International FinanceFINA 5331

Lecture 4:

Exchange rate regime continued.

Currency unions and real exchange rates

Read: Chapters 2Aaron Smallwood Ph.D.

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 way 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.

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

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

ERM II Countries

• That will adopt:• Lithuania

• The have no stated intentions of adopting• Denmark

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)

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

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.

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.

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.

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.

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.

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.

Today

• In January of this year, Latvia becomes the 18th 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.• On June 5, 2014, after news was released that Germany

had an annualized inflation rate of 0.6% in May, the ECB takes a dramatic move, lowering their target on banks overnight lending rate to 0.15% (from 0.25%) and moving their deposit rate to MINUS 0.10%

• As of June 6, the direct quote for the euro was 1.3639.

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.

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 for a

domestic currency (DC):

• The idea is that after adjusting for exchange rates the costs of two goods in two countries should be the same.

Continued: China (with $=FC)

• If , S is too high and the RMB is overvalued. If the reverse is true S is too low and the RMB is undervalued.

• A simple example compares the prices of Big Macs across the world and can be found here:

• http://www.economist.com/content/big-mac-index

Real Exchange rate: Any country against the US

• For other domestic countries (DC) (relative to the $), the real exchange rate is defined as:

• Take Mexico as an example: Suppose St is relatively stable but, Pt

Mex increases much more rapidly than Pt

US. The result, Rt increases. The Mexican peso appreciates in real terms.

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

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%.

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.