1. The International Financial System Prof. Ian Giddy New York University

2. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 2 Global Financial Architecture l Institutions l Issues l Exchange-rate system

3. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 3 Global Financial Architecture l Institutions l Issues l Exchange-rate system World Bank International Monetary Fund Govern- ments Central Banks Govern- ments InvestorsBusinesses Banks Financial Markets

4. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 4 Alternative Bank-Industry Linkages The Equity- Market System The Bank- Based System The Bank- Industrial Crossholding System The State- centered System Investment Vehicles Industrial Companies Individuals Banks Individuals Banks / Investment Vehicles Industrial Companies Individuals Investment Vehicles & Insurance Industrial Companies Banks Individuals Investment Vehicles & Insurance Banks / Investment Vehicles Industrial Companies State Institutions

5. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 5 Global Financial Architecture l Institutions l Issues l Exchange-rate system n Reasons for the boom-bust character of capital flows to emerging market economies? n What measures should be taken to deal with the instability of capital flows? n Role of IMF? Conditionality? n Role of World Bank? Conditionality? n Role of private sector institutions? n Exchange rate regime?

6. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 6 Global Financial Architecture l Institutions l Issues l Exchange-rate system

7. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 7 To Fix or To Float, That is the Question Independent free float Managed float Frequent devaluations or Floating revaluations Crawing peg Tied by formula to inflation Economic index circumstances, and Economic Basket peg policies Fixed Pegged to one currency Absolutely fixed to one currency

8. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 8 Exchange Rate Forecasting l Analyze 1. The economic pressures that can provoke a parity change, and 2. The response of governments to them. l Three issues: 1. How much adjustment is necessary to eliminate underlying pressures. 2. When the pressures will reach the critical point where an exchange rate change or some other drastic measure has to be taken. 3. Whether the exchange rate will be changed, or whether some other policy measure will be eonomically and politically feasible.

9. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 9 Law of One Price p=Sp* The Price of Tin In New YorkOn the KualaOn the Lumpur London Metal MarketMetal Exchange 273c per lb.15.37 ringgitUS$5830 per = US$6.02per kilogramtonne per kilogram a =US5.70= US5.83 per kilogram b per kilogram c a 1 avoirdupois pound = 0.45359 kilograms b US$1 = 2.6965 Malaysian ringgit on the date of calculation c 1 tonne = 1000 kilogram. All data taken from the Commodities section of the London Financial Times.

10. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 10 S t=1 -S t = I - I * S t 1+ I * n JAPAN 1995 n MEXICO 1994 EXCHANGE- RATE CHANGE RELATIVE INFLATION Purchasing Power Parity: Theory and Evidence

11. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 11 Deviations from Purchasing Power Parity Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

12. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 12 Deviations from Purchasing Power Parity Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

13. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 13 US Expected Inflation Rate 2% Inflation & Interest Rates Canadian Expected Inflation Rate 7% US Interest Rate 5% Canadian Interest Rate 10%

14. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 14 US Expected Inflation Rate 2% Inflation & Interest Rates Canadian Expected Inflation Rate 7% US Interest Rate 5% Canadian Interest Rate 10% Expected Rate of Change of the Exchange Rate Expected Rate of Change of the Exchange Rate

15. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 15 Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10%

16. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 16 Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10% Sell Canadian Dollars Forward (at discount of 5%) Sell Canadian Dollars Forward (at discount of 5%)

17. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 17 Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10% Sell Canadian Dollars Forward (at discount of 5%) Sell Canadian Dollars Forward (at discount of 5%) Sell Canadian Dollar Futures (at discount of 5%) Sell Canadian Dollar Futures (at discount of 5%)

18. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 18 The Linkages Again RELATIVE EXCESS MONEY SUPPLY 1 RELATIVE INFLATION RATES 2 3 RELATIVE 4 EXCHANGE INTEREST RATE RATES CHANGE 5 6 FORWARD EXCHANGE PREMIUM OR DISCOUNT

19. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 19 A Framework Country ACountry BDOMESTICECONOMICPOLICIESINFLATION RATE RATE EXCHANGE RATEINTEREST RATE RATE FORWARD RATE

20. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 20 Turkey, 1995 Turkish Lira: Down 33.5%

21. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 21 Turkey, 1995 Turkish Lira: Down 33.5% Turkish prices: up 83.8%!

22. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 22 Forecasting in a Fixed-Rate System

23. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 23 Market Efficiency l Exchange rates exhibit behavior that is characteristic of other speculative asset markets l Exchange rates react quickly to news. 1. Rates are far more volatile than changes in underlying economic variables. 2. They are moved by changing expectations, and hence are difficult to forecast. 3. They change only in response to unanticipated information. In this broad sense they are efficient. l Testing Efficiency: Since one cannot observe expectations directly, tests of efficiency are joint tests of the model and of market efficiency.

24. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 24 A Random Walk?

25. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 25 Unbiased Forward Rate Theory

26. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 26 Corporate Forecasting Look before you leap!

27. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 27 Cap des Biches: Choices for the BCEAO l Foreign-exchange intervention l Money-market intervention (consider interaction with monetary policy) l Fiscal policy--the demand side l Tariffs and subsidies l Exchange controls and capital controls (and jawboning)

28. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 28 Cap des Biches: Choices for GTI-Dakar “We must decide whether it’s worth covering our dollar exposure, given the forward premium and relative interest rates.”

29. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 29 Cap des Biches: Choices for GTI-Dakar “We must decide whether it’s worth covering our dollar exposure, given the forward premium and relative interest rates.” n What is the probability of a devaluation? n How much? n What should GTI-Dakar do?

30. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 30 Cap des Biches: Choices for GTI-Dakar n Renegotiate the $30 million loan, replacing it with a loan denominated in Euros n Keep the USD loan in place, but enter into a 6-year currency swap to effectively convert GTI's payments into Euros. n Hedge the dollar-Euro risk by buying dollars forward, with rolling 3-month forward contracts n Hedge against a possible devaluation of the CFA franc, by selling francs in the 3-month forward market. n Leave the dollar loan unhedged, and pass the cost of any foreign exchange losses on to Senelac, the buyer of GTI's power n Do nothing now but watch the situation carefully and hedge if the risk becomes too great.

31. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 31 Global Financial Architecture Exchange Rate System? FixedFloating …or what?

32. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 32

33. Copyright ©2003 Ian H. Giddy Exchange Rate Systems and Policies 33 Contact Info Ian H. Giddy NYU Stern School of Business Tel 212-998-0426; Fax 212-995-4233 Ian.giddy@nyu.edu http://giddy.org