1. International Finance FINA 5331 Lecture 8: Exchange rate regimes Read: Chapters 2 Aaron Smallwood Ph.D.

2. 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 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.

3. 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

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

5. 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

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

7. 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)

8. 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 (economic/financial events that affects different regions differently). –Factors of production should be mobile

9. 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 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 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.

10. Debt crisis continued (2011) July 2: A compromise is reached so that an installment of the €110 billion 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 totally 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.

11. 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.

12. Debt crisis 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. According to the WSJ, earlier this week, 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. The dollar price of the euro closed at $1.3089 on Monday.

13. Benefits of joining currency unions Reduction in transactions costs such as the bid-ask spread. Increased transparency (traders throughout the eurozone immediately know the costs of goods and services with no need for currency conversion) Deeper financial markets Potential for increased political harmony

14. Costs of being in a currency union Loss of monetary policy independence –Lacking fiscal federalism, policy responses to asymmetric shocks can be limited Loss of exchange rate as an automatic adjustment mechanism. –Greece’s currency today is likely stronger than it would if Greece was not part of the EMU.

15. 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.

16. 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:

17. 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.

18. 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

19. 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%.

20. 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.

21. Review: Asian currency crisis Crony capitalism: A very close connection between government leaders and private enterprise, “lending decisions were often influenced by political considerations” (page 49, Eun and Resnick). Violation of the trillema Maturity mismatch: –Given capital inflow, Asian economies become reliant on short term debt instruments. Aftermath: Average economic growth of Indonesia, Korea, Malaysia, Philippines, and Thailand (source: Krugman and Obstfeld, 6 th Edition): 1996: 7.0%1997: 4.5%1998: -8.1%