These questions are based on the attached article, "How far will Latin American currencies plummet?," published by the Latin American Business Stories website on May 21, 2020.
(a)The interest parity (IP) condition states that,
(IP) (1 + ir - ?)ee = (1+ ir*- ?*)e
where e and ee are the spot and expected exchange rates, ir and ir* are market interest rates inclusive of risk at home and foreign country, respectively, and ? and ?* are the risk premia of home and foreign financial assets.
Consider a Latin American country and treat it as the home economy. Assume that the US is the foreign country. Suppose the risk premium in the home country rises this year, while the market interest rates in both countries, foreign risk premium, and expectations about the future of the exchange rate remain unchanged. How would this temporary increase in risk premium affect the value of home currency against the US dollar as implied by the interest parity condition?
(b) In the situation described in part (a), suppose that risks rise not only this year, but also in the coming years. Assume that people form their expectations about the exchange rate in a future year based on what they think may happen in that year. How would the long-term increase in home market risk affect the expected exchange rate next year, ee, and the current spot exchange rate, e?
(c) The article points out that Latin American currencies had started depreciating against the US dollar in the past couple of years, before the COVID-19 outbreak. According to the article, what were the causes of that trend?
(d)
BUSINESS How far will Latin American currencies plummet? Emerging-market currencies are taking a heavy hit during the coronavirus crisis LABS MAY 21, 2020 Since the beginning of 2020 until this Thursday, the dollar has risen 38% against the Brazilian real (BRL). The escalation of the American currency was even greater at the beginning of the week (42%), but the real has gained some breath in the last two days. The Mexican peso (MXN) and the Col ombian peso (COL) also lost 21% and 17% of their value against the dollar this year. The economic tension generated by the new coronavirus only speeded up a movement that started in 2018, of investors searching for more secure assets amid a likely global economic slowdown fueled by the United States-China commercial dispute. In general, it is the fiscal fragility, aggravated by the new crisis, and the political tensions that are leading to a further det erioration in expectations about Latin American economies and, consequently, to a greater fall in their currencies against the US dollar. READ ALSO: Why, even with more than BRL 1 trillion in measures from the Central Bank, credit is not reaching Brazilian companies? Another reason for the negative performance of emerging currencies, according to a Bank of America (Bofa) report, is that the coronavirus pandemic led investors to liquidate their applications earlier in the emerging markets this year, which also has an effect on exchange rates. Instead of waiting for May, as they have done for the past 12 years, investors began repatriating their money in March and April, which put pressure on the exchange rate and caused the real and other emerging market currencies to lose even more value in that period. READ ALSO: Another effect of COVID-19: Latin America will test negative real interest rates for the first time The biggest concern of global investors is not exactly the level of the exchange rate (high or low), but its stability. With the exchange rate stable (even high), investors could still profit by arbitrating interest rates, that is, taking money at low-interest rates, in developed countries, converting it to the currency of emerging countries, and investing in those with the highest rates interest. The problem is that, as a way to combat the crisis, emerging countries are implementing an aggressive monetary policy that brings interest rates down. With each new cut, another wave of investors will liquidate their investments in these countries and repatriate their money to their homeland, pressuring the exchange rate and threatening the profitability of those who are still investing in emerging countries. This cycle is one of the reasons why analysts do not see the position of emerging currencies against the dollar changing anyt ime soon. Besides, during the coronavirus crisis, many companies in emerging countries are failing to export and, therefore, are not bringing dollars into their economies, which only worsens the scenario and also makes the dollar rise. Economic tension is global, but the Brazilian currency is plummeting faster In all this context, though, Brazil's currency has plummeted more than other emerging currencies. According to a recent article by the Financial Times, the pace of declines in emerging-market currencies will likely be slowed down or even reverted, from now on, as restrictions on economic activities are lifted. But a big question mark will remain to hover above Brazil, where growing political tensions are expected to keep affecting the scenario. On Wednesday afternoon, the president of the Brazilian Central Bank, Roberto Campos Neto, said the monetary authority has ample space for the sale of international reserves and may increase its actions in the exchange arena if it considers it necessary. According to FT, some of the most influential currency-trading banks think it could slide to BRL 6 and beyond. LISTEN ALSO: LABS PODCAST: What will happen with logistics companies after COVID-19? (One more) political crisis in Brazil While Mexico's vulnerability is due to rising idiosyncratic risks of the Andrs Manuel Lpez Obrador (AMLO) government, such as the lack of reforms intended to attract investment and boost productivity, in Brazil, the political tensions in Brasilia combined with the environment of low-interest rates and weak growth have been a determining factor for the surge in the dollar, even after the approval of the Social Security Reform last year. Last week, Brazil lost its second health minister amid the COVID-19 pandemic. With less than a month in office, Nelson Teich called for resignation. Teich took office on April 17th, after Luiz Henrique Mandetta left Jair Bolsonaro's government. Teich did not give details about his resignation, but political analysts say that his main disagreement with Bolsonaro was the usage of chloroquine in the treatment of COVID-19. Like the U.S. President Donald Trump, Bolsonaro is an enthusiast of the drug indicated to treat malaria, lupus, and other diseases. Both Mandetta and Teich, however, like many scientists, have always asked for caution when prescribing the drug since there is still no conclusive research to prove its effectiveness against the new coronavirus. READ ALSO: In addition to the problems directly related to the new coronavirus crisis and the unorthodox way in which the Bolsonaro government has dealt with it, there is also the gravest political crisis of the Brazilian president's administration so far, triggered by the well-known former judge Sergio Moro. He gained notoriety behind the so-called 'Car Wash' (Lava Jato) Operation against corruption that led to the imprisonment of former president Luiz Incio Lula da Silva, among other politicians and businessmen. Three weeks ago, Moro left the post of Minister of Justice after an alleged attempt by Bolsonaro to hamper police investigations, which some claim implicate his sons, by trying to change the chief of the federal police Mauricio Valeixo, an appointee of Moro. Moro was one of the stars of Bolsonaro's government due to his record fighting corruption as a federal judge. Bolsonaro originally touted him as a \"super minister\" in charge of implementing a law-and-order agenda. His exit is another blow to Bolsonaro's government. As reported by FT, at the end of 2019, investors picked the real as one of their favorite bets for 2020, alongside with a forecast of 2% GDP growth and the reform agenda of the Minister of Economy Paulo Guedes. Almost six months later, Guedes seems to have withdrawn from his agenda, at least at this moment, and Bolsonaro has accumulated 30 impeachment requests filed in Congress. Brazil has the third-highest number of coronavirus infections in the world today, answering for one in seven new cases. KEYWORDS Brazil, Business, Coronavirus, Economy, Payments LABS LABS Team
