International Finance FINA 5331 Lecture 7: Crises Read: Chapters 2 Aaron Smallwood Ph.D.

Benefits of pegging your currency Exchange rates are stable –Could possibly benefit trade If pegged to a country with stable inflation, we may be able to import stable inflation. Likely provides an anchor for future inflation.

Drawbacks Loss of monetary policy independence Loss of the exchange rate as an automatic adjustment mechanism following economic shocks. Potential for major currency crises, especially if the trillema is violated.

Trillema The trillema, also known as the “impossible trinity” states that a country can ONLY have TWO of the following three: –Fixed exchange rate system –Free flow of capital –Independent monetary policy.

Integration in Europe Integration in Europe begins with the ECSC in With the Treaty of Rome, the ECSC becomes the EEC, which eventually becomes the EC and then the EU in –ESCS leads to EEC, which leads to EC, which leads to the EU. Monetary integration is formalized with the establishment of the EMS where exchange rates are fixed. The mechanism by which exchange rates are fixes is known as the exchange rate mechanism. The EMS leads to European Monetary Union. The 17 countries that use the euro are part of a currency union known as the EMU. Monetary policy for the entire EMU is overseen by the European Central Bank in Frankfurt.

The EU and the EMU. Today, there are 27 EU countries. The European Union is a political and economic union based on free trade. NOT ALL countries use the euro. There are several distinct groups –EU Countries EU countries who are not in the ERMII and have no intention of adopting the euro EU Countries that will adopt ERM II countr(y)ies that have no stated intentions of adopting the euro ERM II countries that will adopt EMU Countries

Euro Area Austria Denmark BelgiumLatvia Cyprus Lithuania Estonia Finland France Germany GreeceBulgaria IrelandCzech Republic ItalyHungary LuxembourgPoland MaltaRomania Netherlands PortugalSweden SloveniaUK Spain Slovakia EU

EU countries that are not part of the ERMII EU countries that will eventually adopt (or plan to): –Bulgaria –Czech Republic –Hungary –Poland –Romania EU countries (not part of ERMII) with no stated intention of adopting the euro –Sweden –UK

ERM II Countries That will adopt: Latvia Lithuania The have no stated intentions of adopting Denmark

EMU Countries –Austria (in 1999)- Netherlands (in 1999) - Portugal (in 1999) –Belgium (in 1999)- Slovenia (in 2007) –Cyprus (in 2008)- Slovakia (in 2009) –Estonia (in 2011)- Spain (in 1999) –Finland (in 1999) –France (in 1999) –Germany (in 1999) –Greece (in 2000) –Ireland (in 1999) –Italy (in 1999) –Luxembourg (in 1999) –Malta (in 2008)

Is the EMU an OCA? OCA optimum currency area: The best geographic region where one currency is used within the region, and where outside the region, different currency(ies) are used. It is generally accepted that within an OCA: –Countries should be relatively buffered from asymmetric shocks –Factors of production should be mobile

Policy Matters - Public Policymakers Many were skeptical about EMU. –The European Union is not an ideal candidate for a currency union because within the union, labor is immobile, business cycles are weakly correlated, and fiscal transfers are limited. Others focused on the advantages and dynamic gains likely under EMU: –lower transaction costs and exchange rate risk, and greater capital mobility and depth of financial markets across Europe

Policy Matters - Public Policymakers Some Specific Concerns about the EMU  The lack of national exchange rate policy under EMU can be a source of tension if national growth rates are not sufficiently correlated. –Ireland found it helpful to make a small adjustment to the Irish punt’s central rate in  The euro can challenge the dominant role played by the U.S. dollar over the last 50 years. –Liquidity in the US$ market may be affected.

Policy Matters - Public Policymakers  The euro changes some basic aspects of international financial management. –To obtain diversification benefits, the investor must turn to other markets.

More generally, the choice of an exchange rate system: Policy Matters - Private Enterprises The government’s choice of monetary system affects the decisions that firms face. There is greater exchange rate variability under floating. Nominal exchange rate variability –raises the importance of the choice of currency of denomination for cash flows and financial assets –increases the demand for financial instruments that can be used to hedge or offset currency risks.

Debt crisis On April 27,2010, Greece sovereign debt is downgraded to “junk” status by Standard & Poors. Facing a strong probability of default, the EMU and IMF approve a €110 billion rescue package for Greece on May 2, In May 2010, the European Financial Stability Facilty is formed. In conjunction with the IMF, up to €750 billion is available for countries potentially facing a crisis. In Ireland, the Anglo-Irish Bank is effectively nationalized in December On November 21, 2010, Ireland reaches an agreement for a bailout. On March 30, 2011, Ireland announces that it will need an additional €24 billion from the IMF and EFSF to aid ailing banks. The total bailout for Ireland has reached €70 billion. The Portuguese government released figures on March 30, 2011, indicating that the deficit had reached 8.6% of GDP. On April 6, 2011, the Portuguese government asks the EMU for a bailout.

Major currency crises EMS crises of –Following German re-unification contractionary monetary policy caused the currencies of German trading partners to become overvalued. Mexican peso crisis –An overvalued exchange rate, policy mistakes, and political turmoil led to collapse of the peso, a severe recession and inflation before an IMF and US led bailout. Asian currency crisis ( ) –Contagion Argentina ( ) –Failure to use fiscal restraint and inflexibility in labor markets led to the collapse in this board system.

Overvalued/Undervalued? How would we know if a currency was overvalued or undervalued? Most economists use “real exchange rates”. According to the law of the one price:

Real Exchange Rate The real exchange rate is defined as: Take Mexico as an example: Suppose S t is relatively stable but, P t Mex increases much more rapidly than P t US. The result, R t increases. The Mexican peso appreciates in real terms.

Real Exchange rate If a country’s real exchange rate rises, some combination of the following three are occurring: –The nominal exchange rate is appreciating –Domestic prices are rising rapidly –Foreign prices are falling. ALL THREE LIKELY LEAD TO A DECLINE IN THE DEMAND FOR EXPORTS

The Asian currency crisis On July 2, 1997, Thai Baht is devalued. July 11 Philippines devalues the peso July 14: Malaysia floats the ringgit July 17: Singapore devalues August 14: Thailand moves to a float October 14: Taiwan devalues November 14: Korea floats August 17, 1998: Russia abandons its peg Hong Kong: At one point, Hong Kong monetary authority raises rates to 500%.

Asian currency preview: The causes Liberalization of capital markets in a weak domestic financial environment. –Crony capitalism –Surge in risky real estate investment –Maturity mismatch Secondary cause: Over-valued real exchange rates.