Chapter 2 International Monetary System

1、International Monetary SystemChapter 2 (36-60)Lecture ObjectivesIntroduce the institutional framework withinwhich:International payments are made.The movement of capital is accommodated.Exchange rates are determined. Current Exchange Rate Arrangements Fixed versus Flexible Exchange Rate Regimes Euro

2、pean Monetary System Euro and the European Monetary Union The Mexican Peso Crisis The Asian Currency Crisis The Argentine Peso CrisisLecture OutlineCurrent Exchange Rate ArrangementsFree Float The largest number of countries, about 35, allow market forces to determine their currencys value.Managed F

3、loat About 46 countries combine government intervention with market forces to set exchange rates.Pegged to another currency or a basket of currencies Such as the U.S. dollar or euro; e.g. HK$7.80 =US$1No national currency Some countries do not bother printing their own, they just use the U.S. dollar

4、 or euro. For example, Ecuador, Panama, and El Salvador have dollarized. Montenegro and San Marino use the euro.Current Exchange Rate ArrangementsCurrency BoardFixed exchange rates combined with restrictions on the issuing government. Eliminates central bank functions such as monetary policy and len

5、der of last resort (e.g., Hong Kong).Conventional PegExchange rate publicly fixed to another currency or basket of currencies.Country buys or sells foreign exchange or uses other means to control the price of the currency (e.g., Saudi Arabia, Jordan, and Morocco).Current Exchange Rate ArrangementsSt

6、abilized ArrangementA spot market exchange rate that remains within a margin of 2 percent for six months or more and is not floating (e.g., China, Angola, and Lebanon).Crawling PegLike the conventional peg, but the crawling peg is adjusted in small amounts at a fixed rate of change or in response to

7、 changes in macro indicators, (e.g., Bolivia, Iraq, and Nicaragua).The Value of the U.S. Dollar since 1960Fixed versus Flexible Exchange Rate RegimesArguments in favor of flexible exchange rates easier external adjustments countries are insulated from unemployment and inflation in other countriesArg

8、uments against flexible exchange rates exchange rate uncertainty may hamper international trade and investment no safeguards to prevent crises must monitor forex expenses and revenuesFixed versus Flexible Exchange Rate RegimesArguments in favor of fixed exchange rates governments willing to buy and

9、sell currency only at an official rate that is pegged to another currency or a basket of currencies no foreign currency riskArguments against fixed exchange rates fixed exchange rates provide a link between foreign and domestic inflation rates market participants do not believe that fixed rates refl

10、ect true market values Fixed versus Flexible Exchange Rate RegimesSDQ of Dollar price per (exchange rate)$1.40Trade deficitDemand (D)Supply (S)Flexible Exchange Rate RegimesUnder a flexible exchange rate regime, the dollar will simply depreciate to $1.60/, the price at which supply equals demand and

11、 the trade deficit disappears. Fixed versus Flexible Exchange Rate RegimesSupply (S)Demand (D)Demand (D*)D = SDollar depreciates (flexible regime)Q of Dollar price per (exchange rate)$1.60$1.40Fixed versus Flexible Exchange Rate RegimesInstead, suppose the exchange rate is “fixed” at $1.40/, and thu

12、s the imbalance between supply and demand cannot be eliminated by a price change.The government would have to shift the demand curve from D to D* In this example this corresponds to contractionary monetary and fiscal policies.Fixed versus Flexible Exchange Rate RegimesSupply (S)Demand (D)Demand (D*)

13、D* = SContractionary policies(fixed regime)Q of Dollar price per (exchange rate)$1.40European 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 c

14、oordinate exchange rate policies vis-vis non-European currencies. To pave the way for the European Monetary Union.Value of the Euro in U.S. DollarsBenefits of European Monetary Union reduce transaction costs eliminate XR risk promote cross-border investments and mergers increase the depth and liquid

15、ity of the European financial markets promote political cooperation Costs of European Monetary UnionMain cost: the loss of national monetary and exchange rate policy independence. The more trade-dependent and less diversified a countrys economy is, the more prone to asymmetric shocks that countrys e

16、conomy would be.The Long-Term Impact of the EuroIf 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 is likely that the U.S. dollar will lose its place as the dominant world currency.The euro and

17、the U.S. dollar will be the two major currencies.The Mexican Peso CrisisOn 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent.This decision changed currency traders expectations about the future value of the peso. In their rush to get out,

18、 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-bor

19、der flight of portfolio capital.The Mexican Peso CrisisTwo 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.1. Why the peso devaluation was

20、bad for foreign investors?The Asian Currency CrisisThe 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

21、 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 annu

22、al industrial production declines between 10 and 20%.Asian Currency Crisis (December 31, 1996 = 1.00)0.00.20.40.60.81.01.2199619981997Thai bahtKorean wonIndonesian rupiahOrigins of the Asian Currency CrisisAs capital markets were opened, large inflows of private capital resulted in a credit boom in

23、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, Japans recession (and yen depreciation) hurt.Current Account/GDP Rat

24、ios in East Asia, 1996-10.0%-8.0%-6.0%-4.0%-2.0%0.0%2.0%4.0%6.0%ChinaIndonesiaKoreaMalaysiaPhilippinesTaiwanThailandCA/GDPExternal Debt as Percent of GDP in 19970.0%5.0%10.0%15.0%20.0%25.0%30.0%35.0%40.0%45.0%ChinaTaiwanPhilippinesKoreaMalaysiaIndonesiaThailandShort-termLong-termCauses of the Asian

25、CrisesFundamentals or Financial Panic?The “usual suspects” indicators of crisis (low growth, high inflation, high budget deficit, low savings rates, low investment rates) are not observed in AsiaThe “Fundamentals”Significant real appreciation of currencies and exchange rate misalignment.Large and gr

26、owing trade deficits.Circle of “Competitive Devaluations”The first wave of depreciations in summer of 1997 modified the “effective” real exchange rate and worsened cost-competitiveness of other countries that had fixed exchange rate.Trade spilloversExcessive investment in risky and low profitability

27、 projects.The “Fundamentals”O(jiān)verborrowing and overlending in the financial sector because of moral hazard effects (government bail out guarantees).Current account deficits financed with the accumulation of foreign debt in the form of short-term foreign currency denominated and unhedged liabilities.E

28、xcessive lending by international investors in 1990s and sharp reversals of the capital flows in 1997.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 investmentsThe firms, i

29、nvestors and banks that had heavily relied on external borrowing were left with a large stock of short termforeign currency denominatedunhedgedliabilitiesThe exchange rate crises exacerbated the problems and increased the real burden!Chinas Exchange RateChina maintained a fixed exchange rate between

30、 the renminbi (RMB) yuan and the U.S. dollar for a long time.RMB floated between 2005 and 2008 and then again starting in 2010.There is mounting pressure from Chinas trading partners for a stronger RMB.RMB as a Potential Global CurrencyFor the RMB to become a full-fledged global currency, China will

31、 need to satisfy these conditions: Full convertibility of its currency. Open capital markets with depth and liquidity. The rule of law and protection of property rights.The United States and the euro zone satisfy these conditions.The Argentinean Peso CrisisIn 1991 the Argentine government passed a c

32、onvertibility law that linked the peso to the U.S. dollar at parity.The initial economic effects were positive:Argentinas chronic inflation was curtailedForeign investment poured inAs the U.S. dollar appreciated on the world market, the Argentine peso became stronger as well.The Argentinean Peso Cri

33、sisThe strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of pesodollar parity in January 2002.The unemployment rate rose above 20 percentThe inflation rate reached a monthly rate of 20 percentThe Argentinean Peso CrisisThere are at least th

34、ree 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 RussiaCurrency Crisis ExplanationsIn theory, a currencys value mirrors the fundamenta

35、l strength of its underlying economy, relative to other economies, in the long run.In the short run, currency trader expectations play a much more important role.In todays environment, traders and lenders, using the most modern communications, act on fight-or-flight instincts. For example, if they e

36、xpect others are about to sell Brazilian reals for U.S. dollars, they want to “get to the exits first.” Thus, fears of depreciation become self-fulfilling prophecies.Learning outcomes Understand the differences between fixed and floating exchange rates Discuss the current exchange rate arrangements

37、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 f

38、rom the currency crisesEuropes CFOs Try to Ride Currency Winds WSJ 2102 Feb 1 Weaker Euro Propels Regions Exports, but Some Companies Lock In Exchange Rates to Hedge Costs, Cut Volatility Risks . Euros 8% drop since October (reflecting deteriorating economic conditions in Europe and its policy makers struggles to restore confidence in their govts