International Monetary System Chapter 2 (36-60)

Lecture Objectives Introduce the institutional framework within which: International payments are made. The movement of capital is accommodated. Exchange rates are determined.

Lecture Outline Current Exchange Rate Arrangements Fixed versus Flexible Exchange Rate Regimes European Monetary System Euro and the European Monetary Union The Argentine Peso Crisis (2002) The Asian Currency Crisis (1997) The Mexican Peso Crisis (1994)

Current Exchange Rate Arrangements Free Float The largest number of countries, about 33, allow market forces to determine their currency’s value. Managed Float About 46 countries combine government intervention with market forces to set exchange rates. For e.g., India, Brazil and Mexico. Pegged to another currency or a basket of currencies Such as the U.S. dollar or euro; e.g. HK$7.80 =US$1 No national currency Some countries do not bother printing their own, they just use the U.S. dollar or euro. For example, Ecuador, Panama, and El Salvador have dollarized. Montenegro and San Marino use the euro.

Fixed versus Flexible Exchange Rate Regimes Arguments in favor of flexible exchange rates easier external adjustments countries are insulated from unemployment and inflation in other countries national policy autonomy Arguments against flexible exchange rates exchange rate uncertainty may hamper international trade and investment no safeguards to prevent crises must monitor FX expenses and revenues

Fixed versus Flexible Exchange Rate Regimes Arguments in favor of fixed exchange rates governments willing to buy and sell currency only at an official rate that is pegged to another currency or a basket of currencies no foreign currency risk Arguments against fixed exchange rates fixed exchange rates provide a link between foreign and domestic inflation rates market participants do not believe that fixed rates reflect true market values

European Monetary Union (EMU) EMU created with launching of the euro € on 1 Jan. 1999. By 1 July 2002, € became the sole legal tender in the euro zone. Objectives: To establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis-à-vis non-European currencies. To pave the way for the European Monetary Union.

Benefits of European Monetary Union reduce transaction costs eliminate XR risk promote cross-border investments and mergers increase the depth and liquidity of the European financial markets promote political cooperation

Costs of European Monetary Union Main cost: the loss of national monetary and exchange rate policy independence. The more trade-dependent and less diversified a country’s economy is, the more prone to asymmetric shocks that country’s economy would be.

Costs of European Monetary Union

Prospects of the Euro If the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a “United States of Europe” feasible. It may be likely that the U.S. dollar will lose its place as the dominant world currency. The euro and the U.S. dollar are now the two major currencies in the world.

Currency Crisis

The Argentinean Peso Crisis In 1991 the Argentine government passed a convertibility law that linked the peso to the U.S. dollar at parity. The initial economic effects were positive: Argentina’s chronic inflation was curtailed Foreign investment poured in As the U.S. dollar appreciated on the world market, the Argentine peso became stronger as well.

The Argentinean Peso Crisis The strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of peso–dollar parity in January 2002. The unemployment rate rose above 20 percent The inflation rate reached a monthly rate of 20 percent

The Argentinean Peso Crisis There are at least three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis: Lack of fiscal discipline Labor market inflexibility Contagion from the financial crises in Brazil and Russia

The Asian Currency Crisis The Asian currency crisis turned out to be 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. On July 2, 1997 the Thai baht was suddenly devalued. Within days was followed by Philippine peso, Malaysian ringgit, Indonesian rupiah. By the end of 1997, Thai baht and Korean won lost 50% of the value; Indonesian rupiah fell 80%. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession with annual industrial production declines between 10 and 20%.

Asian Currency Crisis (December 31, 1996 = 1.00) Thai baht Korean won Indonesian rupiah

Origins of the Asian Currency Crisis As capital markets were opened, large inflows of private capital resulted in a credit boom in the Asian countries. Fixed or stable exchange rates also encouraged unhedged financial transactions and excessive risk taking by both borrowers and lenders. The real exchange rate rose, which led to a slowdown in export growth. Also, Japan’s recession (and yen depreciation) hurt.

What happened? In 1997, the asset bubble started to burst and the stock market started to drop and emergence of wide losses and defaults signaled the low profitability of past investments The firms, investors and banks that had heavily relied on external borrowing were left with a large stock of short term foreign currency denominated unhedged liabilities The exchange rate crises exacerbated the problems and increased the real burden!!

The Mexican Peso Crisis On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency trader’s expectations about the future value of the peso. In their rush to get out, the peso fell by as much as 40 percent. Faced with an international crises, US administration and IMF put together a $53 billion bail-out plan that stabilized the markets. The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital.

The Mexican Peso Crisis Two lessons emerge: It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. An influx of foreign capital can lead to an overvaluation in the first place.

Learning outcomes Understand the differences between fixed and floating exchange rates Discuss the current exchange rate arrangements Discuss the European Monetary System Know background information about the Euro Benefits and costs of the European Monetary Union Provide a brief discussion of the Argentinean, Mexican and Asian crises Discuss several factors responsible for the onset and development of the currency crises Lessons from the currency crises