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International financial system
 

International financial system

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Introduction to the international financial system, undergraduate International Relations class, American Business School-Paris, November, 30, 2012.

Introduction to the international financial system, undergraduate International Relations class, American Business School-Paris, November, 30, 2012.

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    International financial system International financial system Presentation Transcript

    • The InternationalFinancial SystemABS, International Relations POL 210Pr. Sandrine TesnerNovember 30, 2012
    • The gold standard—until 1914 Currencies were pegged to gold at a fixed rate and convertible into gold The way you computed an exchange rate with another currency was to divide Country A’s gold price by Country B’s gold price. Say the US decides that the gold price is $20 per ounce, and the UK decides that gold = £25 per ounce. Then the $/£ rate is 20/25=.8 Central banks could not, theoretically, issue more currency than there existed gold reserves to match the currency. Countries saw this as a stable system because central banks could not expand the money supply. They could only do so if they produced gold (which the US did for most of the 19th century, producing wild fluctuations in the price of gold and therefore exchange rates). Exchange rates were seen as credible: since the currency was backed by gold, the country could never run out of reserves. In fact there were multiple financial/speculative crises in the second half of the 19th century, in the US in particular, which demonstrated the impracticality of the gold standard.
    • World War I and the interwar period During the War years, the European powers were forced to print money to finance the war effort, causing a de facto breakdown of the gold standard. The system could not cope with the enormous inflation that resulted from the war. Germany’s Weimar Republic collapsed on this reality. After the war, the UK tried to return to a reformed gold standard. Effort ended in 1931. The Great Depression ended any hope of maintaining the system. The upshot is that monetary policy could now be used to fight unemployment and the recession. In the US, the gold standard ended in stages. Congress passed the Gold Reserve Act in January 1934,which nationalized all gold by ordering the Federal Reserve banks to turn over their supply to the U.S. Treasury. The gold standard was officially defunct after President Nixon suspended the convertibility of the dollar into gold in 1971. Let’s see what happened in between.
    • The Bretton Woods system: pegged exchange rates The Bretton Woods conference in 1944 created the IMF and the World Bank (IBRD). A gold-exchange standard existed until 1971. The US dollar was the only currency convertible into gold at a rate of $35 an ounce. Currencies had an adjustable exchange rate vs. the dollar. Basically, the exchange rate was set but countries had a 1% fluctuation band around that rate. Plus, the exchange rate could be adjusted under special circumstances. The IMF maintained gold and currency reserves and could lend to countries that needed it. Countries could only devaluate their currencies with the IMF’s approval and under its auspices. IMF loans were of course conditional on the adoption of various macroeconomic (monetary or fiscal) policies. The circulation of the dollar increased markedly during the postwar period, boosted by such mechanisms as the Marshall Plan and general US global expansion. This raised questions as to whether the US would be able to face convertibility of $ into gold. Nixon closed the gold window in 1971.
    • Fluctuations and the search for order The first test-case of the new fluctuation system was the 1st oil shock in 1973. Developed nations’ current account balances plummeted due to increases in the price of oil and other commodity imports. They used monetary policy (interest rates) to adjust currencies and kick-start their economies after recessions hit. 2nd oil shock, 1978-80, price of oil doubled. But this time the US at least responded differently: to lower inflation, Fed Chairman Paul Volcker announced that he would tighten monetary policy. Dollar appreciated so much in the 1980s that US trade and current deficits worsened. Plaza Accord in 1985 was a decision among the US, France, Germany, the UK, and Japan to force the value of the dollar down though intervention in currency markets. In 1987 there was a stock market crash. US had to lower interest rates to avoid financial collapse of financial and business organizations. US $ depreciated far below agreed-upon range. Failure of 15-or-so years of attempts at managing exchange rates.
    • 1990s: booms and busts A decade of expansion in many countries, punctuated by a series of busts. Collapse of the European Exchange Rate Mechanism (ERM, a semi- pegged system) leads to introduction of the Euro in 1999. UK, forced out of the ERM in 1992, stays outside of the Euro area. 1997-98: financial crises in Southeast Asia and Russia. Other crises in Latin America during the decade. Major new influence on financial markets: quantitative trading strategies, which can create enormous volatility but also tie financial authorities to the actions of a few hedge funds traders. First example of this trend is the bailout package arranged by leading banks in 1998, with Fed assistance, to salvage a hedge fund, Long-Term Capital Management. See, Scott Patterson’s The Quants. A great book to understand today’s financial markets.
    • The global economy is sailing in troubled waters with its financial governance in flux Rising US debt to $15 trillion today, about 103% of GDP. 1/3 of that debt is held by foreigners; China holds $1.16 trillion and Japan $1.11 trillion. Budget deficit is about $1.3 trillion. European debt has also skyrocketed, questioning the viability of the Euro. Banking union in progress but there are conflicts among key partners; recovery in Greece and Spain in particular will be long and painful in the best-case scenario. Financial collapse of 2008 due to introduction of toxic assets; global recession as a result. Leading issue here is the regulation of financial markets and possibly the separation of commercial and investment banking activities. The elephant in the room: China’s growth has slowed to 7.5% (from a high of 14.5% in 2007!). Lack of clarity about China’s intentions and currency management.
    • How does the IMF work?Three key tasks: Surveillance: monitoring macroeconomic policies of IMF member-states and providing advice to them Technical assistance: “guidance and training on how to upgrade institutions, and design appropriate macroeconomic, financial, and structural policies” in low- and middle-income countries. Lending: provides loans to countries that cannot meet their international payments, with the goal of rebuilding reserves, stabilizing currencies, and paying for imports. Concessional lending to low-income countries. Lending is conditional. Two debt relief initiatives. Membership: a specialized UN agency with its own charter, finances, and board. 188 countries represented based on quotas that determine a country’s contributions, voting power, and borrowing ability. The quotas were reformed in 2010. US has 16.75% of votes, Japan 6.23%, Germany 5.8%
    • SDRs: the IMF’s currency Since 1969 special drawing rights are the special currency in which IMF member-states can maintain reserves called allocations. Members can exchange SDRs among themselves or exchange them for currency. Members can earn interest on their SDR holdings if the latter rise above the allocation; they pay interest to the IMF if their SDR holdings fall below their allocation. SDRs cannot be exchanged for goods and services. The SDR is based on a basket of four currencies: dollar, yen, pound, and euro. The SDR/US dollar rate is posted daily by the IMF on its website. The basket composition is reviewed every 5 years. Here is a nice short video on the modus operandi of SDRs: http://bcove.me/7qou4729
    • Issues in market regulation Governments can enforce rules on markets through securities regulators (AMF in France, SEC in the US) and banking commissions. Securities regulators monitor the compliance of listed companies with all laws affecting the trading of securities. They also oversee initial (IPOs) and secondary public offerings of securities. They can mandate the adoption of a corporate governance code. Banking regulators monitor the compliance of financial institutions with national banking laws and payment systems. Established in 1930, the Basel-based Bank for International Settlements (BIS) is the bank of central banks. It carries out research and issues policies on a slew of financial stability and banking supervision matters. In 1988 its Basel Committee issued rules for the maintenance of minimal capital requirements of the banking institutions in G10 countries, These so-called Basel II requirements (now supplemented by Basel III rules) focus on credit and market risks in the financial institutions of G-10 countries, and beyond.
    • Corruption, money laundering and the financing of terrorism Financial institutions must comply with norms and standards deriving from various international agreements to combat corruption, money laundering, and the financing of terrorism. Some of these agreements include: the 2000 UN Convention Against Corruption, the 1999 Convention for the Suppression of the Financing of Terrorism, and the 1988 UN Political Declaration and Action Plan against Money Laundering and the 40 Recommendations of its Financial Action Task Force (FATF Recommendations). To implement these international agreements, governments have adopted national legislation that impose multiple controls on financial institutions, including so-called ‘Know-Your-Customer’ (KYC) requirements. In 1997 the OECD adopted the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions, supplemented by a Recommendation in 2009. Only 39 countries are parties to it though.
    • What constitutes a good business climate? Political stability remains the #1 factor. Openness to trade and FDI, with minimal barriers to either and incentives to FDI in particular. Protection of investors’ property and no limits on profit repatriation. Fair competition. Good infrastructure. Establishing an investment promotion agency and investment-trade missions. Ease of registering a business but also good bankruptcy laws to unwind a business and provide relief to creditors. Compliance with international standards in market regulation, banking supervision, corporate governance, insurance supervision, money laundering. Modern and efficient payment systems. Clear tax policies that avoid uncertainty or sudden changes. A commitment to transparency (i.e. fighting corruption and bribery). Increasingly, a commitment to sustainability and the greening of the economy.
    • Resources and Links A great way to learn about global finance is through financial history. For ex: Ron Chernow’s The House of Morgan and other books, Niall Ferguson’s The Ascent of Money or The World’s Banker (on the House of Rothschild). More recently, Peter Chapman’s The Last of the Imperious Rich, on Lehman Brothers. There’s a slew of books on Goldman Sachs that you can check online. Movies: Margin Call (2011) or Arbritage (2012), Enron: The Smartest Guys in the Room (2005) or Inside Job (2010) World Bank-IFC’s annual Doing Business report: http://www.doingbusiness.org/reports/global-reports/doing-business- 2013 OECD: www.oecd.org/investment/toolkit/ www.imf.org, www.worldbank.org, www.bis.org, www.unctad.org UN’s work on money laundering and the financing of terrorism www.unodc.org/unodc/en/money-laundering/index.html?ref=menuside On corruption, check Transparency International: http://www.transparency.org