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• Preparation of Argentina’s complete balance of payment for the previous year and a forecast for next year.
• Effects of devaluation on sales if it occurs in Argentina’s economy.
• Borrowing decision feasibility for M/s Jeans USA
Trade balance is in a healthy position $4.691 BN and is likely to increase
Exports are $12.078 BN and are expected to increase to $13 BN which is 8% for next year.
Imports are likely to be remain constant
Foreign reserves are $10 BN
Business prospects are excellent in Argentina
BALANCE OF PAYMENTS
| |$ in billions |
|Exports |12.078 |
|Imports |-7.387 |
|Trade Balance |=+4.
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|Service Sector |-1.169 |
|Investment Income |-6.051 |
|( Unrequited Transfers |+0.029 |
|Current Account Balance |=-2.5 |
| | |
| |$ in billions |
|Direct Investment |2.439 |
|Portfolio Investment |-0.199 |
|Other Capital (not mentioned elsewhere) |-1.365 |
|Net Errors and Emissions |-0.341 |
|( Change In Reserves |+1.966 |
|Capital Account Balance |=+2.5 |
From the case study, we agree with the forecast by the consulting company on Argentina’s current account deficit as it was -$2.5billion last year. A deficit on the current account means that a country is importing more than they are exporting.
However, in Argentina business prospect, they exported more than they imported. Therefore, the high number in the current account deficit is mainly from the net investment income rather than the goods and services. The reason for this deficit could be caused by the following which are, Argentina excess spending in the economy, fixed exchange rate, high inflation. Government borrowing could have a part to play as this will increase and aggregate the demand in the economy and thus increases the demand for import. This could be the reason for the high import seen by the industrial, construction and service sector. Fixed exchange rate can also be the cause of current account deficit in the balance of payment in a way that, assuming the currency is overvalued, import will be cheaper. Therefore, there will be a higher demand for import. in the other hand, exports will be uncompetitive and there will be a reduction in exports which will in turn affect balance of payment (current account deficit). High inflation will make goods to be priced highly. This factor can also be offset by a decline in the value of currency.
Moreover, current account deficit is not always a problem but could be beneficial to some extent for several reasons. For example; assuming a current account deficit is financed from capital inflows, then this can be beneficial for the economy. Therefore, flow of investment can increase the productive capacity of the economy. However, Argentina’s income from investments is -$1.905billion which is not sufficient enough to finance the business. Also, assuming the deficit increase continuously, it will cause a devaluation which will help to increase the deficit. If there is a devaluation of the currency, the price of import will increase and the demand will fall. While, export will be cheaper in price and the demand will increase. Therefore, there will be improvement in the current account. However, this condition depends on Marshall-Lerner Condition which states that the sum of export and import elasticity in absolute value must be greater than 1. This is because the factors affecting the current account depend on the total value and not the quantity of export.
Although, devaluation has proven to be beneficial but it can also be a problem. For example; devaluation can lead to imports inflation. Therefore, it will cause a problem for the jean USA to rely only on capital flows. Also, most countries will not be able to invest in Argentina business at low interest rate. In order to avoid this situation, the interest rate needs to be raised to attract enough investors. The high interest rate will eventually reduce the demand on the economy but this can also affect Argentina in all four sectors in a way that they will consume less as the price of the goods increases and they will export more of the beef, wheat and other agricultural product that constitute the main export product.
However, deflation is also helpful. Assuming Argentina increased interest rate or if Argentina government increase tax people will have less money to spend so consumption of import will reduce, thus some investors will stop investing in Argentina’s business because most investors prefer country where there is less or no tax in order to have more profit. Assuming Deflationary policies puts pressure on manufacturers to reduce cost, there will be competitive export and export will increase.
From the balance of payment it can be seen that there is a deficit in the portfolio investment (-$0.199billion) compare to that of direct investment ($2.439billion). This could be caused by such factors as tax, interest rate, exchange rate and dividend.
For example; if the percentage of the dividend is too low investors will not invest in the business.
However, Sam Jones disagrees with the consulting company due to the current account being in the surplus. While this is true, we believe that current account is in surplus due to the fact that agricultural sector export more than they import. For example; assuming that agricultural sector import the same amount as other sectors there will have been a deficit on the trade balance.
Tom Tree agreed with Sam Jones but pointed out that service sector has a deficit of -$1.169 and that the net investment income was in deficit of $6.051 billion. Tom also predicted that this might increase. This shows that there is lost of money in the current account while, in the capital account there is profit as direct investment is $2.439billion. Deficit in net investment income could be caused by low interest rate. It is assumed that If interest rate was to increase, there will be increase in direct investment as most investors prefer to invest in country with high interest rate. However, purchasing power will reduce and goods will be too expensive for people to buy. The industrial, construction and service sector will consume less and export more. Therefore, there will be less import for goods. Assuming this occurs, the Government will raise their currency reserve in order to manipulate the money supply. In other words the currency will be sold in exchange for the country foreign reserve. But, assuming the speculator buys all the foreign reserves, a balance of payment crisis will occur. This is possible to occur if one is not careful as the change in reserve is only $1.966. Therefore, Ivy Veneno is right at some point.
However, interest rate can rise to overcome the above but this will cause hot money flow and increase demand for currency. The main criticism of a fixed exchange rate is that it serves to adjust the trade balance. When trade deficit occurs, there will be an increase in demand for foreign currency which will push up the price of the foreign currency in terms of the domestic currency. This will make the price of foreign goods less attractive to the market. When this occurs, trade deficit will reduce. However, under fixed exchange rate this re-balancing does not occur.
Furthermore, fixed rate balances the demand for export and import (more export than import). This solution is always good for government trading as it helps to maintain low inflation which lowers interest rate. However, low interest rate means lost of foreign investors. This also means increase in price of the goods in home country. An increase in price level both in home country or foreign country will reduce purchasing power which in turn will reduce net export.
In general, assuming foreign price level increase due to nominal fixed exchange rate then foreign goods will be more expensive and import will fall. At the same time, people in the home country will find it cheaper to purchase this goods/service and export will rise. As we can see, both factors increase net export. However, these solutions depend on market freedom, capital mobility and business cycle.
To conclude we can see from the above that such factors as interest rate, exchange rate, devaluation, inflation, tax, and fixed exchange rate has all played a part in the deficit of the current account which can be seen in the balance of payment. We have also seen from the above that most of these factors can also reduce deficit and while reducing deficit is causing another problem. Therefore the best solution is to minimise the above by having an equally exportation (about 80%) from all four sectors and importation of goods (20%). This is unlikely to occur in the economic world. Also, maintaining the fixed exchange rate will improve the balance of payment and the balance of trade will increase during an economic expansion.
Relative PPP formula to be applicable here in this case which is;
Before doing this we have to calculate the inflation rate which is as under:
Inflation for Argentina = PI1ARG/PI0ARG-1= 153/150-1 = 2%
Inflation for USA = PI1USA/PI0USA-1= 126/120-1 = 5% So
= St (Pessos/USD)- So (Pessos/USD) = iArg-iUSD
So (Pessos/USD) `1+iUSD therefore,
This is one of the aspect to understand the rate other aspect is the expected price of pesos after one year which can be calculated by forward rate parity , the formula is as under:
= F1990,1991, (Pessos/USD) = (1+rArg)1
So (Pessos/USD) -(1+rUSA)1
Real Interest Rate: Real Rate = (1+Nominal Rate)/ (1+Inflation Rate)
Real Rate Argentina = 1+6%*/1+2%=3.9%
Real Rate USA = 1+8%*/1+5%=2.9%
In the second part of the case study we examine the important of purchasing power parity theory which is the law of one price on the balance of payment. We found that the balance of payment within a given country does not alter the demand and supply of money in another country rather it observes the value of goods brought (import) and sold (export). This is because we found that 0.9714 peso is equal to $1 and the expected rate of peso after one year would be 0.9814 peso against $1. Therefore, there is a difference of 0.01. this figure gives a strong evidence why the JEANS USA should not borrow money from the bank as the difference between the current and expected rate is just 0.01peso. This expected rate currency are based on the forward rate parity calculation.
However, we advise Sam that they should not borrow peso(s) from the bank because the purchasing power parity (ppp) which is 0.9714 peso is better than the bank’s offer(0.9913 peso). However, if we take 1% commission effect into consideration, JEANS USA will still be better off against bank offer.
In the long run, Argentina will still maintain their exchange rate because they have enough foreign exchange reserves to cover the gap between demand and supply of foreign exchange if it occurs. If we compare the real interest rate of both Argentina and USA, Argentina is better off against USA for the next one year because Argentina has a real interest rate of 3.9% while USA has 2.9%. this shows that Argentina economy will perform better than USA. Therefore, we can conclude that Argentina real interest rate is high enough to off set the economical factors due to the fact that they have enough foreign exchange reserves, higher real interest rate, and high positive trade balance.