Tag Archives: NCO

Mexico: Ready for rise in US interest rates

It seems almost certain that at some point in the near future the interest rates in the United States are going to rise. Interest rates have been hovering around zero for several years now, and it is only a matter of time until they rise at least a little bit.

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When this happens, it will not only have an effect on the domestic economy, but on the international economy as well as we have seen in class through the international finance diagrams. One country in particular that has struggled in the past with movements in the US interest rates is Mexico. However, according to Agustín Carstens, Governor of the Bank of Mexico, the country is in a much better place to handle an increase in US interest rates, whenever that may occur.

Previously, Mexico has suffered from movements in the US interest rates as they were not well prepared and not able to handle these changes very well. In the past, the issue would have looked something like this: the US increases interest rates, which would result in a movement along the US NCO curve up and to the left. This would then cause the supply of dollars to shift to the left, which would increase the exchange rate in the United States and lower net exports. Simultaneously in Mexico, this would cause the NCO curve to shift to the right and the supply of pesos to shift to the right as well, which would decrease the exchange rate and increase net exports. While an increase in net exports may not seem like such a bad thing, this would put Mexico above their natural level of output and may begin to overheat their economy.

But now that Mexico is better prepared and will be able to handle such an increase in US interest rates, this sort of trouble should not occur. “Mexico is trying to have this process of increase in interest rates as orderly as possible,” Ramos-Francia (Mexico’s central bank deputy governor) said. When in fact the US does raise interest rates, Mexico should be able to respond in such a way to stay at (or return after a brief stray from) their natural level of output. In order to do so, after an increase from the US, Mexico could sell bonds domestically to decrease their money supply in order to increase their interest rates. This should result in a partial decrease in investment and a movement up and to the left along their new NCO curve which would shift the supply curve of pesos to the left (about halfway between the original and the intermediate curve), decreasing net exports partially and increasing the exchange rate, but not all the way back to the original level. In this way, Mexico would lower both net exports and investment part way in order to get back to the natural level of output.

While there have been some complaints from emerging markets about how much US policy can negatively affect their growth and progress, Augustín Carstens has said that “there are limits to international policy-making coordination. Developing-economy leaders ‘should take policies in advanced economies as given’ and should ‘deal with their own problems’ through their own powers.”

In saying this, it seems that Carstens maintains a positive view that Mexico has reached a point where they have enough power that they can truly handle their own issues as they come along from movements in the US. This is obviously a good thing for both Mexico and the US, as the United States can make changes as they see fit (as we should) and Mexico will be able to respond accordingly.

Effects on Russia’s Economy

According to the Wall Street Journal, Russia is experiencing an extreme growth in capital outflow. According to the article, this can be related to the recent annex of the Crimean peninsula. In the first quarter of 2014, its capital outflow should be between $65 billion and $70 billion. This has had adverse effects on the economy. Russia’s economy’s growth has been hindered because the increase in capital outflow has cut into investment spending. With all of the money going out, there is not a lot of money coming in for investments.

An article in the New York Times by Andrew E. Kramer discusses the increase in economic pressure that Russia is imposing on Ukraine. According to the article, about 25% of all of Ukraine’s exports go to Russia. Factories in Ukraine have been benefitting from this. In a series of blogs in the New York Times, Russia’s economy has been suffering at the cost of this situation with Ukraine.

Personally, I do not understand why Russia would be willing to sacrifice its own economy for a crisis with a neighbor. At the same time, Ukraine’s factories are benefitting. The way this crisis is working is that Russia is willing to hurt its own economy and help the economy of its rival neighbor. That does not make any sense. Along with that, Russia’s actions have not been seen as favorable in western eyes. The western world is very important politically and economically. Positive relations with it are crucial to success in the world. Russia is continuing to shoot itself in the foot with this crisis in Ukraine. This country is very strong and has a bright future. Putin is throwing it all away.

In my opinion, Russia should pull out of Ukraine as soon as possible. The country will be viewed more positively by the western world. Furthermore, Russia would be saving its own economy. In order to fulfill its potential, the country would need an influx of investments. The only country that would not benefit would be Ukraine. However, the country would not suffer as much. The larger changes would be in the Russian economy. If Putin were to serve his country well, he would end this crisis with Ukraine at once. His country would benefit immediately. Personally, I do not understand why a political leader would want to hurt the economy of his or her country, but maybe that is why I am not in politics.

China’s Banking Purgatory

As of yesterday, the Yuan fell to its lowest value relative to the dollar in ten months because the Chinese government “doubled the currency’s daily trading range” over the weekend.  With the goal of reducing capital inflow so as to decrease the risk of asset bubbles, this policy is part of China’s plan to replace strict currency controls with financial regulation.  Ultimately, China hopes to achieve greater financial stability in doing so.

Personally, I find this rhetoric hard to believe.  We learned in class that China benefits from reduced capital inflows.  Reduced capital inflows imply an increase in net capital outflows, which in turn leads to a boost in China’s net exports, a depreciation of the Yuan, and an increase in GDP.  For this reason, it seems hard to believe that China is committed to loosening currency controls.

This wishy-washy policy is what places China in “banking purgatory.”  By directly impacting financial institutions and private banking, China’s inconstancy places it in an awkward purgatory between fully controlled markets (economic Hell) and capitalism (economic Heaven – obviously my opinions are made very clear here…).

Specifically, China’s wishy-washy policy impacts banking and financial institutions in the following way: given China’s commitment to decreased currency manipulation, many private firms in China (both financial and non-financial) have already pursued billions of dollars worth of options contracts to hedge against an appreciating Yuan.  That said, when the government steps in and redirects changes in the Yuan’s value, these options generate losses for private firms.  In 2014, the Yuan is down 2% relative to the dollar, and this depreciation has resulted in over $2 billion of losses for Chines firms.

For Chinese firms making exportable goods, the losses on these options are minimized by a boost in exports.  However, financial firms, which do not usually export any tangible goods, are not so fortunate.  Given the already unstable state that Chinese financial firms are in (the government is just beginning to warm up to private banking), these losses could have significant implications for shadow banking.

China’s currently uses a public banking system.  This policy has ultimately hurt small businesses, as it is harder for them to meet the strict borrowing requirements set out by a highly risk-averse institution like the Chinese government.  Unable to qualify for public loans, small business turn to shadow banks instead, which force many small businesses into unaffordable loans (shadow banks are financial intermediaries that carry out typical banking activities like commercial lending, but without the limits of traditional depository regulations).

Because China’s small businesses cannot qualify for public loans and cannot afford shadow loans, they are left with very few options for sustainable growth.  Given that small businesses in China are responsible for 60% of China’s GDP and 75% of China’s new jobs, this predicament poses a serious threat to China’s economic sustainability.  A simple solution would be to allow for private, regulated, banking.  And in the beginning of 2014, China did just this, approving a pilot plan for the establishment of 3-5 private banks.  That said, given the losses that Chinese financial firms are experiencing currently (caused by the government’s currency manipulation), I find it unlikely that the proliferation of private banking will come anytime soon.

In this way, China is stuck in an uncomfortable middle ground on its way to economic deregulation; like the Catholic destined for heaven but in need of purification, China is struggling in purgatory as it develops into a capitalist economy.  While China has committed verbally to currency deregulation (a very good step in my opinion), the country’s policies do not yet align with this verbal commitment.  Certainly, it is difficult for a country as big as China to abandon such an engrained tradition of currency manipulation.  But until China commits to doing so, inconsistent policy will plague financial institutions, which will in turn reduce the chances of successful private banking and increase the pain small businesses feel from shadow banking.  Complete commitment to looser currency controls is therefore necessary for China to escape its banking purgatory and fuel sustainable, long-run growth.