s products. In that case, the more the demand for these manufactured goods by other countries, the higher is the demand for the currency of that economy than the supply. Therefore, the domestic currency will appreciate in terms of other currencies.



It is also possible in a situation whereby a country has high skilled labour force than many other countries, the demand for this human capital will be very high by other countries, this will lead to a rise in the currency of such economy in terms of other currencies.
The level of industrialization in an economy should determine whether a country should operate a floating exchange rate or not.
The United States of America (USA)’s economy has a GDP (Gross Domestic Product) of 17947 USD billion as at December 2015.



The share of manufacturing of the GDP is 2159 USD billion. While the share of agriculture of the GDP is 182 USD billion.
The above indicator shows that the major sector in the economy of US is the manufacturing sector. Products like electronics, cars, automobiles, technological devices, computers, phones are manufactured in the United States.
For instance, phones are in high demand across the globe. Hence, a country that could manufacture a high quality and durable phone will get the value of the currency appreciated, because there will be high demand.



In China’s economy, the GDP of China stands at 10866 USD billions and the manufacturing the sector have large share of the GDP. China is an economy known for the production of technological devices which cuts across electronics.
These two economies can adopt floating exchange rate mechanism because of the nature of the industrialization of the economies and the forces of demand and supply of forex will work favorably to the currencies, thereby appreciating the value of their currencies.
For instance, the average exchange rate of dollar and naira under floating exchange rate regime is currently at $1: N345. It is favorable to The United States economy and unfavorable to the Nigerian economy.


THE ECONOMY OF NIGERIA AND THE FLOATING EXCHANGE RATE MECHANISM

The question to ask you is that should the government adopt floating exchange rate policy? Is the economy industrializing? What is the state of capital accumulation? What is the composition the country economy’s international trade?
To know whether floating exchange rate mechanism is suitable for Nigeria’s economy, we will see it in the value of the domestic currency in terms of another currency. We will see if whether the naira is appreciating in terms of dollar under the floating exchange rate mechanism. We should also know whether inflation is associated with the floating exchange rate system.



The Nigeria Apex bank adopted the floating exchange rate mechanism this year and the following indicators can speak about the effectiveness of the mechanism. Before the implementation of this floating policy of exchange rate, the exchange rate of dollar to Naira was an average of $1: N190, but currently under the floating exchange rate regime, the exchange rate of naira in terms of dollars is $1 : N345.9950. With the above indicator, we can conclude that the value of naira (NGN) has depreciated in terms of dollar (USD).



This simply means that, we now need more nairas to demand for a US commodity that we formerly used few nairas to purchase. This has declined the standard of living of the people, hence the development problem will get worse since it will lead to more hunger in the economy.
In regards to inflation rate in Nigeria. Inflation rate as at June 2016 stands at 16.5% and the food inflation rate as at June 2016 stands at 15.3%.
Both indicators for inflation shows double digit inflation rate. This has many economic problems. A high inflation rate especially food inflation rate that is 15.3%, means decline in the standard of living as a result of increase in the cost of living.


This food inflation indicator tells about the basic necessity of life that an individual should at least be able to afford. Food is among the three basic needs of life i.e. food, shelter and clothing. If the cost of living has increased as a result of decline in the value of naira, that means hunger and poverty will increase.


I hereby call the policy makers of developing nations to look into these developmental issues when implementing foreign exchange rate policy. In regards to the composition of trade of the Nigerian economy with the outside world. We have much of our foreign exchange as agricultural products that are primary products. They are extracted and just exported without processing ttem and adding value to them. The value of a commodity or a product determines the price in the international market. Also, the petroleum that has the greatest share of the GDP is exported to the United States of America USA, United Kingdom (UK), and Germany etc in crude form/state.



Values are not attached or added by manufacturing or processing these domestic commodities before exporting them. I believe this is one of the problems why our commodities i.e. agricultural products command low prices in the foreign market. This has led to deficit of our balance of trade.
We have the indicators from “Trade Economics” as at march 2016; the balance of trade is a deficit of (1713) while the exports is 282025 NGN Million and the import is 453334 NGN million.
The deficit of balance of trade (BOT) shows two things;
One, the value of our foreign exchange is very low due to lack of value added.



Two, there are few products that represents our foreign exchange and bulk of these commodities are agricultural products.
For instance, we export crude oil, cocoa, rubber, cashew, palm oil etc. All these commodities including our well known petroleum lack value-added.
On the other hand, the economy imports goods of high value into Nigeria. These products are mainly manufactured and industrialized goods such as electronics and machinery. Even the agricultural products imported from there are processed which made them to have high price. For example, the popular Uncle Ben’s rice from America is a value-added agricultural product.



In regards to capital accumulation or level of investment
Though, the Nigerian economy and other developing economies like Ghana are in the pre-condition for take-off or take-off stage of economic growth, the level of industrialization especially in Nigeria is still very low. The economy of Nigeria is highly dualistic.
For a country to perform well in the international or global market, the level of industrialization of such economy will indicates. For example, capital flows in Nigeria as at March 2016 is -7914 USD million.


That means the capital out flows is greater than the capital inflows in the economy. This shows that the business confidence in Nigeria is very low as capital tends to be invested outside the shores of Nigeria that in Nigeria.
I believe this owes to some factors such as corruption and political and economic instability.
Investor may not want to invest in Nigeria because of the exchange rate and the balance of payments (BOPS). A place where there are political crises such places are not conducive for investment. An economy that is not stable in terms of stability of prices such an economy is not good for investment as well. Let’s take a look at the United States of America’s foreign direct investment stands at 35,823 USD million. In contrast to Nigeria’s FDI which is 887 USD million?


These figures lastly show that the economy of the United States provides enabling and encouraging environment for investment than the economy of Nigeria.
In a nut shell, based on the economic indicators, the Nigerian economy and other developing economies should not adopt a floating exchange rate policy since it is detrimental to the economy by way of the increasing inflation and depreciating the domestic currency.


HOW CAN CURRENCIES OF DEVELOPING ECONOMIES IN RELATION TO THE ADVANCED COUNTERPART BE APPRECIATED?

The currencies of developing nations can be appreciated by development of products that are in high global demand.
Most of the developing economies in Africa and Asia are mono-economy i.e. they only have one major foreign exchange.


If these economies can develop other products like two or three other products that are highly demanded in the global economy, the demand for their currency will rise which will lead to an appreciation of their currencies.
Taking the Nigerian economy as a sample for other developing economies. The economy has petroleum as the major foreign exchange.


In the same economy, there are many untapped mineral resources such as iron ore, steel, lime stones etc. considering the fact that the global economy is in the era of industrialization and mechanization and science and technology. It will be wise for the government to develop the iron ore and steel. Since it has high global value and their development to full capacity will encourage domestic scientific inventions and science and technology will pick up in the economy.


The Nigerian economy have petroleum, if we add iron ore and steel as foreign exchange, the currency will appreciate, since there will be more countries demanding for the products.
The abundant human resources that can be transformed from unskilled into skilled professionals are another way to appreciate the currency of developing economies. For instance, the population figure of Nigeria is 182 as at December 2015. If the human capital can be developed through many ways such as training, education etc other countries will demand for the services of these experts, this will also increase its value of our currency.


The human capital development domestically is very good for the economy because human capital is needed in the process of industrializing the economy. The two most important variables in production function in economics are labour and capital. It can be expressed thus;
QX = f (K,L) or in Cob-Douglas production function, which is QX = AKaLb.
Capital cannot produce a commodity alone without labour, and labour cannot produce a commodity alone without capital.


That is why the emphasis on machinery is the same emphasizing Human Capital development.
Another very important way of appreciating the domestic currencies of developing nations is that the primary products of these economies from mining and agriculture should be processed in order to command reasonable prices in the global market.
Crude oil should be converted into refined oil before exporting it to other countries.
Primary agricultural products that are exported as extracted should be transformed into processed and well packed, well branded agricultural products.


These will lead to appreciation of our currencies in developing nations like Nigeria, India, China and Ghana etc. The economic instability and political instability of developing nations. The ease of doing business in Nigeria stands at 169 as at December 2015. The ease of doing business in Ghana stands at 114. Compare these indicators for these two economies with these countries ease of doing business indicators.


The United States stands at 7 while that of China stands at 84.
From the above figures in the case of doing business, an investor will be more attracted to US economy and China’s economy for investment because the ease of doing business figures are low in these country i.e. it will be favorable and profitable to invest in these economies than investing in Nigeria and Ghana whose indicators are very high signifying unfavorable and mostly unprofitable speculation for investment.



There are many factors that lead to this situation.
One of those factors for the difference in the ease of doing business is the differences in interest rates in these economies.
The interest rates for Ghana and Nigeria are 26% and 14%as at June 2016 respectively.
While the interest rates for China and USA are 4.35% and 0.5% as at June 2016 respectively.
The most important determinants of investment is the rate of interest. If the rate of interest is low, investors will invest because the profitability of the project will exceed the market interest rate. This is true for China and USA based on those figures. While, investors will not invest if the probability of the projects will be less than the market interest rate. This is true for Nigeria and Ghana, whose market interest rates are very high.


The second factor for the difference in the ease of doing business is the volatility of investment. The volatility of the projects or investments depends on the rate of inflation and the price level (exchange rate).
The current inflation rates of USA and China are 0.8% and 1.8% respectively. These are indicators of price stability in these economies. Investors will be happy to invest because the value of their funds or capitals is protected from unnecessary fluctuations.



For instance, in Nigeria and Ghana, the inflation rates are 16.5% and 16.7% respectively. This are very high and hence, shows the level of economic instability in the economy. This can hinder investors from investing because of the uncertainty of the price level in the domestic economy which can affect the value of investor’s funds. The other important factor for the difference in the ease of doing business is the political stability of the country.



A country with high level of security and low political crises tends to attract investors than a country with high level of insecurity and political crises. In fact, investment is not safe in an environment characterized with violence. It scares investors, both domestic entrepreneurs and foreign entrepreneurs.
If developing economies can work on their indicators of ease of doing business, I believe their domestic currency will feel the multiplier effect of the investment that will be ushered into the economies.



In some parts of Nigeria like the North East geopolitical zone, there is high terrorism and political crisis. Due to this singular reason, the inhabitants of the place had deserted some of the cities.
These inhabitants suppose to be the market for the industries in the area but the political conditions and security conditions do not allow them to stay.
Now, if people could desert their home because of political crisis, is it investors that will be happy to invest in such places?
Friends, your guess is as good as mine, knowing fully well that the goal of investors is profit maximization.


Investors will never accept a project proposal in a place that there is political instability and crises.
Hence, all developing countries should work on their security and internal crises because it is only the absence of political crisis that investment can evolve in such economies. Also the developed economies like the USA whose unemployment rate is 4.9% should maintain the economy by providing tight securities in order to curb political and societal crises that can lead to a negative impact on the economy.


THE POLICIES RECOMMENDATIONS IN REGARDS TO THE MAINTENANCE OF FOREIGN EXCHANGE RATE.

You will agree with me that all economies especially developing economies have the desire to achieve a low inflation rate, low rate of unemployment especially youth unemployment, and low food inflation rate and inflation rate.


The inflation rate in the US economy is 0.8% as at June 2016. And the food inflation rate stands at 0.2%.
The significance of these indicators is that the value of the dollar will be stabilized domestically. Low inflation rate is also good for business growth and profitability as well as employment generation. Inflation rate cease to be favored to an economy when it is unusually high, like the inflation Rate in Ghana and Nigeria which are 16.7 % and 16.5% respectively.


 High and double digit inflation will lead to economic problems.
In developing economies, inflation rate should be low. This can be done through pegging or fixing the exchange rate.


A pegged exchange rate or a fixed exchange rate has the advantage of regulating inflation in an economy. For example, under a pegged exchange rate, an importer import sport car Mode 9 at the exchange rate of $1: N200. The price of the sport car model 9,  per unit is $10,000. If he imports 10 units of the cars, the cost of importing or buying per car will be N1, 000,000. The total cost of importing the cars will cost N20, 000,000. The importer may decide to add a profit margin of N100,000. The selling price will now be N2, 100,000.


Under a pegged exchange rate as demonstrated in the above scenario,  a sport car will be sold at 2.1 million naira.
If the exchange rate policy is changed from pegged to floating regime, assuming the exchange rate as at the period of importing the car is $1: 350. If it takes $10,000 to purchase 1 unit of sport car model 9 from US, the naira equivalent to purchase the car will be N3,500,000. If he decides to sell the sport cars at a profit margin of 100,000 selling price of the sport car per unit will be N3.6m
 We can see that inflation has been imported into the domestic economy under floating exchange rate. If the situation is not addressed it will escalate into higher inflation rate in the economy. This is the issue with Nigeria.



For developing economies that has few foreign exchange, I recommend a pegged foreign exchange regime in order to control inflation in the domestic economies.
The interest rate in India economy is 6.5%. In China, the current interest rate at 4.35%. The interest rate in these economies are low though they are  developing economies.
Low interest rate will make investment attractive to both entrepreneurs and investors. Since, the expected yield of the investment will be greater than the interest rate. The opposite is the case when interest rate is very high. High interest rate is what is obtainable in most developing economies of Asia and Africa.


I hereby recommend that all developing economies who desires to appreciate the international value to their currencies should regulate their interest rate and make it low for investment attraction.
Political instability can only lead to many macroeconomic problems. Just as explained and analyzed before, political crises in an economy will lead to economic retrogression. Inflation will rise because of under productions. Unemployment will be on the increase because of political instability.
Investors will be scared from coming in for investment since lives  and properties are not protected.
All the above will only lead to greater dependency on importation with low level of domestic production.


This will continue to lead to depreciation of the value of the domestic economy.
To maintain and stabilize exchange rate in an economy, the political state of the country should be favorable. One of the causes of high unemployment rate in Nigeria for instance is political instability. The current unemployment rate in Nigeria is 12.1% and youth unemployment rate is 21.5%. This high unemployment rates are partly caused by political instability in the economy.
This is in contrast with the US economy where unemployment rate stands at4.9%. Part of the cause of this low unemployment interest rate in this economy is political stability. This owes to the fact that political stability encourages investors and entrepreneurs to invest in an economy.


CONCLUSION

In conclusion, according to Lord Mayard Keynes, “in the long run, we are all dead”. Since in the long run we are all dead, in the short run we will be alive.
The government of developing economies should awake and address these problems in the short run, in order for the problems not to create more problems in the economy. Since in the short run we are still alive, something should be done in the short run to take any economic problem, especially this exchange rate maintenance.



Remember that, if we don’t kill high inflation, high inflation will kill us. If we don’t kill the force of political instability, political instability will kill us.
If we don’t reduce interest rate, high interest rate will place us where we belong in the global economy. I hereby call all developing economies, to awake and kill high inflation, high interest rate and political instability.
Only with these can the economies of developing countries climb the ladder of growth and development.




AUTHOR:  IBRAHIM M. ONOROYIZA (PROGRESS)
INSTITUTION: AMBROSE ALLI UNIVERSITY (AAU) EKPOMA,EDO STATE,
NIGERIA
PMB: 14

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Education Technology: FLOATING EXCHANGE RATE MECHANISM IN DEVELOPING ECONOMIES
FLOATING EXCHANGE RATE MECHANISM IN DEVELOPING ECONOMIES
Globalization has been made possible through global exchange. Globalization is the direct offspring of foreign exchange, that is, the exchange of goods and services among countries across the globe. Therefore, through globalization, an important concept has evolved, which is exchange rate. Exchange rate is the rate at which foreign transaction is made. It is the rate at which a foreign a currency is converted into another currency.
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