International Finance Assignment: An Article Review on “The IMF’s Unmet Challenges”
Question
Task: Prepare an international finance assignment presenting an article review on “The IMF’s Unmet Challenges”.
Answer
PART A
1. Summary of the Article “The IMF’s Unmet Challenges
Based on the article review it has been identified in this international finance assignment that IMF has faced lots of controversies in terms of interventions including surveillance, conditionality in case of loans and so on. This is because global financial issues are always changing and hence the monetary policies are developing in different time periods. It has been found from the analysis that the IMF is an inefficient international organization in terms of managing various economic challenges all over the world. Surveillance is the first unmet challenge of the International Monetary Fund through which the organization evaluates the financial policies of 188 member nations throughout the world. In the case of conditionality, the main issue has been identified regarding a disagreement about how many and what anatomy of commitments required. According to the view of Eichengreen and Woods, the government of a country is sovereign and hence one cannot expect to meet specific conditions from the government of a country. This is why the disagreement has been found between the IMF and the government of a country in case of providing financial assistance. Based on the opinion of authors, the worst policy of IMF is it imposes lots of conditions on the government of an underdeveloped and developing nation in case of providing loan and it creates complexities at the time of the agreement or repaying the amount of loan.
The article depicts that in addition to the surveillance and conditionality of loans, the third important controversy regarding activities of IMF is improper management of sovereign debt crisis. The main issue in this case that has been identified is the coordination problem. The issue has been developed as transaction cost could not be recorded and the proper legal framework is not implemented internationally. The lack of effective management of debt crisis has led the issue of governance in case if the IMF and the organization have faced an awkward situation to ensure the financial prosperity of the whole world. It is recognized that the sovereign debt crisis has been developed as the governments of developing nations have become unable to pay their bills and political issue is responsible behind this problem. IMF could not help properly to over the debt crisis and has faced controversy over the world. It is the duty of IMF to provide proper judgment based on rigorous analysis regarding the sovereign debt crisis but the responsibility could not be fulfilled by the International Monetary Fund due to their management problem.
According to the article, two key factors impartiality and competency are important to an organization like the IMF to ensure the quality of services. However, the IMF could not contribute these two elements and this is why challenges are not met by the organization. Furthermore, the question of legitimacy has also been raised by many critics behind the faults of the IMF. The reason is the IMF could not defend the question of management that was developed during the global financial crisis. The article says that the IMF could exercise its power and it has created the problem in legitimacy. The question has been raised in both cases input legitimacy and output legitimacy. The input legitimacy has dealt with appropriate utilization of power and responsibilities and on the other hand, three issues including surveillance, conditionality, and debt problems have created the output legitimacy issue. It has been discussed that IMF needs to enhance its performance in the competitive market of the 21st century for recovering position.
The surveillance issue of IMF has been started after the collapse of the Bretton Woods System and for overcoming the issue; IMF has developed the plan during the year 2014. This is the stepping stone of the IMF policy reformation and it has enhanced the regulations of IMF. The organization has tackled economic and financial risks and the position of IMF is developed throughout the globe. However, the IMF could not provide proper support in case of the banking crisis in Iceland and from this, it can be stated that the development of the surveillance process of IMF is essential as it would improve organizational performance and responsibilities would be developed among staff. The policy of IMF regarding the development of stability in the exchange rate and capital flows is needed to be enhanced as these have a significant impact on the economic growth of the world. However, at the current stage, the stable exchange rate of IMF is unclear to the world as stability in the exchange rate cannot be made as a result of inflation. The fluctuation has been found in the case of underdeveloped countries as the inflation rate affects their economy and the cost of living.
Considering the Bretton woods era, it can be stated that the IMF provided loans at that tomes to their member nations for adjusting exchange rate pegs. The loan had been taken by the government of a particular country from the IMF while foreign currency reserve was deteriorated. In the modern age, the IMF provides loans for the entire economic and financial sustainability of a nation. Hence, in this case, too many conditions are not good for the government of a nation. The government is the supreme leader of a nation and hence, it can be stated that the IMF needs to assist properly rather than focusing on conditions. The money lending program of IMF is known as standby arrangement and from the year 2015 onwards, the responsibility regarding this has been developed. However, in terms of conditions, it can be said that the IMF has to be liberal to avoid conflicts with the governments of different countries.
At last, it can be said that the IMF has changed its policy in terms of managing the sovereign debt crisis. This is because it would help to ensure their performance and they can get rid of several controversies of the world regarding financial assistance. Recently International Monetary Fund has adopted the policy of restructuring sovereign debts for eliminating uncertainties in the debt repayment. It is a significant role regarding assistance to the government of a nation under a comprehensive situation. Furthermore, the IMF has suggested to the government of different nations to add collective action clause for their sovereign bond contracts.
PART B
1. Purchasing Power Parity (PPP) and International Fisher Effect (IFE) in theory makes derivatives Unnecessary
Purchasing Power Parity and International Fisher Effect
As mentioned by Bahmani-Oskooeeet al.,(2016), while the inflation rate increases in a particular nation, it hampers export sales and amount of import is increased. It creates current account deficits and high depression affects the economic development of the nation. The concept of Purchasing Power Parity focuses on the equilibrium between the exchange rate of home and foreign countries by quantifying the inflation-exchange rate relationship. PPP can be classified into two anatomies including absolute and relative form and both are used for adjusting the foreign exchange rate. The absolute form of PPP emphasizes the maintenance of equality at the time of measuring product prices in the common currency. On the other side, the relative form of PPP says that the rate of change in price should be similar in the case of home and other countries. Hence, the concept of PPP focuses on the adjustment in the change in exchange rates based on inflation.
According to the view ofPuci and Mansaku, (2016), International Fisher effect says that currencies with higher interest rates depreciate quickly as it reveals that higher inflation exists in the market. It has dealt with an effective return on the foreign money market investment. Based on the differences in the nominal interest rates, the effective return on investment has been considered. The application of IFE has been found in the case of multinational business enterprises as they focus on the investment in the money market in different countries.
Derivative Market
As mentioned by Atilganet al.,(2016), the derivative market mainly deals with the reduction of a market risk considering exchange rate inflation and interest factors. Hence, there is no difference between the concept of PPP, IFE, and derivatives. In order to reduce the exchange rate risk in the international market, different derivative instruments including swap, options are used.
PPP and IFE makes Derivative irrelevant
Based on the above discussions, it has been found that inflation; exchange rate and nominal interest rate are three factors that influence the performance of a business firm in the international market. As opined by Lothian, (2016), the financial management decision in the case of the domestic market is not critical as the exchange rate fluctuation factor is not considered here. On the other hand, in the case of the international financial decision-making process, the adjustment between the exchange rate of home and a foreign country is essential as it would help to maintain uniformity in the product prices throughout the nation. The adjustment in the exchange rate helps to recover the trade deficit in the balance of payment account. In the age of globalization, the home and host country relationship is important as it would help an MNC to operate effectively throughout the globe. For instance, the Nissan Company UK has to enhance uniformity in performance with Nissan Japan for maintaining prosperity in the business.
Figure 1: International financial Activities of MNCs
(Source:Adam and Ofori, 2017)
As mentioned by Machobaniet al., (2017), although the derivative market focuses on the hedging of these three types of risks, the application of PPP and IFE are more specific than derivative. This has made the theory of derivative irrelevant in the international market and the theory of Purchasing Power Parity has become popular. The application of the PPP model enhances the decision making of MNCs as it deals with the maintenance of uniformity in the domestic and foreign exchange rates. In this context, it can be stated that multinational organizations can use Big Mac Index that has been derived from the Purchasing Power Parity model. This index helps to identify the difference in the exchange rate between two countries as a result of inflation and strategy of price equalization can be adopted.The index has been developed considering the inflation rate of an economy for a particular time period.
Inflation Rate = (Year A Consumer Price Index – Year B Consumer Price Index/Year B)*100
Key factors that are focused by MNCs in the international business are exporting & importing, remittance of dividends and lending & borrowings. On the contrary, the application of derivative could not provide any common index based on which multinational organizations can adopt the right decisions. Hence, the application of the PPP model has made the derivative unnecessary to use as PPP is a more updated model in case of hedging inflation and exchange rate risk. In the case of PPP the thing is to make a comparison between baskets of goods of two countries but derivate only focuses on the application of risk hedging process.
As depicted by Adam and Ofori,(2017), in the case of the International Fisher effect, it has been identified that nominal and real interest rates both have been considered for evaluating the effect of inflation. The reason for considering these two factors separatelyis multinational organizations can recognize the actual rate of return on investment and they can identify the effect of inflation in the interest rate. Hence, the transparency in the interest rate risk hedging process can be maintained by applying the concept of IFE. On the contrary, in the case of interest rate derivative, only the risk has been identified regarding international transactions and it is the nominal interest rate. The inflation-adjusted interest rate has a significant role for identifying actual investment return and it can help a company to predict the future accurately.The international Fisher effect suggests that “Currencies with high interest would have a higher amount of expected inflation” (Adam and Ofori, 2017, p.121). It can be stated as true as the inflation effect directly impacts the fluctuation in interest rates in the different nations. On the other side, in the case of the derivative market, it has been identified that the risk adjustment mechanism has been discussed. Hence, it is completely clear that the application of the IFE theory has a more effective and wide application than the application of the derivative model. In this context, it can be stated that IFE relies on the assumptions and application of PPP. Based on the view ofArize, (2020), it has been clearly found that the Purchasing Power Parity model helps to MNCs to ensure the equality in the price of commodities in different countries and foreign direct investment policies can be developed. For instance, if the price of US-based clothes in the USA is 30 dollars, the price of that product would be 24.6 GBP in the UK. In this case, the USD and UK currency exchange rates have been considered. The concept of inflation has been considered in the study which has been applied in the case of IFE also. Hence, it can be stated that International Fisher Effect has been developed considering the concept of PPP.The overall analysis reveals that PPP and IFE are the most updated model in case of adjusting inflation, interest rate, and exchange rate. The application of derivative is obsolete as the effectiveness of these two mechanismsis more than the derivative.
Figure 2: Trade and Investment between Two Economies
(Source: Leung and Ward, 2018)
2. Different ways in which derivatives can protect against the failings of International Fisher Effect and Purchasing Power Parity.
Based on the view of Machobaniet al.,(2017), although the PPP and IFE are two important hedging methods in the international market, sometimes these two techniques could not provide effective results in the case of hedging process. This is because the application of nominal and actual interest rate is not consistent and hence application of IFE cannot provide effective result always. The main drawback in the case of PPP is this concept does not focus on the substitute products of tradable goods in different countries. Under these circumstances, derivative can be used to enhance hedging process against the failure of PPP and IFE. As mentioned by Subrahmanyamand Reddy,(2019), PPP model assumes that exchange rate and purchasing power are same in the case of two nations but it is not practical always and hence, the problem has been developed in case of hedging of inflation and interest rate risk. According to the view of Bush and Woodham,(2019), importance of currency risk in the hedging process cannot be denied and major two currency risks are transactional risk and economic risk. The derivative market strategies are used to manage risk for getting high return on high risk and it ensures the efficiency of international financing process. In this context, it can be stated that all types of inflation cannot be properly controlled by the government in an economy as sudden economic collapse might be happened at any time. Considering the example of hyperinflation, it can be stated that money supply has been increased at the time of this inflation and price of commodities increase due to some unavoidable reasons including collapse of particular sector in the economy. According to the view of Sieron, (2019), inflation might be happened as a result of two reasons including excessivedemand over supply and increase in cost of product. Furthermore, inflation can be increased due to increase in money in the economy and it happens as a result of inefficient economic policies of a government. Hence, under these circumstances, PPP and IFE might not provide fruitful results in the risk hedging process.
Figure 3: Demand Pull Inflation
(Source:Sieron, 2019)
Figure 4: Cost Push Inflation
(Source:Sieron, 2019)
Following derivative instruments are used in case of managing risk in the international market and protecting the failure International Fisher Effect and Purchasing Power Parity
Derivative Options
As opined by Leung and Ward, (2018), the derivative option is an important technique in case of managing the risk of exchange rate in the future. The inflation occurs in different time periods in an economy and hence it is essential to adjust the inflation rate properly for selling and buying a product internationally. Option is a predetermined contract in which the price has been fixed for protecting the risk of inflation and exchange rate. In case of PPP model, it is considered that the exchange rate in two countries are fixed but it is not true. Hence, the application of Option derivative strategy can help to enhance hedging process and the issue of PPP can be overcome. Expiration date and Strike price are two key concepts that are used in case of derivative options and these are essential for avoiding risk of foreign exchange rate. The exchange cannot be equal always in the case of two countries as currency risks are fluctuation based on economic performance in two different nations.
Swaps
As stated by Jermann, (2020),Swaps are important elements in case of reducing interest rate and currency risk in a particular nation. The International Fisher effect considers the nominal interest rate and it cannot be adjusted properly as a high inflation. Hence, IFE cannot provide fruitful result always and under these circumstances, it is important to focus on the interest rate swaps as it ensures that rate of interest has been adjusted with respect to the inflation. Hence, it is clear that although the concept of nominal interest has been considered in the Swap, at the time of adjustment of interest rates, the inflation factor is considered. On the other side, the currency swap technique is also used for reducing the issue of the currency exchange rate. The Purchasing power parity does not focus on the right assumptions and this is why currency risks are properly considered in the international transaction process.
Forward Derivative
As mentioned by Kota and Charumathi,(2018), Forward derivative strategy has been considered as an important technique to reduce the risk of inflation as in this process the product buying and selling has been made at an a predetermined agreed price. The main difference between forward derivative and option is option is a standardized contract but forward is a non standardized contract. The main advantage of this type of contract is as a result of inflation one party would get benefit and another party would incur loss. The agreed price cannot be changed as it is done with the free consent of buyer and seller.
Developing Higher return than the rate of Inflation
Based on the view of Wanget al.,(2016) agency problem is the common in case of a business as all stakeholders want to enhance their returns in the competition. Hence, a business entity has to develop their performance in the comprehensive market for satisfying stakeholders. In this case the key problem is moral hazard as everyone expects maximum return on investment. For instance, a manager in a business entity tries to enhance their profit from company investment. Hence, the company has to adopt such a policy that can help to increase return more than inflation. Derivative contracts can helps to manage risk easily and enhance higher return on investment.
Figure 5: Key Areas of Agency Model
(Source: Wang et al., 2020)
References
Adam, A.M. and Ofori, D., 2017.Validity of International Fisher Effect in the West African Monetary Zone. Journal of Economic Cooperation & Development, 38(3), pp.121-143.
Arize, A.C., 2020. Purchasing power parity in developing countries: Evidence from conventional and fractional cointegration tests. International Journal of Banking and Finance, 2(1), pp.29-43.
Atilgan, Y., Demirtas, K.O. and Simsek, K.D., 2016. Derivative markets in emerging economies: A survey. International Review of Economics & Finance, 42, pp.88-102.
Bahmani-Oskooee, M., Chang, T. and Lee, K.C., 2016. Purchasing power parity in emerging markets: A panel stationary test with both sharp and smooth breaks. Economic Systems, 40(3), pp.453-460.
Bush, R. and Woodham, A., 2019. Practical Applications of The New Neutral: The Long-Term Case for Currency Hedging. Practical Applications, 7(2), pp.1-6.
Jermann, U., 2020. Negative swap spreads and limited arbitrage. The Review of Financial Studies, 33(1), pp.212-238.
Kota, H.B. and Charumathi, B., 2018. Determinants of financial derivative disclosures in an emerging economy: a stewardship theory perspective. Australasian Accounting, Business and Finance Journal, 12(3), pp.62-86.
Leung, T. and Ward, B., 2018. Dynamic index tracking and risk exposure control using derivatives. Applied Mathematical Finance, 25(2), pp.180-212.
Lothian, J.R., 2016. Purchasing power parity and the behavior of prices and nominal exchange rates across exchange-rate regimes. International finance assignmentJournal of International Money and Finance, 69, pp.5-21.
Machobani, D., Boako, G. and Alagidede, P., 2017. Uncovered Interest Parity, Purchasing Power Parity and the Fisher effect: Evidence from South Africa. Frontiers in Finance & Economics, 14(2).pp.23-29
Oskooee, M.B. and Bahmani, S., 2016. The Rial-Dollar Exchange Rate and Purchasing Power Parity Theory. Cyrus Chronicle Journal, 1(1), pp.17-22.
Puci, J. and Mansaku, S., 2016. An empirical evidence of the International Fisher Effect on the USD to CNY exchange rate. Academic Journal of Interdisciplinary Studies, 5(1), p.249. Sieron, A., 2019. Money, Inflation and Business Cycles: The Cantillon Effect and the Economy. Routledge.
Subrahmanyam, G. and Reddy, K.S., 2019. Gaps galore in the monetary approach to the purchasing power parity: a theoretical note. Macroeconomics and Finance in Emerging Market Economies, 12(3), pp.197-204.
Wang, Y., Chen, C.R., Chen, L. and Huang, Y.S., 2016. Overinvestment, inflation uncertainty, and managerial overconfidence: Firm level analysis of Chinese corporations. The North American Journal of Economics and Finance, 38, pp.54-69.
