CHETANA ‘S BACHELOR OF MANAGEMENT

STUDIES

SUBJECT: Managerial Economics -II

T OPIC : Dollar Appreciation

Name: Nadar Karthik Soundararajan.

Roll NO.: 2138

Class: S.Y.B.M.S. (A)

Dollar appreciation attributed to a new rising demand power

The watchdog agency and economists still keep calm amid the continued dollar price increases, affirming that everything is still under control. Meanwhile, people believe that there is a rising power which is collecting dollars on the market.

Dollar price shoots up

All commercial banks quoted the dollar price at the ceiling level of 21,036 dong per dollar by the afternoon of June 6. The foreign currency trading band now is one percent, which means that the dollar price quoted by commercial banks must not be more than one percent higher than the dollar price announced by the State Bank of Vietnam.

This is the sharpest dollar price increase so far this year, with which the dollar has regained the peak set in late 2011.

Over the last five days, the dollar price has increased by 150-170 dong per dollar from the 20,870 dong per dollar level which had been stabilized for the last many days. Especially, the 3-month sharpest price increase still takes place, even though the interbank exchange rate stays at 20,828 dong per dollar.

While the unexpected dollar price increases have raised worries among people, bankers say this is not a surprise at all. In principle, the demand for dollar usually increases in June, when enterprises import essential goods, while petroleum importers have to make periodic payment. Once the demand increases, the dollar price would increase accordingly.

Meanwhile, the Vietnam dong interest rates tend to decrease, thus making the dollar more attractive. The speculation may lead to the overvaluation of the dollar.

With the argument, analysts believe that the dollar price increases would last only for a short time.

However, the explanation has not satisfied people and investors. The State Bank of Vietnam has affirmed the profuse foreign currency reserves, while the payment balance remains in stability. 

HSBC, in its latest report, also said that the Vietnam’s foreign currency reserves have increased by 30 percent over the end of 2011, thus helping raise Vietnam’s capability to deal with the negative happenings.

Why does the dollar still increase, then?

Some investors have made a guess that there is a tendency of banks converting their dong capital into dollar capital to optimize their profits in the context of the stagnant dong lending.

Despite the dong interest rate decreases, banks still cannot push up lending in the context of the stagnant production. The banks with profuse capital do not want to lend on the interbank market, where the interest rates have fallen to 3-4 percent. In such circumstances, converting dong into dollar capital proves to be a good choice.

Meanwhile, some other investors think about the possibility of foreign investors withdrawing money from Vietnam. Foreign securities investors have been selling their shares in big quantities on both the Hanoi and HCM City bourses.

Besides, the dollar interest rate downward in Vietnam may also lead to the outflow of the dollar from Vietnam. In the past, Vietnam attracted dollar capital from the world because it offered high deposit interest rates.

There is one more reasonable explanation for the dollar appreciation that the unsatisfactory exports in the first months of the year in the context of the global economic crisis have led to the short supply of dollars.

In fact, if comparing with the beginning of 2012, the current dollar price is not higher. It has just regained the 21,036 dong per dollar peak. Meanwhile, if considering the price performance in the last days, the dollar price has increased by 0.8 percent.

Causes Dollar Appreciation

Supply

Prominent economists such as the late Milton Friedman have claimed that an increase in the supply of dollars causes their value to decline, and vice versa. The total amount of dollars is included within four specific financial measurements labelled M0 through M3, with the tightest definition of money being M0 and the broadest M3. For example, the M2 metric represents the total amount of dollars in global circulation, including checking and savings accounts. M2 amounted to $1.874 trillion in February 2011, according to the Federal Reserve Board.

Inflation

Another important influence on the dollar's value is inflation, which refers to the cost of goods and services. The more dollars it takes to purchase items, the lower the value of the dollar becomes in terms of purchasing capacity. Inflation is measured using economic assessments of cost such as the Bureau of Labour Statistics' Consumer Price Index. If the dollar depreciates, or appreciates at a slower rate than inflation, then the dollar's worth does not keep pace with cost-of-living increases.

Interest Rates

Interest rates also cause the dollar to appreciate and depreciate in value. This is because interest rates affect the cost of borrowing money. When monetary policy allows interest rates to be low, the money supply increases due to the lower cost of borrowing. Low interest rates can also lead to inflation because an increase in wealth corresponds to a higher demand for

products, which means more dollars are required to purchase the same things. As interest rates rise, the dollar is more likely to appreciate in value.

Economy

The U.S. economy is correlated to the value of the dollar, according to Owen F. Hump age and Michael Shenk of the Federal Reserve Bank of Cleveland. Moreover, confidence in the economy leads to investment, which itself increases the cost of U.S. assets including the dollar. For example, international banks invest in dollars as a reserve currency; when the U.S. economy performs well, the amount of these reserves are more likely to increase, placing an upward pressure on the value of the currency.

The Effects of Interest Rate on the Dollar

The interest rate on all financial instruments (derived from the Federal funds target rate, which impacts inter-bank loans and the interest on investments) affects the value of the dollar by increasing or decreasing the demand from international investors for dollar-denominated U.S. assets. Currency traders short the dollar in anticipation of an increase in the interest rate, and vice-versa when they expect a rate cut.

1. Effect of High Interest Rate on the Dollar

o In "International Economics: Theory and Policy," Paul Krugman wrote: "All else equal, an increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currencies."

Currency traders purchase dollars to book higher yields when the interest rate is high. An increase in the real interest rate (inflation adjusted) will lead to an appreciation in the dollar, as overseas investors exert upward pressure on the dollar to purchase U.S. investments (Treasury bonds, money market accounts, CDs) in dollars. As with any commodity, as the demand increases, so does the value.

Effect of Low Interest Rate on the Dollar

o Currency traders and investors of U.S. financial instruments have no incentive to purchase dollars or dollar-denominated investments when the interest rate is low, since the yield on investments will also be low. Thus low interest rate on Treasury bonds will exert downward pressure on the dollar, leading to a depreciation of the currency.

Unintended Consequences

o The stock market and the dollar have an inverse relationship. While high interest rates lead to an appreciation in the dollar, it almost always depresses the stock market, resulting in a bear run (sale of shares) by international investors.

Inflation

o In an article titled "Interest Rates and Dollar Fundamentals" in the Wall Street Journal (Nov. 15, 2007), Alan Reynolds of the Cato Institute wrote: "High interest rates may prop up a currency for a while by attracting international "hot money." But super-high interest rates, like those in Turkey and Brazil, are typically a symptom of inflation-prone monetary policy, requiring a high risk premium to bribe investors to hold that country's IOUs. In any case, high interest rates are certainly not something most Americans would envy or hope to emulate."

Foreign Trade

o A strong dollar driven by high interest rates will make exports more expensive and imports cheaper. The converse is true when the dollar weakens. However, exporters with manufacturing facilities overseas will benefit from a strong dollar.