INTERNATIONAL FINANCIAL SYSTEM AND EXCHANGE RATES Principles of Macroeconomics Lecture 12

INTERNATIONAL FINANCIAL SYSTEM AND EXCHANGE RATES

Principles of MacroeconomicsLecture 12

IntroductionIntroduction

Fundamental difference between payment transactions

Domestic transaction—use only one currency Foreign transaction—use two or more currencies

Foreign exchange— money denominated in the currency of another group of nations

Exchange rate—price of a currency Number of units of one currency that buys one unit

of another currency Exchange rate can change daily

International Capital Market Obtaining external financing. Main purpose is to provide a mechanism

through which those who wish to borrow or invest money can do so efficiently.

Foreign-Exchange Market—made up of: over-the-counter (OTC)

commercial and investment banks majority of foreign-exchange activity

security exchanges trade certain types of foreign-exchange

instruments

International financial market consists of:

Essential Terms

Security - a contract that can be assigned a value and traded (stocks, bonds, derivatives and other financial assets)

Stocks – An instrument representing ownership Bonds - a debt agreement Derivatives - the rights to ownership (financial

instruments; futures, forwards, options, swaps)

Essential Terms II

Stock exchange, share market or bourse - is a corporation or mutual organization which provides facilities for stock brokers and traders, to trade company stocks and other securities

Over-the-counter (OTC) trading - is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via corporate-owned facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.

Capital Market

Debt: Repay principal plus interest Bond has timed principal & interest

payments

Equity: Part ownership of a company Stock shares in financial gains or losses

• System that allocates financial resources according to their most efficient uses

• Common capital market intermediaries:•Commercial Banks•Investment Banks

International Capital Market (ICM)

Lenders Spread / reduce risk Offset gains / losses

Lenders Spread / reduce risk Offset gains / losses

Network of people, firms, financial institutions and governments borrowing and investing internationally

Borrowers

Expands money supply Reduces cost of money

Borrowers

Expands money supply Reduces cost of money

Purposes

International Capital Market Drivers

Information technologyInformation technology

DeregulationDeregulation

Financial instruments

(securitization)

Financial instruments

(securitization)

World Financial CentersWorld Financial Centers

At present, the three main financial centers are London, New York and Tokyo

London is one of the three leading world financial centres. It is famous for its banks and Europe's largest stock exchange, that have been established over hundreds of years (e.g. Lloyd's of London, London Stock Exchange). The financial market of London is also commonly referred to as the City. It has historically been situated around the part of London called Square Mile, but in the 1980's and 1990's a large part of the City of London's wholesale financial services relocated to Canary Wharf.

Country or territorywhose financial sector

features few regulationsand few, if any, taxes

Country or territorywhose financial sector

features few regulationsand few, if any, taxes

Operational centerExtensive financial activity

and currency trading

Operational centerExtensive financial activity

and currency trading

Booking centerMostly for bookkeeping

and tax purposes

Booking centerMostly for bookkeeping

and tax purposes

Offshore Financial Centers

IMF defines OFC as:

Jurisdictions that have relatively large numbers of financial institutions engaged primarily in business with non-residents;

Financial systems with external assets and liabilities out of proportion to domestic financial intermediation designed to finance domestic economies; and

More popularly, centers which provide some or all of the following services: low or zero taxation; moderate or light financial regulation; banking secrecy and anonymity.

Main Components of ICM: International Bond Market

Foreign bond Interest ratesEurobond

Bond that is issued outside the country in whose currency the bond is denominated

Bond sold outside a borrower’s country and denominated in the currency of the country in which it is sold

Driving growth are differential interest rates between developed and developing nations

Market of bonds sold by issuing companies, governments and others outside their own countries

International Equity Market

Market of stocks bought and soldMarket of stocks bought and soldoutside the issuer’s home countryoutside the issuer’s home country

Market of stocks bought and soldMarket of stocks bought and soldoutside the issuer’s home countryoutside the issuer’s home country

Factors contributing towards growth:

•Spread of Privatization

•Economic Growth in Developing Countries

•Activities of Investment Banks

•Advent of Cybermarkets

Governments Commercial banks International companies Wealthy individuals

Eurocurrency Market

Unregulated market of currencies banked outside

their countries of origin

Foreign exchange market: a market for converting the currency of one country into the currency of another.

Exchange rate: the rate at which one currency is converted into another

Foreign exchange risk: the risk that arises from changes in exchange rates

Foreign Exchange Market

Foreign Exchange Market

Conversion: To facilitate sale or purchase, or invest directly abroad

Hedging: Insure against potential losses from adverse exchange-rate changes

Arbitrage: Instantaneous purchase and sale of a currency in different markets for profit

Speculation: Sequential purchase and sale (or vice-versa) of a currency for profit

Market in which currencies are bought and soldand their prices are determined

The Functions of the The Functions of the Foreign Exchange MarketForeign Exchange Market

The foreign exchange market serves two main functions: Convert the currency of one country

into the currency of another Provide some insurance against

foreign exchange riskForeign exchange risk: the adverse

consequences of unpredictable changes in the exchange rates

Currency Conversion

Consumers can compare the relative prices of goods and services in different countries using exchange rates

International business have four main uses of foreign exchange markets

•To exchange currency received in the course of doing business abroad back into the currency of its home country•To pay a foreign company for its products or services in its country’s currency

• To invest excess cash for short terms in foreign markets

• To profit from the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates, also called currency speculation

Insuring against Foreign Insuring against Foreign Exchange RiskExchange Risk

A spot exchange occurs when two parties agree to exchange currency and execute the deal immediately

The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day Reported daily Change continually


Forward exchanges occur when two parties agree to exchange currency and execute the deal at some specific date in the future Exchange rates governing such future transactions are

referred to as forward exchange rates For most major currencies, forward exchange rates

are quoted for 30 days, 90 days, and 180 days into the future

When a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed


Currency swap: the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk

The Nature of the Foreign The Nature of the Foreign Exchange MarketExchange Market

The foreign exchange market is a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems

The most important trading centers include: London, New York, Tokyo, and Singapore

London’s dominance is explained by: History (capital of the first major industrialized nation) Geography (between Tokyo/Singapore and New York)

Two major features of the foreign exchange market: The market never sleeps Market is highly integrated

Institutions of Foreign Exchange Market Interbank Market: market in which the

world’s largest banks exchange currencies at spot and forward rates. “Clearing mechanism”

Securities Exchanges: exchange specializing in currency futures and options transactions.

Over-the-Counter Market: Exchange consisting of a global computer network of foreign exchange traders and other market participants.

Trends in Foreign-Exchange Trading

9-7

Quoting Currencies

Quoted currency = numeratorBase currency = denominatorQuoted currency = numeratorBase currency = denominator

(¥/$) = Japanese yen needed to buy one U.S. dollar(¥/$) = Japanese yen needed to buy one U.S. dollar

Yen is quoted currency, dollar is base currencyYen is quoted currency, dollar is base currency

Currency Values

Change in US dollar against Polish zloty

February 1: PLZ 5/$ March 1: PLZ 4/$

%change = [(4-5)/5] x 100 = -20%

US dollar fell 20%

Change in Polish zloty against US dollar

Make zloty base currency (1÷ PLZ/$) February 1: $.20/PLZ March 1: $.25/PLZ

%change = [(.25-.20)/.20] x 100 = 25%

Polish zloty rose 25%

Change in Polish zloty against US dollar

Make zloty base currency (1÷ PLZ/$) February 1: $.20/PLZ March 1: $.25/PLZ

%change = [(.25-.20)/.20] x 100 = 25%

Polish zloty rose 25%

Cross RateCross Rate

Dollar Euro Pound SFranc Peso Yen CdnDlr

Canada 1.3931 1.6466 2.4561 1.0695 0.1198 0.0122 ....

Japan 114.50 135.32 201.85 87.898 9.8420 .... 82.185

Mexico 11.633 13.749 20.510 8.9309 .... 0.1016 8.3504

Switzerland 1.3026 1.5395 2.2965 .... 0.1120 0.0114 0.9350

United Kingdom 0.5672 0.6704 .... 0.4355 0.0488 0.0050 0.4071

Euro 0.8461 .... 1.4917 0.6495 0.0727 0.0074 0.6073

United States .... 1.1819 1.7630 0.7677 0.0860 0.0087 0.7178

• Exchange rate calculated using two other exchange rates• Use direct or indirect exchange rates against a third currency

Cross Rate ExampleCross Rate Example

Direct quote method

1) Quote on euro = € 0.8461/$2) Quote on yen = ¥ 114.50/$3) € 0.8461/$ ÷ ¥ 114.50/$ = € 0.0074/¥4) Costs 0.0074 euros to buy 1 yen

Indirect quote method

1) Quote on euro = $ 1.1819/€2) Quote on yen = $ 0.008734/¥3) $ 1.1819/€ ÷ $ 0.008734/¥ = € 135.32/¥4) Final step: 1 ÷ € 135.32/¥ = € 0.0074/¥5) Costs 0.0074 euros to buy 1 yen

Currency Convertibility

Governments can place restrictions on the convertibility of currency A country’s currency is said to be freely convertible

when the country’s government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it

A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations

A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency

Government restrictions can include A restriction on residents’ ability to convert the

domestic currency into a foreign currency Restricting domestic businesses’ ability to take

foreign currency out of the country Governments will limit or restrict

convertibility for a number of reasons that include: Preserving foreign exchange reserves A fear that free convertibility will lead to a run on

their foreign exchange reserves – known as capital flight

Currency Convertibility

Commercial and Investment Banks

Greatest volume of foreign-exchange activity takes place with the big banks

• Top banks in the interbank market in foreign exchange are so ranked because of their ability to:

– trade in specific market locations– engage in major currencies and cross-trades– deal in specific currencies– handle derivatives

» forwards, options, future swaps– conduct key market research

• Banks may specialize in geographic areas, instruments, or currencies

– exotic currency—currency of a developing country

» often unstable, weak, and unpredictable

Top 10 Currency Traders (% of overall volume, May 2005 )

Rank Name % of volume

1 Deutsche Bank 17.0

2 UBS 12.5

3 Citigroup 7.5

4 HSBC 6.4

5 Barclays 5.9

6 Merrill Lynch 5.7

7 J.P. Morgan Chase 5.3

8 Goldman Sachs 4.4

9 ABN AMRO 4.2

10 Morgan Stanley 3.9

International Monetary International Monetary SystemSystem Rules and procedures by which different

national currencies are exchanged for each other in world trade.

Such a system is necessary to define a common standard of value for the world's currencies.

Refer to the institutional arrangements that countries adopt to govern exchange rates Floating Pegged exchange rate Dirty float Fixed exchange rate

Floating exchange rates occur when the foreign exchange market determines the relative value of a currency

The world’s four major currencies – dollar, euro, yen, and pound – are all free to float against each other

Pegged exchange rates occur when the value of a currency is fixed relative to a reference currency

International Monetary International Monetary SystemSystem

Dirty float occurs when countries hold the value of their currency within a range of a reference currency

Fixed exchange rate occurs when a set of currencies are fixed against each other at some mutually agreed upon exchange rate

Pegged exchange rates, dirty floats and fixed exchange rates all require some degree of government intervention

International Monetary International Monetary SystemSystem

Evolution of International Monetary Evolution of International Monetary SystemSystem

The Gold StandardThe Gold Standard- In place from 1700s to 1939In place from 1700s to 1939- a monetary standard that pegs currencies

to gold and guarantees convertibility to gold- It was thought that gold standard contained

an automatic mechanism that contributed to the simultaneous achievement of a balance-of-payments equilibrium by all countries.

- The gold standard broke down during the 1930s as countries engaged in competitive devaluations

The Gold StandardThe Gold Standard

Roots in old mercantile trade

Inconvenient to ship gold, changed to paper- redeemable for gold

Want to achieve ‘balance-of-trade equilibrium

USAJapan

Gold

Trade

Balance of Trade Balance of Trade EquilibriumEquilibrium

Trade Surplus

GoldIncreased

money supply = price

inflation.

Decreased money supply

= price decline.

As prices decline, exportsincrease and trade goes

into equilibrium.

Between the WarsBetween the Wars

Post WWI, war heavy expenditures affected the value of dollars against gold

US raised dollars to gold from $20.67 to $35 per ounce

Dollar worth less?

Other countries followed suit and devalued their currencies

Bretton Woods

In 1944, 44 countries met in New Hampshire

Countries agreed to peg their currencies to US$ which was convertible to gold at $35/oz

Agreed not to engage in competitive devaluations for trade purposes and defend their currencies

Weak currencies could be devalued up to 10% w/o approval

Created the IMF and World Bank

International Monetary Fund (IMF)

The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars

The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility

International Monetary Fund Discipline

Maintaining a fixed exchange rate imposes monetary discipline, curtails inflation

Brake on competitive devaluations and stability to the world trade environment

Flexibility Lending facility:

Lend foreign currencies to countries having balance-of-payments problems

Adjustable parities: Allow countries to devalue currencies more than

10% if balance of payments was in “fundamental disequilibrium”

Purposes of IMFPurposes of IMF

Promoting international monetary cooperation

Facilitating expansion and balanced growth of international trade

Promoting exchange stability, maintaining orderly exchange arrangements, and avoiding competitive exchange devaluation

Making the resources of the Fund temporarily available to members

Shortening the duration and lessening the degree of disequilibrium in the international balance of payments of member nations

monitors economic and financial developments and policies, in member countries and at the global level, and gives policy advice to its members based on its more than fifty years of experience.

For example: In its annual review of the Japanese economy for 2003, the IMF Executive Board urged Japan to adopt a comprehensive approach to revitalize the corporate and financial sectors of its economy, tackle deflation, and address fiscal imbalances.

International Monetary FundInternational Monetary Fund

The IMF commended Mexico in 2003 for good economic management, but said structural reform of the tax system, energy sector, the labor market, and judicial system was needed to help the country compete in the global economy.

In its Spring 2004 World Economic Outlook, the IMF said an orderly resolution of global imbalances, notably the large U.S. current account deficit and surpluses elsewhere, was needed as the global economy recovered and moved toward higher interest rates.


lends to member countries with balance of payments problems, not just to provide temporary financing but to support adjustment and reform policies aimed at correcting the underlying problems.

For example: During the 1997-98 Asian financial crisis, the IMF acted swiftly to help Korea bolster its reserves. It pledged $21 billion to assist Korea to reform its economy, restructure its financial and corporate sectors, and recover from recession. Within four years, Korea had recovered sufficiently to repay the loans and, at the same time, rebuild its reserves.


In October 2000, the IMF approved an additional $52 million loan for Kenya to help it cope with the effects of a severe drought, as part of a three-year $193 million loan under the IMF's Poverty Reduction and Growth Facility, a concessional lending program for low-income countries.


provides the governments and central banks of its member countries with technical assistance and training in its areas of expertise.

For example: Following the collapse of the Soviet Union, the IMF stepped in to help the Baltic states, Russia, and other former Soviet countries set up treasury systems for their central banks as part of the transition from centrally planned to market-based economic systems.


IMF QuotasIMF Quotas - each member’s monetary contribution Based on national income, monetary reserves,

trade balance, and other economic indicators Pool of money that can be loaned to members Basis for how much a country can borrow Determines voting rights of members

Board of GovernorsBoard of Governors - IMF’s highest authority One representative from each member country Board of Executive Directors—24 persons

handles day-to-day operations

IMF AssistanceIMF AssistanceProvides assistance to member countries

Intended to ease balance-of-payment difficulties

Recipient country must adopt policies to stabilize its economy

Special Drawing Rights (SDRs)Special Drawing Rights (SDRs)

An international type of monetary reserve currency, created by the International Monetary Fund (IMF) in 1969, which operates as a supplement to the existing reserves of member countries.

Created in response to concerns about the limitations of gold and dollars as the sole means of settling international accounts,

SDRs are designed to augment international liquidity by supplementing the standard reserve currencies.

Serves as the IMF’s unit of account unit in which the IMF keeps its records used for IMF transactions

Some countries pegged their currencies’ value

Based on the weighted average of four currencies

1986–1990: USD 42%, DEM 19%, JPY 15%, GBP 12%, FRF 12% 1991–1995: USD 40%, DEM 21%, JPY 17%, GBP 11%, FRF 11% 1996–2000: USD 39%, DEM 21%, JPY 18%, GBP 11%, FRF 11% 2001–2005: USD 45%, EUR 29%, JPY 15%, GBP 11% 2006–2010: USD 44%, EUR 34%, JPY 11%, GBP 11%

Special Drawing Rights (SDRs)Special Drawing Rights (SDRs)

Role of the World BankRole of the World Bank

The official name for the world bank is the International Bank for Reconstruction and Development

Purpose: To fund Europe’s reconstruction and help 3rd world countries.

Overshadowed by Marshall Plan, so it turns towards development Lending money raised through WB bond sales

Agriculture Education Population control Urban development

Collapse of the Collapse of the Fixed Exchange SystemFixed Exchange System

The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s The US dollar was the only currency that could be

converted into gold The US dollar served as the reference point for all

other currencies Any pressure to devalue the dollar would cause

problems through out the world

Collapse of the Collapse of the Fixed Exchange SystemFixed Exchange System

Factors that led to the collapse of the fixed exchange system include President Johnson financed both the Great Society

and Vietnam by printing money High inflation and high spending on imports On August 8, 1971, President Nixon announces

dollar no longer convertible into gold Countries agreed to revalue their currencies

against the dollar On March 19, 1972, Japan and most of Europe

floated their currencies In 1973, Bretton Woods fails because the key

currency (dollar) is under speculative attack

The Floating Exchange RateThe Floating Exchange Rate

The Jamaica agreement revised the IMF’s Articles of Agreement to reflect the new reality of floating exchange rates Floating rates acceptable Gold abandoned as reserve asset IMF quotas increased

IMF continues role of helping countries cope with macroeconomic and exchange rate problems

Exchange Rates Since 1973Exchange Rates Since 1973

Exchange rates have been more volatile for a number of reasons including: Oil crisis -1971 Loss of confidence in the dollar - 1977-78 Oil crisis – 1979, OPEC increases price of oil Unexpected rise in the dollar - 1980-85 Rapid fall of the dollar - 1985-87 and 1993-95 Partial collapse of European Monetary System -

1992 Asian currency crisis - 1997

Fixed Versus Floating Exchange Rates

Floating: Monetary policy

autonomy Restores control to

government Trade balance

adjustments Adjust currency to

correct trade imbalances

Fixed: Monetary discipline .Speculation Limits speculators Uncertainty Predictable rate

movements Trade balance

adjustments Argue no link between

exchange rates and trade Link between savings

and investment

Exchange Rate RegimesExchange Rate Regimes

Pegged Exchange Rates Peg own currency to a major currency ($) Popular among smaller nations Evidence of moderation of inflation

Currency Boards Country commits to converting domestic currency

on demand into another currency at a fixed exchange rate

Country holds foreign currency reserves equal to 100% of domestic currency issued

Exchange-Rate ArrangementsExchange-Rate Arrangements

IMF permitted countries to select and maintain an exchange-rate arrangement of their choice

IMF surveillance and consultation programs designed to monitor exchange-rate

policies determine whether countries were

acting openly and responsibly in exchange-rate policy

Broad IMF categories for exchange-rate regimes

peg exchange rate to another currency or basket of currencies with only a maximum 1% fluctuation in value

peg exchange rate to another currency or basket of currencies with a maximum of 2 ¼% fluctuation

allow the currency to float in value against other currencies

Countries may change their exchange-rate regime

From pegged to floating currencies

Crisis Management by the IMF

The IMF’s activities have expanded because periodic financial crises have continued to hit many economies Currency crisis

When a speculative attack on a currency’s exchange value results in a sharp depreciation of the currency’s value or forces authorities to defend the currency

Banking crisis Loss of confidence in the banking system leading to a

run on the banks Foreign debt crisis

When a country cannot service its foreign debt obligations

Determination of Exchange RatesDetermination of Exchange Rates

Floating rate regimes—allow changes in the exchange rates between two currencies to occur for currencies to reach a new exchange-rate equilibrium Currencies that float freely respond to supply

and demand conditions No government intervention to influence the

price of the currency

Economic Theories of Economic Theories of Exchange Rate DeterminationExchange Rate Determination

Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another

Price and exchange rates: Law of One Price Purchasing Power Parity (PPP) Money supply and price inflation

Interest rates and exchange rates

Law of One PriceLaw of One Price In competitive markets free of

transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

Example: US/French exchange rate: $1 = .78Eur A jacket selling for $50 in New York should retail for 39.24Eur in Paris (50x.78)

Purchasing Power Parity

By comparing the prices of identical products in different currencies, it should be possible to determine the ‘real’ or PPP exchange rate - if markets were efficient

In relatively efficient markets (few impediments to trade and investment) then a ‘basket of goods’ should be roughly equivalent in each country

Money Supply and Inflation

PPP theory predicts that changes in relative prices will result in a change in exchange rates A country with high inflation should expect its

currency to depreciate against the currency of a country with a lower inflation rate

Inflation occurs when the money supply increases faster than output increases

Determination of Exchange RatesDetermination of Exchange Rates

Fisher EffectFisher Effect - links inflation and interest ratesnominal interest rate in a country is the real interest rate plus inflationbecause the real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation

• International Fisher Effect (IFE)International Fisher Effect (IFE) - links interest rates and exchange ratesthe interest-rate differential is a predictor of future changes in the spot exchange rate

interest-rate differential based on differences in interest rates

currency of the country with the lower interest rate will strengthen in the future

Determination of Exchange Rates Determination of Exchange Rates

Other factors affecting exchange rate movements ConfidenceConfidence—safe currencies considered

attractive in times of turmoil Technical factorsTechnical factors

release of national statistics seasonal demands for a currency slight strengthening of a currency

following a prolonged weakness

Helpful Reading

Economics. Samuelson, & Nordhaus (2005) Ch. 34 & 36

Documents

INTERNATIONAL FINANCIAL SYSTEM AND EXCHANGE RATES Principles of Macroeconomics Lecture 12