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Today’s Agenda

Note on TF office hours: W, 1:30-2:30pm, KMEC 7-181,TF: Ms. Desi Peteva, MBA2

Why study int’l monetary systems? Terminology of exchange rates & currency regimes. Differences b/n devaluation & depreciation? Ideal currency? Explain currency regime choices. Describe Euro creation. Case-in-point: the stubborn forex regime in China.

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Why study int’l monetary system?

Fact: the volatility of exchange rates has increased.

Volatile exchange rates increase risk, create profit opportunities.

The international monetary system is the structure within which foreign exchange rates are determined.

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Currency Terminology

• Foreign currency exchange rate: price of one country’s currency in units of another currency or commodity

– The system, or regime, classified as: – fixed,

– floating, or

– managed exchange rate regime.

• Par value: the rate @ which currency is fixed, pegged.

• Floating or flexible currency: government does not interfere in valuation of currency

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Currency Terminology Spot exchange rate: quoted price for foreign

exchange to deliver @ once, or @ T+2 for interbank transactions• ¥114/$ (114 yen to buy one US $), immediate delivery

Devaluation: drop in foreign exchange value pegged to gold or another currency. Opposite to revaluation.

Weakening, depreciation: refers to drop in foreign exchange of a floating currency. Opposite to appreciation.

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Currency Terminology

Soft or weak currency: currency expected to devalue/ depreciate relative to major currencies;

Hard or strong: the opposite. Eurocurrencies: type of money although in reality

they are domestic currencies of a country deposited in another country.• E.g.: Eurodollar - US$ denominated deposit in bank

outside of US

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Evolution of the International Monetary System

Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973-Present

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Bimetallism: Before 1875

A “double standard”: both gold and silver were used as money, accepted as means of payment.

Some countries were on the gold standard, some on the silver standard, some on both.

Exchange rates among currencies were determined by either their gold or silver contents.

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The Gold Standard, 1876-1913

• Countries set par value for currency in terms of gold• Acceptance in Europe in 1870s• US adopted it 1879• “Rules of the game”:

– Rule 1: Set a rate @ which can buy/sell gold for currency.

– Rule 2: Credibly maintain adequate reserves of gold.– E.g. US$ gold rate $20.67/oz, Brits pegged at

£4.2474/oz– US$/£ rate calculation

$20.67/£4.2472 = $4.8665/£

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The Gold Standard, 1876-1913

Since the rate of exchange for gold was fixed, the exchange rates b/n currencies was fixed too.

Gold standard worked until WW1 WW1 interrupted trade flows & free movement of

gold forcing nations suspend gold standard. J.M. Keynes called it “the barberian relique”.

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Inter-War years & WWII, 1914-1944

• During WWI: currencies fluctuate over wide ranges to gold – Due to S & D for imports/exports

– Due to speculative pressure, – SHORT SELLING week currencies.

– BUYING strong currencies.SHORT SELLING: investor expects price to fall soon, borrows

currency & sells it.

• 1934: US devalued currency to $35/oz from $20.67/oz.

• 1924 - end WWII: exchange rates determined by currency value in gold.

• During WWII & after, main currencies lost convertibility. US$ remained only convertible currency.

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Bretton Woods & IMF

• Bretton Woods, NH: US coalition created post-war international monetary system.

– establishes US$ based monetary system

– IMF (International Monetary Fund) & World Bank– IMF renders temp assistance to member-countries to defend

currency & overcome econ problems

• All member-countries fix currencies in gold, not required to exchange it.

• Only US$ convertible to gold (@ $35/oz, Central banks only)

– The advent of central banking worldwide.

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Bretton Woods• Countries establish exchange rate vis-à-vis US$

• Agree to maintain currency values +/- 1% par by trading US$ & gold.

• No use of devaluation as a competitive trade policy

• Up to 10% devaluation w/o formal approval by IMF.

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Bretton Woods

• Special Drawing Right (SDR): international reserve assets

– A unit of account for IMF & base some countries peg exchange rates.

– Is weighted average 5 IMF members currencies, w/ largest exports/ imports

• Members deposits US$ & Gold in IMF, get SDR.

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Fixed exchange rates, 1945-1973

• Worked well for post-WW2• Fiscal & monetary policies & external shocks caused

collapse– US$ main reserve currency.– Heavy overhang of US$ abroad. – Lack of confidence.– Heavy outflows of US gold.

• Nixon (08/15/71): suspend trading gold. Allow exchange rates to float freely.

• Nixon (08/15/71): yet another run on US$. • Devalue US$ to $42/oz gold.

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Fixed exchange rates, 1945-1973

Triffin paradox To maintain the gold-exchange system, the US

had to run Balance of Payment deficits continuously.

But: large, persistent deficits would diminish confidence and lead to a run on the US$.

This would destroy the system – indeed, it happened in the 50s & 60s.

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World Currency EventsOPEC embargo

1973-74

Jamaica Agreement

1/1976

EMS created

3/1979

OPEC raises prices

1979

Latin American Debt Crisis

8/1982

Plaza Agreement

9/1985

Louvre Accord

2/1987

Maastricht Treaty

9/1991

EMS crisis

2/1992

Peso Collapse

12/1994

Asian Crisis

6/1997

Russian Crisis

8/1998

Euro Launched

1/1999

Brazilian real crisis

1/1999

Turkey

2001

Argentine peso crisis

1/2002

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Why do Currency Crises Happen?

Long run: In theory, a currency’s value mirrors the fundamental strength of its underlying economy, relative to other economies.

Short run: currency traders’ expectations play a much more important role.

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How do Currency Crises Happen?

Mass exodus causes sharp drop in currency valuation currency crisis.

Fears of depreciation become self-fulfilling prophecies.

Policy for recovery unclear – appears to be contextual. Therefore we can examine Mexican & Asian crises to gain perspective.

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Mexican Peso Crisis (1994-95)

The Mexican government announced a plan to devalue the peso against the dollar by 14%.

Investors’ response: dump Mexican currency, stocks and bonds 40% drop in peso.

Led to flotation of peso. Crisis spilled over to Latin America/Asia. “Tequila Crisis”.

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Importance of Mexican Crisis

This was the 1st serious int’l financial crisis sparked by cross-border flight of portfolio capital. • In prior crises, currency had been abandoned; here also

the stocks & bonds.

Underscored degree of interdependency of financial systems world-wide.

Highlighted the inherent riskiness of relying on foreign capital to finance domestic investments. • Influx of foreign capital can cause overvaluation of

currency.

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Asian Crisis (1997-98)

Thai baht devalued on July 2, 1997. Sparked crisis region-wide; overflowed to Russia and Latin America.

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.

Many firms with foreign currency bonds were forced into bankruptcy.

The region experienced a deep, widespread recession, which is still ongoing, despite IMF bail-out packages.• Moral hazard?

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Why Asia? Weak domestic financial systems. Free international capital flows. Market sentiment – sparked contagion. Inconsistent economic policies and incomplete

disclosure thereof. Hardest hit countries (Indonesia, Korea, Thailand)

had especially high ratios of • (1) short-term foreign debt/FX reserves and • (2) broad money (representing banking system

liabilities)/FX reserves.

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Lessons? Financial market liberalization must be paired with

development of strong domestic financial system. Note: Mexico and Korea joined the OECD a few

years prior to crises – OECD membership had required significant market liberalization.

Governments should • strengthen financial market regulation & supervision• discourage short-term cross-border investments• encourage FDI and long-term equity & bond

investments.

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IMF on Currency RegimesIMF Regime Classification No separate legal tender (39): Ecuador Currency Board (8): commit exchanging domestic currency

at a fixed rate to foreign currency. Conventional Fixed Peg (44): Country pegs its currency

(formally) at a fixed rate to major currency ± 1% variation Pegged Exchange w/in Horizontal Bands (6): maintain

within margins wider than ± 1% around de facto fixed peg. Crawling Peg (4): Currency adjusted periodically in small

amounts at pre-announced rate

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Contemporary Currency Regimes

Exchange Rates w/in Crawling Peg (5): Currency maintained within certain fluctuation margins around a central rate that is adjusted periodically

Managed Floating w/ No Preannounced Path for Exchange Rate (33): Monetary authority active intervention in foreign exchange markets

Independent Floating (47): Exchange rate is market determined.

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Fixed vs. Flexible Exchange Rates

Why countries prefer fixed exchange rates?• Stability in international prices for the conduct of trade

• Anti-inflationary, requires country to follow restrictive monetary & fiscal policies

• Credibility, if central banks maintain large international reserves to defend fixed rate

• Fixed rates may be maintained @ rates inconsistent with economic fundamentals. For example, Asia these days…

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The curious case of Asia Recently Asian countries have shown reluctance to

allow their currencies to rise against the dollar Why?

• Prefer fixed exchange rates (ergo stability)

Consequences:• Rise of the euro – good or bad? What do you think?

Solutions:• Float of exchange rates of Asian economies.

• Financial sector liberalization in China.

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Ideal Currency Or Impossible Trinity?

Exchange rate stability –value of currency would be fixed to other currencies

Full financial integration – complete freedom of monetary flows allowed, traders & investors could move funds in response to economic opportunities

Monetary independence – domestic monetary policies by each individual country to pursue national economic policies, e.g. limiting inflation, foster prosperity & full employment.

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The Impossible Trinity

Increased Capital Mobility

Full Financial Integration

Monetary Independence

Exchange Rate Stability

Pure Float Monetary Union

Full Capital Controls

Can have only 2-sides/ system.E.g., if Monetary Independence & Financial Integration,

cannot attain Exchange Rate Stability.

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Emerging Markets & Regime Choices

Currency Boards: country’s central bank commits to back monetary base, with foreign reserves @ all times• means a unit of domestic currency cannot be

introduced w/o an additional forex reserves– Argentina (1991), fixed Peso to US$

– Bulgaria (1997), fixed Leva to Euro.

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Emerging Markets & Regime Choices

Dollarization: use of US$ as official currency– Panama, 1907 & Ecuador, 2000.

Why dollarization?• Removes possibility of currency volatility;

• Eliminate possibility of currency crises;

• Economic integration with US & other dollar based markets

Why not dollarization?• Loss of sovereignty over monetary policy

• Loss of power of seignorage, the ability to profit from printing own money.

• Central bank no longer lender of last resort.

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Living on the edge…

Free-Floating Regime

•Currency free to float

•Independent monetary policy & free movement of capital allowed, but @ loss of stability

•Increased volatility

Currency Board or Dollarization

•No monetary independence

•No political influence on monetary policy

•Seignorage rights lost

Emerging Market Country

High capital mobility

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The Euro

European Monetary System (EMS):15 Member nations

Maastricht Treaty’ 92 – timeline of economic & monetary union.• Convergence criteria called

– Nominal inflation < 1.5% above average for EU lowest 3 inflation rates year before.

– LT interest rate < 2% above average for EU lowest 3 interest rates.

– Fiscal deficit < 3% of GDP.– Government debt < 60% of GDP.

• European Central Bank (ECB) established.

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The Euro & Monetary Unification

The euro, €, was launched on Jan. 4, 1999 with 11 member states

Benefits of the euro?• Lower transaction costs in EU.

• Currency risks reduced.

• All consumers and businesses, both inside and outside of the euro zone enjoy price transparency and increased price-based competition

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The Euro & Monetary Unification

Successful unification ?• ECB has to coordinate monetary policy

– Focus on price stability.

• Fixing the euro– 12/1998, national exchange rates were fixed to the Euro.

– 1/1999 euro trading on world currency markets.

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Euro’s Way-up

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Tradeoffs b/n Exchange Rate Regimes

Discretionary Policy

Policy Rules

Non-cooperation Between Countries

Cooperation Between Countries

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What Lies Ahead?

Tradeoff b/n rules & discretion, cooperation & independence.

Discretion

Rules

No cooperation b/n Countries

Cooperation b/n Countries

•Gold Standard

•US Dollar, 1981-1985

•Bretton Woods

•European Monetary System

?

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Summary Terminology

• Foreign currency exchange rate

• Spot exchange rate

• Devaluation (revaluation)

• Depreciation (appreciation)

The impossible trinity of goals for forex: fixed value, convertibility, independent monetary policy.

Currency board or dollarization? Fixed vs. Floating Exchange Rates. Euro advent.