Presentation on theme: "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."— Presentation transcript:
1Today’s AgendaNote on TF office hours: W, 1:30-2:30pm, KMEC 7-181,TF: Ms. Desi Peteva, MBA2Why 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.
2Why 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.
3Currency TerminologyForeign currency exchange rate: price of one country’s currency in units of another currency or commodityThe system, or regime, classified as:fixed,floating, ormanaged exchange rate regime.Par value: the which currency is fixed, pegged.Floating or flexible currency: government does not interfere in valuation of currency
4Currency TerminologySpot exchange rate: quoted price for foreign exchange to once, T+2 for interbank transactions¥114/$ (114 yen to buy one US $), immediate deliveryDevaluation: drop in foreign exchange value pegged to gold or another currency. Opposite to revaluation.Weakening, depreciation: refers to drop in foreign exchange of a floating currency. Opposite to appreciation.
5Currency TerminologySoft or weak currency: currency expected to devalue/ depreciate relative to major currencies;Hard or strong: the opposite.Eurocurrencies: type of money although in reality they are domestic currencies of a country deposited in another country.E.g.: Eurodollar - US$ denominated deposit in bank outside of US
6Evolution of the International Monetary System Bimetallism: Before 1875Classical Gold Standard:Interwar Period:Bretton Woods System:The Flexible Exchange Rate Regime: 1973-Present
7Bimetallism: Before 1875A “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.
8The Gold Standard,Countries set par value for currency in terms of goldAcceptance in Europe in 1870sUS adopted it 1879“Rules of the game”:Rule 1: Set a which can buy/sell gold for currency.Rule 2: Credibly maintain adequate reserves of gold.E.g. US$ gold rate $20.67/oz, Brits pegged at £4.2474/ozUS$/£ rate calculation$20.67/£ = $4.8665/£
9The Gold Standard,Since the rate of exchange for gold was fixed, the exchange rates b/n currencies was fixed too.Gold standard worked until WW1WW1 interrupted trade flows & free movement of gold forcing nations suspend gold standard.J.M. Keynes called it “the barberian relique”.
10Inter-War years & WWII, 1914-1944 During WWI: currencies fluctuate over wide ranges to goldDue to S & D for imports/exportsDue 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 $20.67/oz.end WWII: exchange rates determined by currency value in gold.During WWII & after, main currencies lost convertibility. US$ remained only convertible currency.
11Bretton Woods & IMFBretton Woods, NH: US coalition created post-war international monetary system.establishes US$ based monetary systemIMF (International Monetary Fund) & World BankIMF renders temp assistance to member-countries to defend currency & overcome econ problemsAll member-countries fix currencies in gold, not required to exchange it.Only US$ convertible to gold $35/oz, Central banks only)The advent of central banking worldwide.
12Bretton Woods Countries establish exchange rate vis-à-vis US$ Agree to maintain currency values +/- 1% par by trading US$ & gold.No use of devaluation as a competitive trade policyUp to 10% devaluation w/o formal approval by IMF.
13Bretton WoodsSpecial Drawing Right (SDR): international reserve assetsA unit of account for IMF & base some countries peg exchange rates.Is weighted average 5 IMF members currencies, w/ largest exports/ importsMembers deposits US$ & Gold in IMF, get SDR.
14Fixed exchange rates, 1945-1973 Worked well for post-WW2 Fiscal & monetary policies & external shocks caused collapseUS$ 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 $42/oz gold.
15Fixed exchange rates, 1945-1973 Triffin paradox To maintain the gold-exchange system, the US had to run Balance of Payment deficits continuously.But: large, persistent deficits would diminish confidence and lead to a run on the US$.This would destroy the system – indeed, it happened in the 50s & 60s.
16Latin American Debt Crisis World Currency EventsOPEC embargoJamaica Agreement1/1976EMS created3/1979OPEC raises prices1979Latin American Debt Crisis8/1982Plaza Agreement9/1985Louvre Accord2/1987Maastricht Treaty9/1991EMS crisis2/1992Peso Collapse12/1994Asian Crisis6/1997Russian Crisis8/1998Euro Launched1/1999Brazilian real crisisTurkey2001Argentine peso crisis1/2002
17Why 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.
18How 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.
19Mexican 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”.
20Importance 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.
21Asian Crisis ( )Thai baht devalued on July 2, 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?
22Why 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.
23Lessons?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 shouldstrengthen financial market regulation & supervisiondiscourage short-term cross-border investmentsencourage FDI and long-term equity & bond investments.
24IMF on Currency Regimes IMF Regime ClassificationNo separate legal tender (39): EcuadorCurrency 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% variationPegged 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
25Contemporary Currency Regimes Exchange Rates w/in Crawling Peg (5): Currency maintained within certain fluctuation margins around a central rate that is adjusted periodicallyManaged Floating w/ No Preannounced Path for Exchange Rate (33): Monetary authority active intervention in foreign exchange marketsIndependent Floating (47): Exchange rate is market determined.
26Fixed vs. Flexible Exchange Rates Why countries prefer fixed exchange rates?Stability in international prices for the conduct of tradeAnti-inflationary, requires country to follow restrictive monetary & fiscal policiesCredibility, if central banks maintain large international reserves to defend fixed rateFixed rates may be rates inconsistent with economic fundamentals. For example, Asia these days…
27The curious case of Asia Recently Asian countries have shown reluctance to allow their currencies to rise against the dollarWhy?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.
29Ideal Currency Or Impossible Trinity? Exchange rate stability –value of currency would be fixed to other currenciesFull financial integration – complete freedom of monetary flows allowed, traders & investors could move funds in response to economic opportunitiesMonetary independence – domestic monetary policies by each individual country to pursue national economic policies, e.g. limiting inflation, foster prosperity & full employment.
30The Impossible Trinity Pure FloatMonetary UnionFull Capital ControlsIncreased Capital MobilityFull Financial IntegrationMonetary IndependenceExchange Rate StabilityCan have only 2-sides/ system.E.g., if Monetary Independence& Financial Integration,cannot attain Exchange Rate Stability.
31Emerging Markets & Regime Choices Currency Boards: country’s central bank commits to back monetary base, with foreign all timesmeans a unit of domestic currency cannot be introduced w/o an additional forex reservesArgentina (1991), fixed Peso to US$Bulgaria (1997), fixed Leva to Euro.
32Emerging Markets & Regime Choices Dollarization: use of US$ as official currencyPanama, 1907 & Ecuador, 2000.Why dollarization?Removes possibility of currency volatility;Eliminate possibility of currency crises;Economic integration with US & other dollar based marketsWhy not dollarization?Loss of sovereignty over monetary policyLoss of power of seignorage, the ability to profit from printing own money.Central bank no longer lender of last resort.
33Emerging Market Country Living on the edge…Emerging Market CountryHigh capital mobilityCurrency Board or DollarizationNo monetary independenceNo political influence on monetary policySeignorage rights lostFree-Floating RegimeCurrency free to floatIndependent monetary policy & free movement of capital allowed, loss of stabilityIncreased volatility
34The Euro European Monetary System (EMS):15 Member nations Maastricht Treaty’ 92 – timeline of economic & monetary union.Convergence criteria calledNominal 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.
35The Euro & Monetary Unification The euro, €, was launched on Jan. 4, 1999 with 11 member statesBenefits 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
36The Euro & Monetary Unification Successful unification ?ECB has to coordinate monetary policyFocus on price stability.Fixing the euro12/1998, national exchange rates were fixed to the Euro.1/1999 euro trading on world currency markets.