Exchange Rate Management and Control

This assignment focuses on the management and control of exchange rates, a crucial aspect of international finance. It draws from various sources, including academic articles, books, and online resources, to provide an in-depth analysis of the topic. The assignment covers key concepts such as currency values, economic policies, and international finance theories, highlighting their impact on exchange rate management and control.

RUNNING HEAD: Foreign Exchange- Research and Trading Report
Foreign Exchange- Research and Trading Report

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Contents
Introduction......................................................................................................................................2
Factors having greatest influence on the value of Exchange Rates.................................................2
Supply and Demand.....................................................................................................................2
Inflation and Deflation.................................................................................................................3
Interest Rates and Money Supply Policy.....................................................................................3
Balance of Payments....................................................................................................................4
Asset Prices..................................................................................................................................5
Politics and Wars.........................................................................................................................5
Management of Value of CNY by PBOC and Future Direction of PBOC Policy..........................6
Conclusion.......................................................................................................................................8
References......................................................................................................................................10

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Introduction
Foreign Exchange rate can be defined as the rate at which the currency of one country may be
transformed into the currency of another country (Moosa & Bhatti, 2010). It is considered as one
of the most important means which assists in determining the relative level of the economic
health of a country. The foreign exchange rate provides a window to the economic stability of a
country. The fluctuations in exchange rates re caused daily with the changes in market forces of
demand and supply of the currencies from one county to another.
This report focuses on the factors that have an influence on the value of exchange rate such as
the supply and demand, inflation and deflation, interest rates and money supply policy, balance
of payments, asset prices and politics and war (Block, Hirt & Danielsen, 2011). This report also
discusses the management of the value of Chinese Yuan (CNY) by Peoples Bank of China
(PBOC) along with the opinion regarding the future direction of PBOC policy.
Factors having greatest influence on the value of Exchange Rates
Following are the factors that have the greatest influence on the value of exchange rates.
Supply and Demand
The forces of demand and supply have a great influence on the determination of exchange rates
(Levi, 2009). The value of a currency is expected to increase when there is high demand for that
currency in comparison with the currency for which there is less demand (Gabaix & Maggiori,
2015). The value of a currency is declined in comparison with other currency when the holders
of such currency have a desire of disposing it in exchange for other currencies. The detection of
opportunity in a particular currency by the market participants, either for higher investment
returns or direct appreciation, results in the increase in demand for that currency (Corsetti &
Lloyd, 2016). This in turn will lead to currency appreciation as the purchasers will outbid on
another. When such an opportunity is moved to another currency/ country, first currency holders
sell their currency for obtaining the currency associated with new opportunity. The fall and rise
of the exchange rate depend on the basic economic conditions that prompt investors, traders and
others to obtain more of a specific currency (Metcalf, 2018).

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For example, in 1971, there was upward float in the exchange rate and then a downwards float
against all the foremost currencies until the year 1976. One of the main reason behind this
depreciation was a rapid demand expansion in the UK.
Inflation and Deflation
Inflation can be defined as the rate at which there is an increase in the general level of prices of
goods and services (Hart, 2009). The variations in the inflation rate have short term and long
term implications for the foreign exchange market. The value of the currency increases with the
fall in inflation rate of a country. Lower inflation also results in slower rate of increase in the
prices of goods and services. Rising currency value is exhibited by the country having a
consistent lower inflation rate whereas depreciation in the currency is witnessed by the country
with higher inflation rate (Weale, Blake, Christodoulakis, Meade & Vines, 2015). In other
words, cost of production is increased due to inflation which subsequently results in the increase
in prices for goods which in turn leads to less competitive exports. This further leads to fall in
exports thereby weakening the domestic currency. High signs of inflation have the capability of
bringing an increase in the domestic currency due to the anticipation of traders regarding the
possibility of slowing down of inflation by increasing interest rates attempted by the local central
bank. Deflation, on the other hand, is considered as the symbol of economic depression and is
complemented by a weaker currency and lower interest rates (Frenkel & Johnson, 2013).
For example, UK suffered from the peak of inflation in the late 1970s and early 1980s. For a
very long time, the value of pound has been weak in comparison with dollar which is
depreciating since the preceding 116 years by an annual rate of 1 percent. This depreciation is
considered to be a result of the higher inflation rate in Britain which resulted in degrading the
purchasing power of the pound by a minuscule 0.22 percent every year.
Interest Rates and Money Supply Policy
The official monitory policy of a country sets the interest rates which have a great influence on
the exchange rates (Bodenstein, Erceg & Guerrieri, 2017). The level of economic activity is
influenced by the Central banks along with the influencing the behavior of lenders and borrowers
in their currency by fluctuating the interest rates. The rate of foreign exchange, inflation and
interest rates are correlated. The dollar exchange rate and currency value is affected as a result of
changes in interest rates. Appreciation in the currency of a country is witnessed when there is an

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increase in the interest rates. This is due to the fact that higher interest rates provide higher rates
to the lenders which in turn attract larger foreign capital and lead to a rise in the exchange rates.
The hunt for best possible returns by the foreign investors leads to the attraction of larger
investment funds to the country and this leads to the strengthening of the currency due to higher
interest rates. Moreover, the official monetary policy in eased and the interest rates are lowered
when the central bank views the economy as sluggish. This in turn weakens the country
currency. Moreover, the increase in the money supply reduces the interest rates which further
leads to a reduction in the exchange rates.
For example, a rise in the UK interest rates was witnessed during the mid- 1970s, without any
equivalent increase in the interest rates in US, the difference is accounted for by a discount on
sterling. From 1973 to 1976, it was expected that there will be a substantial depreciation in
sterling and therefore, the interest rates of UK were required to be in excess of US rates by an
equal margin.
Balance of Payments
Balance of payments (BOP) can be defined as the summary of all the international transactions
of a country in a specific period of time (Stern, 2017). When the exports of a country are more
than its imports then it is known as trade surplus. Moreover, when the imports of a country are
more than its exports then it is known as trade deficit. A country has firmer currency in cases
when the exports are more than the imports in comparison with the country which is involved in
more importing. Changes in the balance of payments of a country cause variations in the
exchange rate. More foreign receipts are generated in a country having a trade surplus than the
foreign debts. For the purpose of conversion of these foreign receipts into the local currency, the
requirement arises for selling the foreign currencies and purchasing the local currency. This
purchasing of the local currency is in excess of the sale made by the importers exchanging their
funds into foreign currencies for paying for their purchases. The value in comparison with other
currencies is lifted as a result of excess demand for the domestic currency. There are two
interrelated and different markets at work: the demand and supply of a particular currency
(exchange rate) and the market for the international market’s financial transactions (balance of
payments). The exchange rate is not impacted by the balance of payments in a fixed- rate system

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as the currency flows is adjusted by the central banks for offsetting the exchange of funds
internationally.
For example, a deficit on the current account balance of payments was faced by UK throughout
the 1950s and 60s. Trade deficit was considered as the major economic problem faced by UK.
For the purpose of financing the current account deficit, the use of capital flows or diminishing
foreign exchange reserves were required. This along with several other factors resulted in the
devaluation of sterling in the year 1967. From $2.80 to $2.40 which was a devaluation of nearly
14%.
Asset Prices
The prices of the assets also have an influence on the foreign exchange rate. Assets comprise of
items such as equities, bonds and real estate (industrial, commercial and residential). In cases,
where a buoyant market is enjoyed by assets in a particular country, the chances of the attraction
of international investment managers are increased for the purpose of maximizing their returns
(Andersen, Bollerslev, Diebold & Vega, 2007). The buying of local currency will significantly
increase due to relatively high returns as there is a flow of foreign funds into the better
performing assets. When the rates are increased by the central bank (returns increase and the
prices of asset prices fall), there is an appreciation in the currency due to the attraction of the
investors towards it (Cooper, 2014). There is a relationship between the general trend of the
currency and the return on assets: the increased risk taking among people leads to the
depreciation in the low- yielding currencies.
For example, the financial markets of the US faced financial market movements of an average of
over 25% of euro area during the year 1989- 2004, whereas 8% of the variance of asset prices of
US were accounted for by euro area markets.
Politics and Wars
The currency strength of a country is also affected by political stability, economic performance
and proneness to wars (MacDonald, 2007). Foreign investors are more attracted to a country
which suffers from less risk for political turmoil. This in turn draws the investment away from
the countries prone to more political and economic risk. In other words, the currency market
participants does not like risk and uncertainty, especially political uncertainty as it has the

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capability of causing unintended consequences which are not priced in by the investors and
traders at the commencement (Quinn & Weymouth, 2016). The value of the local currency of the
country is appreciated as a result of increase in the foreign capital. When the financial and trade
policy of a country is sound, there is no uncertainty in the currency’s value. However,
depreciation in the exchange rates of a country can be witnessed when such a country is prone to
political confusions. The fluctuations in the exchange rates are caused by terrorist attacks and
wars which leads the investors towards seeking the safest place for their money (Suleman &
Berka, 2017).
For example, before the start of the First World War, every £1 was worth under $5. The pound
was weakened as a result of Napoleonic wars which are considered as one of the exceptional
period which led to the temporary spiking up of the pound to $10. The First World War resulted
in the suspended gold standard and the war imposed financial burden on the sterling which made
it sink to $3.66 (Connington, 2016).
Management of Value of CNY by PBOC and Future Direction of PBOC Policy
Unlike the international trade partners of China who allow free floating of the value of their
currencies against others, the currency policy of China is strictly controlled where the trading
activity is controlled and the daily movements of the yuan is regulated by China on the foreign
exchange market. For the purpose of taming the economic instability, People’s Bank of China
(PBOC) fixed the exchange rate at slightly higher than 8 yuan to the US dollar and maintained it
until 2005 when the currency policy was moved towards liberalization by the introduction of a
narrow trading band. The trading band was allowed to be widened in the past decade by the
Chinese government starting at +/- 0.3% and finally reaching +/- 2% by March 2014 (FXCM,
2016).
The People’s Bank of China has maintained strict rules for banks and individuals holding foreign
currency. This is the reason due to which the currency is not yet considered to be fully
convertible. Investors are required to sell their dollars or foreign currency directly to the
People’s Bank of China when they want to exchange it for yuan so that it can be incorporated by
PBOC into the foreign reserves of the country. The portion of the reserves of China is used for
the purpose of influencing the value of yuan through the interventions in the foreign exchange

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market. The foreign currency reserves are sold in the market by PBOC for strengthening yuan.
When the currency of the country is required to be weakened PBOC makes the use of its local
currency for buying foreign currency. In case where interference is required, the government can
make the use of interbank market for buying or selling the currency, where the PBOC
“designated foreign exchange banks” are maintained for operating on its behalf for spot market
transactions.
The People’s Bank of China also has instruments such as derivative contracts at its disposal for
influencing the value of the currency and market. PBOC has used some of these instruments for
bringing sophistication in the management of foreign reserves and currency rates. These
instruments are used as it does not require PBOC to sell dollar supplies immediately and is
therefore advantageous. This further leads to slowing down of the depletion of China’s reserves
thereby maintaining market confidence in its ability for intervening in the future.
After the liberalization of currency policy in the year 2005, higher interest rates had been
maintained by PBOC. However, in the year 2014, the local interest rates were eased by PBOC
for the purpose of counteracting the slowing economy. The foreign currency inflows were
discouraged into the economy as a result of rate easing thereby leading to the pressure for the
weakening of yuan.
The currency rate of China is currently maintained within a controlled band that varies in
accordance with the market demand. PBOC is said to prefer near-term levels of currency by way
of its interbank foreign exchange system. Mid-price is used by PBOC for guiding the daily fixing
of the exchange rate of yuan against dollar on the basis of the previous closing price of yuan
against US dollar. The People’s Bank of China has allowed the exchange rate to fall or rise up to
2% on daily basis from official midpoint (South China Morning Post, 2017).
The power of the Chinese currency is a result of its exports made to America. The payment for
the exports is received in dollars by the Chinese companies from the United States. The dollars
are deposited by such companies into the banks in exchange for yuan for the purpose of making
payment to their employees. The dollars are then send to PBOC by the banks. It is then
stockpiled into the foreign exchange reserves which in turn cause a reduction in the supply of

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dollars available for trade (Yu, 2014). This results in rising of the dollar’s value and falling of
yuan’s value. Dollars are utilized by PBOC for purchasing U.S Treasures (Amadeo, 2017).
The regime used for the management of yuan has now been changed by People’s Bank of China
by way of removing a component utilized for the purpose of calculating their submissions to the
daily reference rate of the currency. Counter- cyclical factor has been introduced by China for
reducing the fluctuations in yuan initiating the introduction of capital controls. This led to better
control of PBOC over yuan but weakened the efforts made earlier for making yuan more market
driven and accessible (Bloomberg, 2018).
The future direction of the PBOC policy is highlighted by the signals as to future reforms of the
financial signals of the country and the direction of the monetary policy. Yi Gang, the Deputy
Governor of PBOC, referred to the repeated reference of the central government to stability in
the monetary policy and creation of an external environment that is capable of stably proceeding
financial reforms and preventing risk. The deputy governor of People’s Bank of China has also
signified that PBOC will continue its managed floating exchange rate framework for keeping the
stability in yuan currency. The framework will be based on the demand and supply and the value
of yuan against a basket of currencies. The yuan exchange rate is expected to be further
liberalized in order to maintain the stable position of yuan in the global monetary system.
(Reuters, 2017)
Conclusion
Foreign exchange is the rate at which the currency of one country may be transformed into the
currency of another country. this report assists in concluding that there are a number of factors
which influences the value of exchange rate including demand and supply, interest rate and
money supply policy, inflation and deflation, balance of payments, asset prices and politics and
wars, etc. (James, Marsh & Sarno, 2012). Moreover, this report focused on the management of
Chinese Yuan (CNY) by People’s Bank of China (PBOC) along with the opinion regarding the
future direction of PBOC policy. Therefore, it can be concluded that the maintenance of strict
rules by PBOC has resulted in stable position of yuan. Moreover, steps are being taken to
maintain this stability of yuan in the global monetary system with the help of floating exchange
rate framework.

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References
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from https://www.thebalance.com/how-does-china-influence-the-u-s-dollar-3970466
Andersen, T. G., Bollerslev, T., Diebold, F. X., & Vega, C. (2007). Real-time price discovery in
global stock, bond and foreign exchange markets. Journal of international
Economics, 73(2), 251-277.
Block, S. B., Hirt, G. A. & Danielsen, B. R. (2011). Foundations of financial management. Tata
McGraw-Hill Education.
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https://www.fxcm.com/insights/how-does-china-control-exchange-rates/

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