The international financial system
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The international financial system

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The international financial system The international financial system Presentation Transcript

  • THE INTERNATIONAL FINANCIAL SYSTEM
  • Balance of Payments
    • The balance of payments is a booking system for recording all receipts and payments that have a direct bearing on the movement of funds between nations.
    • It measures the effects of international financial transactions on the economy.
  • Balance of Payments
    • The current account shows international transactions that involve currently produced goods and services .
    • The trade balance is part of this account, and shows the difference between exports and imports
  • Balance of Payments
    • The capital account shows the net receipts from capital transactions. Capital flows into a country are recorded as receipts, whereas outflows are registered as payments
  • Balance of Payments
    • Given these definitions, the following equation holds:
    • Current Account + Capital Account =
    • Net Change in Governmental International Reserves
    • - Assets denominated in foreign currencies
    • - Gold
  • U.S. Balance of Payments
    • The U.S. runs a persistent deficit in its balance of trade.
    • This deficit is essentially offset by a persistent surplus in its capital account.
    • As a result, the trade deficit does not result in a significant change in U.S. governmental international reserves.
  • TYPES OF EXCHANGE RATE SYSTEMS
    • Fixed Exchange Rate Systems require that governments maintain the rate at which one currency can be exchanged for another within one percent.
    • Floating Exchange Rate Systems let
    • market forces set exchange rates.
  • History of the International Monetary System: The Gold Standard, 1876-1913
    • Each country set the rate at which its currency could be converted into a weight of gold
      • Eg. U.S. declared one ounce of gold = $20.67 UK pegged the pound at £ 4.247 per ounce
    • Thus, the $/ £ exchange rate was $20.67/£ 4.247 = $4.8665/ £
    • Each country had to maintain adequate reserves of gold to back its currency value.
  • History of the International Monetary System: The Inter-War Years and WWII, 1914-1944
    • During WW I and the early 1920s, currencies were allowed to fluctuate.
    • The volume of world trade began to stagnate in the 1920s and fell in the 1930s.
    • U.S. adopted a modified gold standard in 1934 devaluing the $ from $20.67/ounce of gold to $35/ounce of gold.
    • Most currencies became inconvertible during WWI except for the $.
  • History of the International Monetary System: Bretton Woods, 1944
    • The U.S. emerged from WWII as the world’s largest economic power.
    • By default, the U.S. dollar was called the reserve currency , meaning it was used by other countries to denominate the assets they held in international reserves
  • Meeting in Bretton Woods, New Hampshire, the Allies Created a New International Financial System
    • New international institutions were established:
      • International Monetary Fund (IMF)
      • International Bank for Reconstruction and Development (World Bank)
      • The General Agreement on Tariffs and Trade (GATT) monitors trade between countries and promotes lowering of trade barriers - GATT has evolved into the World Trade Organization (WTO)
  • Bretton Woods Established a New Fixed Exchange Rate System
    • $ tied to gold at $35/ounce ($ is convertible)
    • Other currencies tied to the $ - countries agreed to maintain the value of their currencies within 1% of par
    • Devaluation >10% required IMF approval.
  • History of the International Monetary System: Fixed Exchange Rates, 1945-1973
    • Widely diverging national monetary and fiscal policies, differential rates of inflation, and various external shocks led to the demise of the Bretton Woods system.
    • Outflow of $ - U.S. Marshal Plan to rebuild Europe
    • Rise of foreign claims on U. S. Gold Supply
    • Special Drawing Rights adopted in January 1968 to expand international liquidity
      • SDRs could be used in settlement of international claims
      • SDRs tied to IMF reserves (gold and foreign currencies)
  • Response to U.S. Gold Outflows
    • August 15, 1971, President Nixon ended convertibility of $ into gold
    • Smithsonian Agreement in December 1971 led to restoration of fixed exchange rates
    • February 12, 1973 - $ again devalued by 10% to $42.22 per ounce of gold
  • History of the International Monetary System: Shift to Floating Exchange Rates, 1973 to Present
    • Industrial nations decided to let their currencies float in March 1973
    • U.S. inflation leads to a dollar crisis in 1978
    • 1978-1985 - dollar recovers as U.S. inflation is brought under control
    • The value of the dollar increases - 1983-1987
    • 1987-present - value of $ stabilizes, then begins depreciating once again
  • Exchange Rate Regimes in the International Financial System: Fixed Exchange Rate
    • In a fixed exchange rate regime , the values of currencies are kept pegged relative to one currency so that exchange rates are fixed.
    • The currency against which the others are pegged is known as the anchor currency .
  • Fixed Exchange Rate Systems: Bretton Woods
    • Fixed exchange rates
    • Other central banks keep exchange rates fixed to $: $ is reserve currency
    • $ convertible into gold for central banks only ($35 per ounce)
    • International Monetary Fund (IMF) sets rules and provides loans to deficit countries
    • World Bank makes loans to developing countries
  • Fixed Exchange Rate Systems
    • European Monetary System, 1979-1990
      • Created by the European Union
      • Exchange rate between any pair of member countries was not allowed to fluctuate outside narrow limits - the “snake”
      • New currency unit: ECU
      • Exchange Rate Mechanism (ERM)
  • Fixed Exchange Rate Systems: How they work
    • There are essentially two situations where a central bank will act in the foreign exchange market. There are when the domestic currency is either:
      • Overvalued
      • Undervalued
  • Fixed Exchange Rate Systems: How they work
    • When the domestic currency is overvalued , the central bank must purchase domestic currency to keep the exchange rate fixed. As a result, the central bank loses international reserves*.
    • When the domestic currency is undervalued , the central bank must sell domestic currency to keep the exchange rate fixed. As a result, the central bank gains international reserves*.
    • International reserves refers to a central bank’s holdings in a foreign currency.
  • Intervention in the Foreign Exchange Market: the Money Supply
    • Intervention in the foreign exchange market (buying or selling domestic currency in exchange for foreign currency) impacts the exchange rate; but it also can impact the monetary base and the money supply.
  • Intervention in the Foreign Exchange Market: the Money Supply
    • Suppose the Fed sells $1 billion in a foreign currency in exchange for $1 billion in U.S. currency.
    • Results:
      • Fed holding of international reserves falls by $1 billion.
      • Currency in circulation falls by $1 billion.
  • Intervention in the Foreign Exchange Market: the Money Supply
    • Suppose the Fed sells $1 billion in a foreign currency in exchange for a check written on a domestic bank.
    • Results:
      • Fed holding of international reserves falls by $1 billion.
      • Deposits with the Fed fall by $1 billion.
  • Intervention in the Foreign Exchange Market: the Money Supply
    • In either case, we draw the same conclusion: a central bank’s purchase of domestic currency and corresponding sale of a foreign currency leads to an equal decline in its international reserves and the monetary base . The exchange rate rises.
  • Intervention in the Foreign Exchange Market: the Money Supply
    • Obviously, the opposite is true is the transaction reversed: a central bank’s sale of domestic currency and corresponding purchase of a foreign currency leads to an equal increase in its international reserves and the monetary base . The exchange rate falls.
  • Intervention in a Fixed Exchange Rate System Case 1: Central Bank uses foreign currency assets to purchase domestic currency; E t rises Case 2: Central Bank uses domestic currency to buy foreign currency; E t falls Since E t+1 = E par with fixed exchange rate, R F doesn't shift
  • Intervention in a Fixed Exchange Rate System: Case 1. Overvalued Exchange Rate (panel a)
      • Central bank sells international reserves to buy domestic currency
      • M B  , M s  , i D  , R D shifts to right to get to point 2
      • If the central bank does not intervene, the domestic currency must be devalued by setting a new (lower) par value.
  • Intervention in a Fixed Exchange Rate System: Case 2. Undervalued Exchange Rate (panel b)
      • Central bank sells domestic currency and buys international reserves
      • M B  , M s  , i D  , R D shifts to left to get to point 2
      • If the central bank doesn’t intervene, the domestic currency must be revalued by setting a new (higher) par value
  • Intervention in the Foreign Exchange Market: Sterilized Intervention
    • The Fed offsets the effect of intervention (selling $1 billion in foreign currency) through an open market purchase of $1 billion in bonds.
    • Results:
      • International reserves, -1 billion
      • Monetary base unchanged
      • E t  unchanged: no shift in R D and R F
  • Unsterilized Intervention leads to exchange rate overshooting
    • Sell $, buy F: MB  , M s 
    • M s  , P  , E e t +1  , expected appreciation of F  , R F shifts right
    • M s  , i D  , R D shifts left, go to point 2 and E t 
    • In long run, i D returns to old level, R D shifts back, go to point 3
    • Exchange rate overshooting
    Figure 14.1: Effect of a Sale of Dollars and a Purchase of Foreign Assets
  • Foreign Exchange Intervention: The Bottom Line
    • An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, and increase in the money supply, and a depreciation of the domestic currency.
    • An unsterilized intervention in which domestic currency is purchased by selling foreign assets leads to a drop in international reserves, a decrease in the money supply, and an appreciation of the domestic currency.
  • Sterilized Intervention
    • A sterilized intervention has no effect on the exchange rate .
    • It leaves the money supply unchanged , and so has no way of impacting interest rates.
    • Because the expected returns on dollar and foreign assets are unaffected, the exchange rate remains unchanged.
    • Thus, there is no way to maintain a fixed exchange rate by central bank intervention in foreign exchange markets without losing control of the nation’s monetary policy.
  • Fixed Exchange Rate Systems: How they work
    • Devaluation can occur when the domestic currency is overvalued. Eventually, the central bank may run out of international reserves, eliminating its ability to prevent the domestic currency from depreciating.
    • Revaluation will occur when the central bank decides to stop intervening when its domestic currency is undervalued. Rather than acquiring international reserves, it lets the par value of the exchange rate reset to a higher level.
  • Key weakness of fixed rate system
      • Asymmetry: pressure on deficit countries losing international reserves to  M s , but no pressure on surplus countries to  M s
  • Speculation Under A Fixed Exchange Rate System
    • Germany increased interest rates in September 1992.
    • This led to pressure on the pound.
    • To relieve this pressure, either the Germans had to pursue an expansionary monetary policy (let interest rates fall) or the British had to pursue a contractionary monetary policy (let interest rates rise).
    • Neither was willing to do so.
    • Speculators recognized that sooner or later the mark would appreciate and the pound would depreciate.
    • This led to a massive sell-off of pounds (and purchase of marks).
    • The British pulled out of the ERM allowing the pound to depreciate by 10% against the mark.
  • Exchange Rate Crisis of September 1992
    • At E par , R F right of R D because Bundesbank tight money keeps German interest rates high
    • Bank of England buys £, i D  , R D shifts right
    • When speculators expect devaluation, E e t +1  , R F shifts right
    • Requires much bigger intervention
    • When UK pulls out of ERM, £  10%, big losses to central bank
    Figure 14.3 Foreign Exchange Market for British Pounds in 1992
  • The Practicing Manager: Profiting from a FX Crisis
    • September 1992, £ overvalued
    • Once traders know central banks can't intervene enough, £ only head one direction, 
      • One-sided bet, "heads I win, tails I win"
      • Traders sell £, buy DM
      • £  10% after September 16
        • Citibank makes $200 million
        • Soros makes $1 billion
  • Exchange Rate Regimes in the International Financial System: Floating Exchange Rate
    • In a floating exchange rate regime , the values of currencies are allowed to fluctuate against one another.
    • When countries attempt to influence exchange rates via buying and selling currencies, the regime is referred to as a managed float regime (or a dirty float ).
  • Exchange Rate Regimes in the International Financial System: Managed Float
    • Central banks are reluctant to give up their ability to intervene in foreign exchange markets.
    • Limiting changes in exchange rates makes it easier for firms and individual to plan purchases/sales in the international marketplace.
  • Exchange Rate Regimes in the International Financial System: Managed Float
    • Countries with a trade surplus are reluctant to allow their currencies appreciate since it hurts domestic sales.
    • On the other hand, countries with a trade deficit do not want to see their currency lose value since it makes foreign goods more expensive.
  • Currency Boards
    • To combat persistent inflation, some countries have elected to tie their exchange rate to that of a larger country, in essence adopting the more disciplined monetary policy of their bigger neighbor
    • Under a currency board system , the domestic currency is 100% backed by foreign reserves and the central bank or government stands ready to convert local currency into foreign currency at a fixed rate.
    • Under a “ dollarization ” policy, the country simply adopts the $ as its currency; e.g., Panama, Ecuador, El Salvador
  • Current International Financial System
    • A hybrid of fixed and a flexible exchange rate systems
    • While foreign exchange rates fluctuate in response to market forces
    • Many countries “manage” the magnitude of these fluctuations through central bank interventions (e.g., a “ dirty float ”)
    • And some countries continue to keep the value of their currency fixed against other currencies via currency board or dollarization systems.
  • Exchange Rate Regimes: The Impossible Trinity
    • Ideally, an exchange rate regime should enable the attainment of three goals:
      • Exchange rate stability – where the value of the domestic currency is fixed in relationship to other major currencies
      • Full financial integration – where there is complete freedom of monetary flows between countries
      • Monetary independence – where the country is free to set domestic monetary and fiscal policies to achieve national economic goals
    • Unfortunately, a nation cannot achieve all three goals simultaneously.
      • If, like the U.S., it elects to achieve monetary independence and full financial integration, it has to give up exchange rate stability.
      • If, like the nations of the European Union, it elects to achieve exchange rate stability and full financial integration, it has to give up monetary independence.
      • Today, increasing global capital mobility is pushing most nations towards full financial integration. Thus, their currency regimes are being “cornered” into being either purely floating or integrated with other currencies in monetary unions.
  • The Impossible Trinity Full Financial Integration Full Capital Controls Exchange Rate Stability Monetary Independence Increased Capital Mobility Pure Float Monetary Union
  • Foreign Exchange Crises in Emerging Market Countries
    • Mexico in 1994, East Asia in 1997, Brazil in 1999, and Argentina in 2002 experienced domestic economic problems that resulted in speculative attacks on their currencies.
    • Central banks lost international reserves trying to preserve the value of their currency.
    • In the end, they had to devalue.
    • This resulted in severe depressions that caused hardship and political unrest.
  • Capital Controls: 1. Control on Capital Outflows
    • Capital outflows can promote financial instability in emerging market economies, often forcing a devaluation of the currency. This has led to the imposition of controls on capital outflows.
    • Empirical evidence shows, however, that controls on outflows are unlikely to work
      • Seldom effective during a crisis
      • May actually increase the problem by leading to an increase in capital flight
      • Often lead to corruption
      • May lull government authorities into thinking that they don’t need to make financial system reforms.
  • Capital Controls: 2. Controls on Capital Inflows
    • Capital Inflows can lead to a lending boom and excessive risk taking by banks and also give rise to the risk of a future crisis if capital moves out suddenly.
    • Thus, controls on capital inflows may be a good method for controlling risk-taking on the part of financial institutions.
    • However, they may block productive resources from entering a country.
    • A better solution would be to improve bank regulation and supervision.
  • The Role of the IMF
      • There is a need for international lender of last resort (ILLR) and IMF has played this role
      • However, IMF “bail-outs” create moral hazard problems by promoting excessive risk-taking
      • The IMF needs to limit moral hazard by lending only to countries with good bank supervision
      • The IMF needs to act as ILLR infrequently, and to act with dispatch when it decides to do so