Structured derivatives contracts, hedging exchange appreciation and financial instability: Brazil, China and Korea

Abstract

There has been a great deal of discussion recently over the use of exchange rates to ameliorate international imbalances. At the same time many developed countries have embarked a highly expansionary monetary policies, expanding the types and amounts of securities held on central bank balance sheets and attempting to use these purchased to alter the shape of the yield curve by buying medium and longer term securities. These two policies are inter-related since effective monetary expansion and zero short term interest rates accompanied by extremely low medium term interest encourage interest rate arbitrage and a reach for yield amongst institutional and retail investors which tends to increase exchange rate volatility and produce unidirectional cumulative movements of exchange rates in surplus countries which may cause substantial financial instability in the countries whose currencies are under pressure to appreciate.While it is often argued that these relative movements in exchange rates will aid the international balances of payments adjustment process, whether this is correct remains to be seen. however, export firms in countries with appreciating exchange rates will seek means to subvert an adjustment process based on reducing their profitability. Derivatives contracts have been crucial in subverting the impact of exchange rates on the adjustment process and thus on the profitability of export firms in surplus countries. I have already written on the role of derivatives in aggravating the Asian financial crisis (in the Cambridge Journal of Economics special

The Fourth Dimension

“…These studies show the role of carry trade in exchange rate distortion due to interest rate differentials among currencies. Along this same line, Kregel (2010:1) argues that “derivatives contracts have been crucial in subverting the impact of exchange rates on the adjustment process and thus on the profitability of export firms in surplus countries.”…”