International Business Final Exam
International Monetary Fund (IMF)
- maintain order in the international monetary system through a combination of discipline and flexibility -Fixed exchange rates stopped competitive devaluations and brought stability to the world trade environment -Fixed exchange rates imposed monetary discipline on countries, limiting price inflation -In cases of fundamental disequilibrium, devaluations were permitted -The IMF lent foreign currencies to members during short periods of balance-of-payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment
When do International companies use the foreign exchange market?
-The payments they receive for exports, the income they receive from foreign investments or the income they receive from licensing agreements with foreign firms are in foreign currencies -They must pay a foreign company for its products or services in its country's currency -They have spare cash that they wish to invest for short terms in money markets -They are involved in currency speculation - the short-term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates
forward exchanges
-To insure or hedge against a possible adverse foreign exchange rate movement *Two parties agree to exchange currency and execute the deal at some specific date in the future
capital flight
-When residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency -Most likely to occur in times of hyperinflation or economic crisis
Examples of Capital Controls
1. Exchange controls on the buying and selling of a national currency related to the market rate 2. limits/ceilings on the volume for the international sale or purchase of various financial assets 3. Transaction taxes 4. Limitations on foreign investment by domestic financial institutions 5. Requirements on the length of an investment in the country 6. Requirements for mandatory approvals on capital flows 7. "Suitcase ban": Limits on the amount of money a company or private citizen is allowed to remove from the country 8. Limits on ATM withdrawals
Three Capital Control Examples from Neely, "An Introduction to Capital Controls
1. Malaysia's Capital Controls: 1998-99 2. The U.S. Interest Equalization Tax: 1963-74 3. Chile's Encaje: 1991-98
Exchange rate regime considerations
1. Monetary Policy 2.Trade 3. Liability dollarization 4. Risks Premium 5. International reserves
China - Practices and Policies disadvantage foreign competition
1. Partial or full barriers to investment in certain sectors 2. Complicated or opaque licensing and branching processes 3.Unclear rules, laws and regulations 4. Inconsistent regulatory interpretation and implementation of regulations at the local level 5.Some domestic firms use this for competitive
Objectives of capital controls
1. Reduce the volume of capital flows 2. Alter the composition of capital flows (towards longer maturity flows) 3. Reduce real exchange rate pressures 4. Allow for a more independent monetary policy
Policy implications of the Impossible Trinity
(1) If a country has a fixed exchange rate and wishes to retain monetary policy autonomy, it must restrict capital flows (i.e. introduce capital controls) Example: China restricts the international flow of capital in and out of the country. Thus, it can fix its exchange rate and conduct an independent monetary policy (2) A country may allow capital flows and retain monetary policy autonomy, but it must let the exchange rate float Example: The US allows free flows of capital and conducts an independent monetary policy. Thus, the U.S. currency must float (3) Fixed exchange rate in a world of mobile capital essentially implies adopting the monetary policy of the country to which you peg Example: Hong Kong allows free floating flows of capital and fixes its exchange rate (peg to $U.S.) Thus, it cannot have an independent monetary policy
"Four Fears" - Why use Capital Controls
(1) Fear of appreciation --> Capital inflow causes upward pressure on the exchange value of a country's currency above its intrinsic value - making its exports more expensive (2) Fear of "hot money" --> Rapid inflow of capital may be followed by rapid outflow (3) Fear of large inflows --> Large volume of inflows can fuel asset price bubbles and encourage excessive risk-taking (4) Fear of loss of monetary autonomy --> Nations are reluctant to give up monetary policy flexibility
Benefits of international cooperation in monetary policy
(1) Reduced currency volatility almost certainly increases international trade and investment (2) Fixed rates tend to stabilize domestic monetary conditions so that international monetary stability reinforces domestic monetary stability (3) Predictable currency values can reduce trade conflicts: a rapid change in currency value often leads to an import surge, protectionist pressures, and commercial antagonism (e.g; currency wars can lead to trade wars)
How do prices influence exchange rates?
- Law of one price - Purchasing Power Parity Theory (PPP) - A positive relationship exists between the inflation rate and the level of money supply *When the growth in the money supply is greater than the growth in output, inflation will occur
What has happened to exchange rates since 1973?
- exchange rates have been more volatile and less predictable than they were between 1945 and 1973 because of * the 1971 and 1979 oil crises * the loss of confidence in the dollar after U.S. inflation in 1977-78 * the rise in the dollar between 1980 and 1985 * the partial collapse of the EMS in 1992 * the 1997 Asian currency crisis * the global financial crisis of 2008-2010; sovereign debt crisis of 2010-2011
great strength of the gold standard
- it contained a powerful mechanism for achieving balance-of-trade equilibrium by all countries (When the income a country's residents earn from its exports is equal to the money its residents pay for imports)
How well does PPP work?
Empirical testing of PPP theory suggests that: -It is most accurate in the long run, and for countries with high inflation and underdeveloped capital market -It is less useful for predicting short-term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates
The NY Times article, "Looking Overseas, Businesses Learn to Master Currency Exchange
For small businesses, the foreign exchange rates if left un-hedged can be very costly -Examples of the trip to India and surrounding countries, where the rupee had a double-digit climb against the dollar (cost from $7500 per person to $9000 per person) Some options for small businesses on FX risk -Work with global currency traders/currency trading company to lock in costs early (the trader hedges for a fee) -Work with a commercial bank and purchase a forward contract -Buy only in US dollars had put the risk on your supplier ***Some suppliers will charge a "fee." but is known upfront so cost/price is clear
Intellectual Property Rights in China
Piracy and counterfeiting remain a problem in China although not as rampant as in previous years Improved IPR enforcement by authorities The majority of U.S. businesses still consider enforcement to be ineffective "The nature of the debate over IPR has changed in the past several years from a singular focus on enforcement to a dual concern over enforcement and the impact of China's innovation policy" "Access to the China IPR enforcement system remains difficult for foreign businesses, in particular, those operating in creative and innovative sectors."
Floating exchange rates
Provides Monetary policy autonomy, help countries recover from financial crises. and automatic trade balance adjustments
fixed exchange rate system
Provides monetary discipline (Ensures that governments do not expand their money supplies at inflationary rates), Minimizes speculation, and reduces uncertainty (Promotes the growth of international trade and investment)
Currency wars - The United States
Quantitative easing (U.S. FOMC action in 2008/09) -The U.S. Federal Reserve injects money into the U.S. economy through the purchase of financial assets (like Treasury and corporate bonds) In effect, the Federal Reserve is creating new money QE2 -Bernanke announces FOMC will buy and additional $600 of longer-term Treasury securities in November 2010 QE3 -In September of 2012, the FOMC began buying an additional $40 billion in mortgage-backed securities each month until it sees improvement in the labor market
Steps to fight currency manipulation - Bergsten
Unilateral steps or with other G7 nations: (1) Countervailing currency intervention against manipulators (2) Taxes on further dollar buildups by manipulators (3) Application of countervailing duties (CVD) on imports subsidized by currency manipulation that injure domestic industries (4) Submission of an Article 15 (4) case to the WTO seeking authorization to apply across the board import restraints to manipulators
Foreign exchange hedging
Using various methods to minimize or eliminate foreign exchange risk. The most common forms of hedging are: forward contracts or options Note: There is a cost to hedging, but exposure decreases
Appreciated currency
When currencies appreciate, export and import-competing industries lose while domestically-oriented industries gain Domestic consumers/voters also gain as the domestic currency price of imported goods falls, lowering the cost of living
Purchasing power parity theory (PPP)
given relatively efficient markets (a market with no impediments to the free flow of goods and services) the price of a "basket of goods" should be roughly equivalent in each country *Predicts that changes in relative prices will result in a change in exchange rates, at least in the short run *A country with very high inflation should see its currency depreciate relative to others (investor uncertainty will cause move away from this currency)
law of one price
in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency
Passive hedging strategy
match (through forecasting) inflows and outflows, hedge or cover 50% of FX exposure not higher percentage
Dollarization
partial or full: eliminate the domestic currency and replace with the U.S $ (e.g; Panama, El Salvador) or another currency (e.g, Liechtenstein uses Swiss Franc)
pegged exchange rate system
pegs the value of its currency to that of another major currency or basket of currencies -Popular among the world's smaller nations -Imposes monetary discipline and leads to low inflation -Adopting a pegged exchange rate regime can moderate inflationary pressures in a country *Many Gulf states peg their currencies to the U.S. dollar
Liability dollarization
sharp depreciation can lead to widespread defaults for dollar borrowers, creating incentives to manage a float
gold par value
the amount of a currency needed to purchase one ounce of gold
international monetary system
the institutional arrangements that countries adopt to govern exchange rates
exchange rate
the rate at which one currency is converted into another The price of one currency in terms of another ("exchange rate") is determined by supply and demand for the currency in the Forex market (>$3 trillion/day)
foreign exchange market
used to convert the currency of one country into the currency of another
Foreign Exchange Risk
when a company deals with a foreign currency or must exchange foreign currency for its home currency, foreign exchange risk is the possibility that the currency will change unfavorably before payment is made or received in that currency
freely convertible
when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency *Most countries today practice free convertibility but many countries impose restrictions on the amount of money that can be converted
nonconvertible
when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency
Dual exchange rate system
when different international transactions are subject to different official exchange rates. Generally, one change rate is applied to current account transactions such as exports rate is applied to current account transactions such as exports and imports, and another is applied in capital account transactions such as exports and imports, and another is applied to capital account transactions such as capital flows"
externally convertible
when non-residents can convert their holdings of domestic currency into a foreign currency, but when the ability of residents to convert currency is limited in some way
QE as "currency manipulation"
"QE aims primarily, if not solely, at domestic economic outcomes. It is conducted in domestic rather than foreign currency. Successful QE helps rather than hurts a country's trading partners by strengthening growth, and thus imports, of the country undertaking the policy (IMF 2011). The distinction between QE and direct currency manipulation should be crystal clear."
Currency Wars - Bergsten
"The international monetary system is (sic) facing a clear and present danger: currency wars. Virtually every major country is seeking depreciation, or at least, non-appreciation, of its currency to strengthen its economy and create jobs." -"Mervyn King, Bank of England, worried: "that in 2013 what we will see is the growth of actively managed exchange rates as an alternative to the use of monetary policy Currency manipulators: "China, a number of other Asians (Taiwan and Korea), several oil exporters, and a couple of Europeans (Switzerland)." Largest losers: The United States (trade and current account deficits and excess unemployment) and Europe (trade deterioration and job losses) -The impact is particularly acute for the U.S. increasing the US current account imbalance by $200-500 billion annually and costing it 1-5 million jobs
Jamaica Agreement
-A new exchange rate system was established in 1976 at a meeting in Jamaica -The rules that were agreed on then are still in place today -Under the Jamaican agreement: (1) Floating rates were declared acceptable (2) Gold was abandoned as a reserve asset (3) Total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion - today they are about $767 billion
World Bank
-Also called the international bank for reconstruction and development (IBRD) -Countries can borrow form the World Bank in two ways (1) Under the IBRD scheme, money is raised through bond sales in the international capital market -Borrowers pay a market rate of interest - the bank's cost of funds plus a margin of expenses (2) Through the International Development Agency, an arm of the bank created in 1960 -IDA loans go only to the poorest countries
countertrade
-Barter-like agreements where goods and services are traded for other goods and services -Was common in the past when more currencies were nonconvertible, but today involves less than 10% of world trade *loophole to nonconvertible currency
Why did the fixed exchange rate system collapse?
-Bretton Woods worked well until the late 1960s -It collapsed when huge increases in U.S. welfare programs and the Vietnam War were financed by increasing the money supply and causing significant inflation Note: other countries increased the value of their currencies relative to the U.S. dollar in response to speculation the dollar would be devalued -However, because the system relied on an economically well managed U.S., when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point *the U.S. dollar came under speculative attack
How Managers reduce Economic exposure
-Distribute productive assets to various locations so the firm's long-term financial well-being is not severely affected by changes in exchange rates -Ensure assets are not too concentrated in countries where likely rises in currency values will lead to an increase in the foreign prices of the goods and services the firm produces
How are exchanges rates determined?
-Exchange rates are determined by the demand and supply for different currencies -Three factors impact future exchange rate movements: (1)A country's price inflation, (2)A country's interest rate, (3) Market psychology
How managers minimize exchange rate risk
-Have central control of exposure to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies -Distinguish between transaction and translation on the one hand, and economic exposure on the other hand -Attempt to forecast future exchange rates -Establish good reporting systems so the central finance function can regularly monitor the firm's exposure position -Produce monthly foreign exchange exposure reports
Bretton Woods System
-In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system that would facilitate postwar economic growth -Under a new agreement: (1) A fixed exchange rate system was established (2) All currencies were fixed to gold, but only the U.S. dollar was directly convertible to gold (3) Devaluations could not be used for competitive purposes (4) A country would not devalue its currency by more than 10% without IMF approval Note: Bretton Woods formed three institutions including the General Agreement on Tariffs and Trade (GATT), today's WTO, but 2 of them were monetary institutions)
What is foreign exchange risk and how can firms hedge against it?
-The foreign exchange market provides some insurance to protect against foreign exchange risk *The possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm -A firm that insures itself against foreign exchange risk is hedging
gold standard
-a system in which countries peg currencies to gold and guarantee their convertibility - dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value (payment for imports was made in gold or sliver) -payment was made in paper currency which was linked to gold at a fixed rate -Died in 1939 after World War I (1914) and and lost of confidence in the system
floating exchange rate system
-exists when a country allows the foreign exchange market to determine the relative value of a currency Examples: US dollar, the EU euro, the Japanese yen, and the British pound all floating freely against each other *Their values are determined by market forces and fluctuate day to day
intermediate or dirty float or managed float
-exists when a country tries to hold the value of its currency within some range of a reference currency such as the U.S. dollar *China pegs the yuan to a basket of other currencies
Role of the IMF Today
-focuses on lending money to countries in financial crisis -There are three main types of financial crises: (1) Currency crisis (2) Banking crisis (3) Foreign debt crisis
Translation exposure (balance sheet)
-the impact of currency exchange rate changes on the reported financial statements of a company - exposures that arise from translation of account balances recorded in foreign currencies other than entity's reporting currency *Concerned with the present measurement of past events; Gains or losses are "paper losses" ; They are unrealized
Economic (competitive exposure)
-the extent to which a firm's future international earning power is affected by changes in exchange rates - risks that arise when changes in exchange rate impact the competitive dynamics facing a company, for example changing the cost structure of a foreign competitor *Concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs
Transactional exposure
-the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values -exposure that occurs from transactions (sales or purchases) that are in a foreign currency *Includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies
spot exchange rate
-the rate at which a foreign exchange dealer converts one currency into another currency on a particular day *Spot rates change continually depending on the supply and demand for that currency and other currencies * Spot exchange rates can be quoted as the amount of foreign currency one U.S. dollar can buy, or as the value of a value of a dollar for one unit of foreign currency
The Trilemma of international finance
1) Fixed exchange rates 2) Monetary Policy Sovereignty 3) Capital mobility (money flowing in and out)
How can managers minimize exchange rate risk?
1. Buy forward 2. Use swaps 3. Lead and lag payable and receivables (difficult to implement)
Unintended consequences of capital controls
1. Capital controls "are administratively burdensome", requiring the government to discriminate between different types of credit, encouraging evasion, lobbying, and rent-seeking (see next slide for definiton) 2. More difficult for small companies to raise funds; larger firms have the resources and scale to configure assets and circumvent controls 3. Smaller firms depend more heavily on banks which are more closely monitored by the government 4. Large companies responded by delaying tax payments, borrowing from suppliers, and sometimes disgusting loans as direct investment 5. The potential for a black market in hand currency and "a culture of transgression", damaging transparency and liquidity 6. Lower investment and growth - inevitably investment will seek less cumbersome destinations 7. Increase country reputation for economic/political risk 8. sterilization/fiscal cost of excess reserve requirements - holding reserves has high associated costs 9. Interherant conflict with the free-market model 10. Financial dis-intermediation - With banks needing to conform strictly to government regulations, firms will seek other forms of external financing
The "irreconcilable trilogy" / "impossible trinity"
3 desirable capacities of countries, only 2 of the 3 are achievable (1) Capacity to use stabilization instruments (or to conduct monetary and fiscal policy) (2) The capacity to defend the exchange rate (3) The capacity to have free capital movement
Open Market Operation
A country's central bank buys or sells government bonds, foreign currency, or other financial assets on the open market as part of monetary policy, thus affecting the central bank's reserves: The objectives of the transactions include: (1) Control the money supply (2) Control on interest rates (3) Control of inflation (4) Control of the exchange rate in relation to the reserve currency (US $)
"Free floating" currency countries
A currency's value floats in the Forex Market; governments allow market forces to determine the exchange rate Examples of floating countries: U.S., Canada, UK, EU, Australia, New Zealand, Mexico, Sweden
Depreciated currency
A relatively depreciated currency encourages exports and expenditures switching from imports to domestic goods When currencies depreciate, export and import, competing industries gain at the expense of domestic consumers and non-traded industries Depreciation can have contractionary effects that follow from higher prices
How has the IMF done?
By 2012, the IMF was committing loans to 52 countries in economic and currency crisis All IMF loan packages require tight macroeconomic and monetary policy However, critics worry: (1) The "one-size-fits-all" approach to macroeconomic policy is inappropriate for many countries (2) The IMF is exacerbating moral hazard - when people behave recklessly because they know they will be saved if things go wrong (3) The IMF has become too powerful for an institution without any real mechanism for accountability But, as with many debates about international economics, it is not clear who is right However, in recent years, the IMF has started to change its policies and be more flexible -Urged countries to adopt fiscal stimulus and monetary easing policies in response to the 2008-2010 global financial crisis
China Adds Curbs to Pulling Money Out of the Country"
China added new restrictions on pulling yuan out of the country as authorities seek to prevent a flood of capital outflows from destabilizing the financial system → if money flows out in large quantities, what happens? -China is throwing up administrative roadblocks to contain capital outflows before likely U.S. Interest-rate increase New restrictions are a setback for the long-term plan to open up China's financial markets and internationalize the yuan "It is a smart move to use administrative measures to reduce capital outflows and defend the exchange rate because China's foreign reserves are dropping," said Ken Cheung, HK based currency strategist China has also used other ways to clamp down on outflows in recent months such as made it more difficult to buy insurance policies in HK
Intermediate or "Managed Float" Countries
Some countries allow their currencies to fluctuate "float" on the daily Forex market within a narrow (+1 or -1) or wide (up to +30 or -30) range The Central Banks of "managed float" countries intervene in the currency markets by buying and selling to manage the rate of exchange Examples: Colombia, India, Indonesia, Peru, Singapore, Costa Rica, Hungary, and China (very managed)
"beggar thy neighbor" effect
Countries are looking for ways to expand growth and create jobs in a period of global economic weakness A weaker exchange rate makes a country's exports cheaper in relation in those of competitive countries -Some major countries pursue monetary policies (e.g,; U.S. QE policies) that effectively weaken their currency's exchange rate -Other countries have seen their currencies strengthen as capital seeks reward in faster growing emerging markets which makes their exports more expensive and creates economic instability
fixed "pegged" exchange rates
Governments establish a fixed price for their currency in terms of another country's currency (global reserve currency = U.S. $) or a "basket" of currencies The fixed price is "pegged" to the $ or "basket" Governments maintain the pegged rate through the Forex market and/or monetary policy/open market operations A pegged regime requires a credible commitment to defend the peg against speculators -Currency board: the government sets a conversion rate to a foreign currency and guarantees full convertibility through the accumulation of reserves (e.g., Hong Kong pegs to the U.S.$) -Dollarization - partial or full: eliminate the domestic currency and replace with the U.S $ (e.g; Panama, El Salvador) or another currency (e.g, Liechtenstein uses Swiss Franc)
"Currency Wars"
How Brazil is going? What is happening to Brazil's economy? -Money flowing into Brazil Brazilian Real appreciating -Also, commodities are in demand, which Brazil exports -Inflation is a challenge for Brazil ***If Brazil lowers interest rate (to decrease inflow of money), inflation may grow further -Also, challenge to Brazil's manufacturing base What are "Currency Wars"? -A Currency War is when two or more countries engage in intentional currency devaluation in an attempt to improve their competitiveness in global markets How should developing nations respond? If you were the head of Brazil's central bank, what would you do? -Brazil's response: cut the Selic rate from 12.5 % to 8% over a 12 month period, implemented capital controls, imposed new import tariffs and instituted government purchasing preferential program for domestic goods
Capital Controls
National restrictions or prohibitions on capital (money) -Moving into (inflows) a country, generally to prevent crises -Out (outflows) of a country, generally to manage crises
currency crisis
Occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates Example: Brazil 2002
Chile's Encaje: 1991-98
Reason: During 1980s and early 1990s international capital returned to Chile in increasing levels due to Chile's reduced debt and sound macroeconomic policies Chilean response: Fearing that these capital inflows could cause an appreciation of the exchange rate and the danger of building up short-term debt, Chile restricted capital inflows -Portfolio flows were made subject to the encaje, or one year mandatory, non-interest paying 20% deposit with the central bank in 1991, which later went to 30% in 1992. The penalty for early withdrawal was 3% -The result was that short-term flows were taxed heavier than long term flows -The author notes that, "if Chile's capital controls helped, it was to buy time for structural reforms and effective financial regulations."
Malaysia's Capital Controls: 1998-99
Reason: The July 1997 devaluation of the Thai Baht caused capital outflows from Southeast Asia leading to a fall in exchange rates and equity prices Malaysia Response: Malaysia did not follow IMF recommendation to raise interest rates, which could slow the domestic economy. Instead, Malaysia imposed capital controls banning transfers between domestic and foreign accounts, and between foreign accounts, eliminated credit facilities to offshore parties, prevented repatriation of investments (out of Malaysia) until September 1999. Foreign exchange transactions were only permitted at authorized institutions The effect was to discourage short-term capital flows but permit long-term transactions
The U.S. Interest Equalization Tax: 1963-74
Reasons: During this period, the United States had both a fixed-exchange-rate regime for the dollar (Bretton-Woods System) and pressure toward the balance of payment deficits. This position was strained even further with interest rates in European countries and elsewhere tended to be higher than the U.S. U.S. Response: Faced with the alternative of devaluing the dollar, the U.S. proposed the Interest Equalization tax to raise prices that Americans would have to pay for foreign assets The Interest Equalization Tax went from 1.05% on one-year bills to 15% on equity and bonds with greater than 28.5-year maturity on bonds from most developed countries of the time -Canada and the developing world were exempt due to their specific dependence on U.S. capital markets Total outflows did not change very much Unintended consequences of this tax were the growth of foreign financial markets -International borrowing in London rose from $350m in 1962 to $1 B in 1963 with New York borrowing from $2 B in 1962 to $600 M in 1963
Monetary policy autonomy
Removing the obligation to maintain exchange rate parity restores monetary control to a government
Bretton Woods II system
System of central bank financing of the US current account deficit combined with a floating exchange rate Combined with People's Bank of China's increasing dollar reserves "Implicit 'grand bargain' in which the U.S. accepts the deficits that result from the dollar's role and other countries finance those deficits without complaining too much." - Bergsten This is an unsustainable long-term "The ultimate moral hazard: an absence of market pressure on the United States to adjust its economic policies when it should be doing so, to keep its imbalances from reaching unsustainable levels."
The Asian Currency Crisis
The 1997 Southeast Asian financial crisis was caused by events that took place in the previous decade including: -An investment boom - fueled by huge increase in exports -Excess capacity - investments were based on projections on future demand conditions -High-debt - investments were supported by dollar-based debts Expanding imports - caused current account deficits By mid-1997, several key Thai financial institutions were on the verge of default -Speculation against the baht Thailand abandoned the baht peg and allowed the currency to float The IMF provided a $17 billion bailout loan package -Required higher taxes, public spending cuts, privatization of state-owned businesses, and higher interest rates Speculation caused other Asian currencies including the Malaysian Ringgit, the Indonesian Rupaih and the Singapore Dollar to fall These devaluations were mainly driven by -Excess investment and high borrowings, much of it in dollar-denominated debt -A deteriorating balance of payments position
Mexican Currency Crisis of 1995
The Mexican currency crisis of 1995 was a result of: -High Mexican debts -A pegged exchange rate that did not allow for a natural adjustment of prices To keep Mexico from defaulting on its debt, the IMF created a $50 billion aid package -Required tight monetary policy and cuts in public spending
Are capital controls a good idea?
The consensus in favor of capital mobility has always been less clear-cut than in favor of free trade, for two main reasons: (1) Capital flows can push a currency far above its intrinsic value, widening the trade deficit and hollowing out domestic manufacturing (2) They can fuel borrowing booms, especially in countries with underdeveloped financial systems, leading to devastating busts when the money flows out."
currency board
The government sets a conversion rate to a foreign currency and guarantees full convertibility through the accumulation of reserves (e.g., Hong Kong pegs to the U.S.$) Countries with a pegged exchange regime commit to converting their domestic currency on demand into another currency at a fixed exchange rate -The currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued -The currency board can issue additional domestic notes and coins only when there are foreign exchange reserves to back them
forward exchange rate
The rate at which two parties agree to exchange currency and execute a deal at some specific point in the future, usually 30 days, 60 days, 90 days, or 180 days in the future
Automatic trade balance adjustments
Under Bretton Woods, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would have to agree to a currency devaluation
Risk premium
a peg can reduce the country risk premium, leading to lower borrowing costs for government and private sector
International reserves
a peg requires international reserves, especially if it comes under attack from speculators
Trade
a peg to trade partners has been shown to promote trade and economic integration (i.e. Panama)
foreign debt crisis
a situation in which a country cannot service its foreign debt obligations, whether private sector or government Example: Greece and Ireland 2010
banking crisis
a situation in which a loss of confidence in the baking system leads to a run on the banks, as individuals and companies withdraw their deposits
Lead strategy
attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and pat foreign currency payables before they are due when a currency is expected to appreciate
inefficient market school
companies can improve the foreign exchange market's estimate of future exchange rates by investing in forecasting services
Options
contracts to hedge exposures arising within 7 to 12 months
Forward contracts
contracts used to hedge exposures within 6 months
Market-based
controls consist of taxes on cross-border capital movements and dual exchange rate system
Lag strategy
delay collection of foreign currency receivables if that currency is expected to appreciate and delay payables if the currency is expected to depreciate
Administrative (i.e, direct) controls
either prohibit or require prior approval for certain capital account transactions
fixed exchange rate system
exists when countries fix their currencies against each other at some mutually agreed on exchange rate Example: European Monetary System (EMS) prior to 1999
Monetary policy
floating provides the opportunity to pursue autonomous monetary policy
Distributional Effects of Exchange rate regimes
follow from these aggregate costs and benefits: -Groups involved in foreign trade and investment (international banks and investors, and exporters) should favor fixed-rate systems because exchange rate stability promotes trade and investment -By contrast, groups whose economic activity is limited to the domestic economy (non-tradeable producers, import-competing sectors) should prefer a floating regime that allows government monetary policy to stabilize domestic conditions
efficient market school
forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money
