1. International Finance FINA 5331 Lecture 3: Exchange rate regimes Read: Chapters 2 Aaron Smallwood Ph.D.

2. Classifications There are various classifications as it can be difficult to determine what countries are actually doing (de-facto) as compared to what the claim they do (de-jure). The IMF provides an annual classification of different exchange rate systems. The most recent classification can be found at: https://www.imf.org/external/pubs/nft/2013/areaers/ar2013.pdf

3. IMF Classification of Exchange Rate Regimes Categories were recently changed: No separate legal tender Currency board Conventional pegs Stabilized arrangement Crawling peg Crawl-like arrangements Horizontal band Other managed arrangements Floating Free floating

4. Free Floating Intervention occurs only “exceptionally” with the aim being to calm markets. According to the IMF, intervention must be limited to 3 times in the previous 6 months, with each intervention lasting fewer than 3 days. Example: United States

5. Floating Exchange rates are largely market determined without obvious policy interference. Intervention can be direct or indirect, but only serves to “moderate the rate of change and prevent undue fluctuations in the exchange rate.” Examples: Brazil, India, Thailand

6. Managed arrangements A residual category, which captures countries that cannot be placed into others. Countries in this category are typically characterized by frequent changes in policy. Examples: Iran, Myanmar, Syria, Switzerland

7. Exchange rates within horizontal bands The domestic currency is pegged to another currency or group of currencies. The exchange rate is maintained within bands that are wider than +/-1% of the established target: Example: While ERMII countries could fall into this category, they choose not to. The only country that falls into this category is Tonga.

8. Crawl-like arrangements The exchange rate must remain in a narrow band of 2% relative to a “statistically identified trend” for at least 6 months. The annualized rate of change in the exchange must be at least 1%. Most prominent example: China.

9. Yuan-Dollar

10. Currency issues In June 2010, the RMB price of the dollar was 6.8322. On March 12, 2013, the price had dropped to 6.1258. Represents a 11.53% appreciation of the yuan. In a recent interview, Huo Jianguo, President of the Chinese Academy of International Trade and Economic Cooperation stated: “Hot money is flowing into China, and that will push up the yuan exchange rate.”

11. Effects??? Exporters that accept payment in currencies like the dollar are seeing profits eroded. – In competitive industries, like apparel, it can be very difficult to pass costs on to customers. – Says, Donald Lee of Esquel Group: “The appreciation in the value of the yuan will have a big impact on our business. Most of our customers are invoiced in dollars, yet a very large percentage of our cost structure is in renminbi. In our industry, we are facing a situation of excess global capacity and, as a result, a very high level of competition. Therefore, we cannot simply pass on the increase in our costs caused by the revaluation to our customers. Instead, we will need to address this cost increase in other ways.”

12. Recent developments In April, 2012, the PBOC announced that it would widen the trading bands within which the RMB was allowed to fluctuate each day from +/-0.50% to +/-1.00%. It is very widely expected that China will announce another widening this year with the ultimate aim of making the yuan more market determined and ultimately an international reserve currency.

13. How do we avoid risk? According to an article in China Daily, “In order to minimize currency exchange losses, suppliers are also trying out financial instruments, such as Chinese yuan- NDF contracts. By fixing the desired exchange rate, a NDF contract allows you to hedge against risk of exchange rate fluctuations.” The article goes on to say: “ ‘Using financial instruments requires significant capital’, said Chen Cunman, a power equipment salesman in Suzhou…`The most effective method to minimize currency loses is yuan settlement.’ ”

14. Crawling pegs The domestic currency is pegged to another currency or basket of currencies at an established target rate, that is either publicly announced or made available to the IMF. The target rate is periodically adjusted, perhaps in response to changing economic indicators.

15. Example: Nicaragua

16. Stabilized arrangement An arrangement where the spot rate remains within a margin of 2% for 6 months or more. There can be a small number of specified outliers. There is no actual policy commitment. –Example: Vietnam

17. Conventional pegs The country pegs its currency at a fixed rate to another currency (or group of currencies). The currency cannot fluctuate by more than 1% relative to the established target: Example: Saudi Arabia, formerly China

18. Saudi’s currency

19. Currency boards Currency board countries are sometimes called “hard peggers”. Example: Hong Kong…. The currency board is a separate government institution whose only responsibility is to buy and sell foreign currency at an established price. The country will typically maintain foreign currency reserves equivalent to 100% of the total amount of outstanding domestic money and credit.

20. No separate legal tender The country uses another country’s (or group of countries’) currency as its own: Example: Ecuador (US dollar)

21. 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.

22. 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.

23. 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.

24. Integration in Europe Integration in Europe begins with the ECSC in 1951. With the Treaty of Rome, the ECSC, EUROTOM, and the EEC are formed, which eventually are absorbed into the EU in 1994. –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 fixed is known as the exchange rate mechanism. The EMS leads to European Monetary Union. The 18 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.

25. The EU and the EMU. Today, there are 28 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

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

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

29. EMU countries Austria (1999)Italy (1999) Belgium (1999)Latvia (2014) Cyprus (2008)Luxembourg (1999) Estonia (2011)Malta (2008) Finland (1999)Netherlands (1999) France (1999)Portugal (1999) Germany (1999)Slovak Republic (2009) Greece (2000)Slovenia (2007) Ireland (1999)Spain (1999)

30. 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

31. 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, 2010. In May 2010, the European Financial Stability Facility 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 2008. 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.

32. Debt crisis continued (2011) July 2: A compromise is reached so that an installment of the €110 billion to Greece can be made. European leaders call on private bondholders to contribute to the bailout. July 21: A new bailout is approved for Greece. Originally valued at €109 billion, the total has recently increased to €130 billion. August 7: The ECB begins to actively intervene to aid bond markets in PIIGS countries. October 26: In a summit of EU leaders, a grand plan is put together, where bondholders indeed agree to take up to 50% losses on holdings of Greek debt. As a result of severe political pressure, prime ministers George Papandreou (Greece) and Silvio Berlusconi (Italy) resign in November.

33. Debt crisis continued December 9: In a summit in Brussels, an intergovernmental treaty is agreed to, which among other things, cements more rigid rules for broaching thresholds on deficit and debt to GDP levels. December 21: The ECB announces that it will provide€489 billion in three-year loans to more than 500 banks in the EMU. As of January 4, 2012, with Italian sovereign debt hovering around 7%, the dollar price of the euro is $1.2923.

34. Debt crisis: 2012 In late January, the “fiscal pact” agreed to in December is signed by all EU members except the UK and the Czech Republic. On February 12, Greece’s parliament passes an austerity bill in anticipation of receiving additional bailout funds. On March 13, the eurozone agrees to an additional bailout of Greece totaling €130 billion. In April, French voters elected Socialist Party candidate François Hollande, an opponent of austerity, as their new president. In Greece, voters rejected austerity policies backed by the two incumbent parties.

35. Debt crisis continued June 2012: Spain requests a bailout for private banks only. June 25: Cyprus requests a bailout September 6, 2012: Outright Monetary Transactions program is agreed to by the European Central Bank. The ECB agrees to the sterilized purchase of sovereign bonds from countries that have requested bailouts September 25, 2012: The European Stability Mechanism is formally established. The ESM will replace the EFSF with a maximum lending capacity of 500 billion euros for sovereign entities in the EMU that are in need of financial support.

36. Calm? March 25, 2013: Cyprus reaches a deal with the troika to receive the bailout of 10 billion euros. Cyrpus’ largest bank (Bank of Cyprus) will be restructured, while its second largest bank will be eliminated. As the size of the austerity program increases, eurozone unemployment reaches an all time high of 12% in March 2013. –Significant difference across the eurozone. Unemployment rates broach 24.3% and 21.7% in Spain and Greece, but are only 5.4% in Germany as of March. July 2, 2013: A second Portuguese cabinet member resigns in protest over continued austerity programs imposed by the “troika” (European Central Bank, the EU, and the IMF). June’s unemployment rate in Portugal broaches 17%. Given the ECB backstop, the euro had stabilized in spite of turmoil. It closed at 1.2973 on July 2, 2013.

37. Today In January of this year, Latvia becomes the 18 th EMU country. At least for now, markets appear to have stabilized. On March, 12, 2014, the euro price of the dollar hit it’s highest level in almost 3 years, reaching $1.3948.

38. Major currency crises EMS crises of 1992-93. –Following German re-unification contractionary monetary policy caused the currencies of German trading partners to become overvalued. Mexican peso crisis 1994-95. –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 (1997-98) –Contagion Argentina (2001-02) –Failure to use fiscal restraint and inflexibility in labor markets led to the collapse in this board system.

39. 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:

40. 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.

41. 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

42. 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%.

43. 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.