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Today’s Agenda

Today’s Agenda. Note on TF office hours: W, 1:30-2:30pm, KMEC 7-181,TF: Ms. Desi Peteva, MBA2 Why study int’l monetary systems? Terminology of exchange rates & currency regimes. Differences b/n devaluation & depreciation ? Ideal currency? Explain currency regime choices.

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Today’s Agenda

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  1. Today’s Agenda • Note on TF office hours: W, 1:30-2:30pm, KMEC 7-181,TF: Ms. Desi Peteva, MBA2 • Why study int’l monetary systems? • Terminology of exchange rates & currency regimes. • Differences b/n devaluation & depreciation? • Ideal currency? • Explain currency regime choices. • Describe Euro creation. • Case-in-point: the stubborn forex regime in China.

  2. Why study int’l monetary system? • Fact: the volatility of exchange rates has increased. • Volatile exchange rates increase risk, create profit opportunities. • The international monetary system is the structure within which foreign exchange rates are determined.

  3. Currency Terminology • Foreign currency exchange rate: price of one country’s currency in units of another currency or commodity • The system, or regime, classified as: • fixed, • floating, or • managedexchange rate regime. • Par value: the rate @ which currency is fixed, pegged. • Floating or flexible currency: government does not interfere in valuation of currency

  4. Currency Terminology • Spot exchange rate: quoted price for foreign exchange to deliver @ once, or @ T+2 for interbank transactions • ¥114/$ (114 yen to buy one US $), immediate delivery • Devaluation: drop in foreign exchange value pegged to gold or another currency. Opposite to revaluation. • Weakening, depreciation: refers to drop in foreign exchange of a floating currency. Opposite to appreciation.

  5. Currency Terminology • Soft or weak currency: currency expected to devalue/ depreciate relative to major currencies; • Hard or strong: the opposite. • Eurocurrencies: type of money although in reality they are domestic currencies of a country deposited in another country. • E.g.: Eurodollar - US$ denominated deposit in bank outside of US

  6. Evolution of the International Monetary System • Bimetallism: Before 1875 • Classical Gold Standard: 1875-1914 • Interwar Period: 1915-1944 • Bretton Woods System: 1945-1972 • The Flexible Exchange Rate Regime: 1973-Present

  7. Bimetallism: Before 1875 • A “double standard”: both gold and silver were used as money, accepted as means of payment. • Some countries were on the gold standard, some on the silver standard, some on both. • Exchange rates among currencies were determined by either their gold or silver contents.

  8. The Gold Standard, 1876-1913 • Countries set par value for currency in terms of gold • Acceptance in Europe in 1870s • US adopted it 1879 • “Rules of the game”: • Rule 1: Set a rate @ which can buy/sell gold for currency. • Rule 2: Credibly maintain adequate reserves of gold. • E.g. US$ gold rate $20.67/oz, Brits pegged at £4.2474/oz • US$/£ rate calculation $20.67/£4.2472 = $4.8665/£

  9. The Gold Standard, 1876-1913 • Since the rate of exchange for gold was fixed, the exchange rates b/n currencies was fixed too. • Gold standard worked until WW1 • WW1 interrupted trade flows & free movement of gold forcing nations suspend gold standard. • J.M. Keynes called it “the barberian relique”.

  10. Inter-War years & WWII, 1914-1944 • During WWI: currencies fluctuate over wide ranges to gold • Due to S & D for imports/exports • Due to speculative pressure, • SHORT SELLING week currencies. • BUYING strong currencies. SHORT SELLING: investor expects price to fall soon, borrows currency & sells it. • 1934: US devalued currency to $35/oz from $20.67/oz. • 1924 - end WWII: exchange rates determined by currency value in gold. • During WWII & after, main currencies lost convertibility. US$ remained only convertible currency.

  11. Bretton Woods & IMF • Bretton Woods, NH: US coalition created post-war international monetary system. • establishes US$ based monetary system • IMF (International Monetary Fund) & World Bank • IMF renders temp assistance to member-countries to defend currency & overcome econ problems • All member-countries fix currencies in gold, not required to exchange it. • Only US$ convertible to gold (@ $35/oz, Central banks only) • The advent of central banking worldwide.

  12. Bretton Woods • Countries establish exchange rate vis-à-vis US$ • Agree to maintain currency values +/- 1% par by trading US$ & gold. • No use of devaluation as a competitive trade policy • Up to 10% devaluation w/o formal approval by IMF.

  13. Bretton Woods • Special Drawing Right (SDR): international reserve assets • A unit of account for IMF & base some countries peg exchange rates. • Is weighted average 5 IMF members currencies, w/ largest exports/ imports • Members deposits US$ & Gold in IMF, get SDR.

  14. Fixed exchange rates, 1945-1973 • Worked well for post-WW2 • Fiscal & monetary policies & external shocks caused collapse • US$ main reserve currency. • Heavy overhang of US$ abroad. • Lack of confidence. • Heavy outflows of US gold. • Nixon (08/15/71): suspend trading gold. Allow exchange rates to float freely. • Nixon (08/15/71): yet another run on US$. • Devalue US$ to $42/oz gold.

  15. Fixed exchange rates, 1945-1973 Triffin paradox • To maintain the gold-exchange system, the US had to run Balance of Payment deficits continuously. • But: large, persistent deficits would diminish confidence and lead to a run on the US$. • This would destroy the system – indeed, it happened in the 50s & 60s.

  16. World Currency Events

  17. Why do Currency Crises Happen? • Long run:In theory, a currency’s value mirrors the fundamental strength of its underlying economy, relative to other economies. • Short run: currency traders’ expectations play a much more important role.

  18. How do Currency Crises Happen? • Mass exodus causes sharp drop in currency valuation  currency crisis. • Fears of depreciation become self-fulfilling prophecies. • Policy for recovery unclear – appears to be contextual. Therefore we can examine Mexican & Asian crises to gain perspective.

  19. Mexican Peso Crisis (1994-95) • The Mexican government announced a plan to devalue the peso against the dollar by 14%. • Investors’ response: dump Mexican currency, stocks and bonds  40% drop in peso. • Led to flotation of peso. Crisis spilled over to Latin America/Asia. “Tequila Crisis”.

  20. Importance of Mexican Crisis • This was the 1st serious int’l financial crisis sparked by cross-border flight of portfolio capital. • In prior crises, currency had been abandoned; here also the stocks & bonds. • Underscored degree of interdependency of financial systems world-wide. • Highlighted the inherent riskiness of relying on foreign capital to finance domestic investments. • Influx of foreign capital can cause overvaluation of currency.

  21. Asian Crisis (1997-98) • Thai baht devalued on July 2, 1997. Sparked crisis region-wide; overflowed to Russia and Latin America. • Far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. • Many firms with foreign currency bonds were forced into bankruptcy. • The region experienced a deep, widespread recession, which is still ongoing, despite IMF bail-out packages. • Moral hazard?

  22. Why Asia? • Weak domestic financial systems. • Free international capital flows. • Market sentiment – sparked contagion. • Inconsistent economic policies and incomplete disclosure thereof. • Hardest hit countries (Indonesia, Korea, Thailand) had especially high ratios of • (1) short-term foreign debt/FX reserves and • (2) broad money (representing banking system liabilities)/FX reserves.

  23. Lessons? • Financial market liberalization must be paired with development of strong domestic financial system. • Note: Mexico and Korea joined the OECD a few years prior to crises – OECD membership had required significant market liberalization. • Governments should • strengthen financial market regulation & supervision • discourage short-term cross-border investments • encourage FDI and long-term equity & bond investments.

  24. IMF on Currency Regimes IMF Regime Classification • No separate legal tender (39): Ecuador • Currency Board (8): commit exchanging domestic currency at a fixed rate to foreign currency. • Conventional Fixed Peg (44): Country pegs its currency (formally) at a fixed rate to major currency ± 1% variation • Pegged Exchange w/in Horizontal Bands (6): maintain within margins wider than ± 1% around de facto fixed peg. • Crawling Peg (4): Currency adjusted periodically in small amounts at pre-announced rate

  25. Contemporary Currency Regimes • Exchange Rates w/in Crawling Peg (5): Currency maintained within certain fluctuation margins around a central rate that is adjusted periodically • Managed Floating w/ No Preannounced Path for Exchange Rate (33): Monetary authority active intervention in foreign exchange markets • Independent Floating (47): Exchange rate is market determined.

  26. Fixed vs. Flexible Exchange Rates • Why countries prefer fixed exchange rates? • Stability in international prices for the conduct of trade • Anti-inflationary, requires country to follow restrictive monetary & fiscal policies • Credibility, if central banks maintain large international reserves to defend fixed rate • Fixed rates may be maintained @ rates inconsistent with economic fundamentals. For example, Asia these days…

  27. The curious case of Asia • Recently Asian countries have shown reluctance to allow their currencies to rise against the dollar • Why? • Prefer fixed exchange rates (ergo stability) • Consequences: • Rise of the euro – good or bad? What do you think? • Solutions: • Float of exchange rates of Asian economies. • Financial sector liberalization in China.

  28. Ideal Currency Or Impossible Trinity? • Exchange rate stability –value of currency would be fixed to other currencies • Full financial integration – complete freedom of monetary flows allowed, traders & investors could move funds in response to economic opportunities • Monetary independence – domestic monetary policies by each individual country to pursue national economic policies, e.g. limiting inflation, foster prosperity & full employment.

  29. Full Capital Controls Monetary Independence Exchange Rate Stability Increased Capital Mobility Pure Float Monetary Union Full Financial Integration The Impossible Trinity Can have only 2-sides/ system.E.g., if Monetary Independence & Financial Integration, cannot attain Exchange Rate Stability.

  30. Emerging Markets & Regime Choices • Currency Boards: country’s central bank commits to back monetary base, with foreign reserves @ all times • means a unit of domestic currency cannot be introduced w/o an additional forex reserves • Argentina (1991), fixed Peso to US$ • Bulgaria (1997), fixed Leva to Euro.

  31. Emerging Markets & Regime Choices • Dollarization: use of US$ as official currency • Panama, 1907 & Ecuador, 2000. • Why dollarization? • Removes possibility of currency volatility; • Eliminate possibility of currency crises; • Economic integration with US & other dollar based markets • Why not dollarization? • Loss of sovereignty over monetary policy • Loss of power of seignorage, the ability to profit from printing own money. • Central bank no longer lender of last resort.

  32. Emerging Market Country High capital mobility Living on the edge… • Currency Board or Dollarization • No monetary independence • No political influence on monetary policy • Seignorage rights lost • Free-Floating Regime • Currency free to float • Independent monetary policy & free movement of capital allowed, but @ loss of stability • Increased volatility

  33. The Euro • European Monetary System (EMS):15 Member nations • Maastricht Treaty’ 92 – timeline of economic & monetary union. • Convergence criteria called • Nominal inflation < 1.5% above average for EU lowest 3 inflation rates year before. • LT interest rate < 2% above average for EU lowest 3 interest rates. • Fiscal deficit < 3% of GDP. • Government debt < 60% of GDP. • European Central Bank (ECB) established.

  34. The Euro & Monetary Unification • The euro, €, was launched on Jan. 4, 1999 with 11 member states • Benefits of the euro? • Lower transaction costs in EU. • Currency risks reduced. • All consumers and businesses, both inside and outside of the euro zone enjoy price transparency and increased price-based competition

  35. The Euro & Monetary Unification • Successful unification ? • ECB has to coordinate monetary policy • Focus on price stability. • Fixing the euro • 12/1998, national exchange rates were fixed to the Euro. • 1/1999 euro trading on world currency markets.

  36. Euro’s Way-up

  37. Policy Rules Non-cooperation Between Countries Cooperation Between Countries Discretionary Policy Tradeoffs b/n Exchange Rate Regimes

  38. Rules No cooperation b/n Countries Cooperation b/n Countries Discretion What Lies Ahead? • Tradeoff b/n rules & discretion, cooperation & independence. • Bretton Woods • Gold Standard • European Monetary System ? • US Dollar, 1981-1985

  39. Summary • Terminology • Foreign currency exchange rate • Spot exchange rate • Devaluation (revaluation) • Depreciation (appreciation) • The impossible trinity of goals for forex: fixed value, convertibility, independent monetary policy. • Currency board or dollarization? • Fixed vs. Floating Exchange Rates. • Euro advent.

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