Transcript Contents of the course - Solvay Brussels School of

International Finance
Lecture n°1
Balance of Paiements
Reminder
Addendum
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The international financial system
 Introduction
Different forms of exchange rates organisation :
fixed
floating
managed
monetary unions
Questions of
adjustment of balance of paiements
liquidity provision in the system
international money deficition and usage
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The international financial system
 Impossible Trinity :
Exchange rate stability
Full financial integration (free capital flows)
Monetary independence
Full Capital Controls
Monetary
Independence
Pure float
Exchange rate
stability
Impossible
Trinity
Full Financial
Integration
Is there a best system?
What design of institutions?
Monetary Union
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The international financial system
International money
Caracteristics : International money should be :
defined
convertible
inspire confidence
store of value
Summary issues & concerns of financial markets :
Adjustments of BOP
Provision of liquidity
-> 4 different systems address these 2 issues.
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Adjustment issue : the BOP
Balance of payments (BOP) - reminder:
Balance of paiements : sum of all the transactions between
the residents of a country and the rest of the world
BOP = current account balance + capital account + financial
account + changes in reserves
BOP = (X - M) + (CI - CO) + (FI - FO) + FXB
Current account = exports - imports of goods and services
Capital account = capital inflows - capital outflows =
capital transferts related to purchase and sale of fixed assets
Financial account = financial inflows - financial outflows =
net foreign direct investments + net portfolio investments
Sum of 3 first terms = Basic balance
FXB : changes in official monetarry reserves (gold, foreign
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currencies, IMF position)
Adjustment issue : the BOP
Balance of payments (BOP) - reminder:
In equilibrium : BOP = 0
Deficit country : BOP < 0
Surplus country : BOP > 0
Deficit country (current account deficit)
X - M < 0 : too many imports compared to exports
Money supply > money demand (in domestic currency)
Too large amount of domestic currency : deflationary
pressures
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Adjustment issue : the BOP
Possible policies for a deficit country :
let the FX rate depreciate and restore competitiveness,
leading to a rise in X and a reduction in M (if FX rates are
floating)
reduce the stock of money by direct intervention : buy
domestic currencies against foreign currencies held in
monetary reserves (if FX rates are fixed)
increase interest rates to attract capital inflows (financing
the deficit) and to reduce demand for imports (monetary
view)
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Adjustment issue : the BOP
Surplus country (current account surplus)
X - M > 0 : too many exports compared to imports
Money demand > money supply (in domestic currency)
Lack of domestic currency : inflationary pressures
Possible policies for a surplus country :
let the FX rate appreciate and decrease competitiveness,
leading to a reduction in X, and an increase of M
increase the supply of money by direct intervention : sell
domestic currencies and buy foreign currencies, growing the
monetary reserves, to avoid FX appreciation
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Adjustment issue : the BOP
Possible policies for a surplus country :
increase the supply of money and sterilise to avoid a price
rise : exchange M1 and M3 : sell government bonds against
domestic currencies. The process is here :
increase the domestic money supply by buy foreign
currencies using domestic currencies to ease the
appreciation pressure
reduce back the supply of domestic money by selling
government bonds
lower interest rates to discourage capital inflows (increase
outflows) and to reduce financial surplus
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Adjustment issue : the BOP
Adjustment issue - reminder
The deficit is not dependant of the exchange rate (in
theory)
In practice, however :
prices and wages are sticky
some regional shocks can create asymmetric disequilibrium
large players like government and financial insitutions
influence equilibrium
surplus and deficit countries experience asymetric pressures
for adjustments
Problem of adjustments : central concern of government
-> need for design of institutions
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International Finance
Lecture n°3
FX rate determination
Overshooting
Addendum
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Monetary approach
Overshooting model - Specification
Equations (1) and (2) lead to :
s = s- + (1/) (m - p - y + i*)
in logarithm
meaning that the exchange rate and price level are function
of three exogenous variables :
• the real money supply (m-p)
• the domestic real income (y)
• the foreign interest rate (i*)
s- is the long-run exchange rate, determined by monetary
(inflation differential) and real factors (economic fundamentals). If
s above s-, then s is expected to appreciate.
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Monetary approach
Overshooting model - Graphical Equilibrium
P
Q
45°
 p= 0
Peq
Q
Seq
s
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Monetary approach
Overshooting model - Graphical Equilibrium
QQ: asset market equilibrium :
Negative slope, a relatively high level of s is required iof p is
low. The dynamic is as follows :
If p falls, the real supply money rises (m-p rises when p falls).
Then, i falls to maintain MM equilibrium (1).
Then se has to fall to maintain the interest parity condition
(i=i*+ se ) : the exchange expected to appreciate.
p=0 : goods market equilibrium:
The curve expresses the combinations of p and s that
ensure that excess demand is equal to zero, that is, that the
goods market are in equilibrium. Positively sloped, but flatter
than 45°.
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Monetary approach
p=0 : goods market equilibrium:
The mechanism is as follows:
A decrease in p has two effects :
(1) it increase the real value of money supply (m-p),
leading to a decrease of i, that in turn lead investment and
aggregate demand to grow (Keynes effect)
(2) it increases competitiveness, leading to an increase of
the net demand for export (X-M)
These 2 effects lead to an excess demand on the goods
market. Therefore, s has to fall (i.e. appreciate) more that
proportionally in order to restore the equilibrium. The fall
in s has to compensate both the Keynes effect and the
competitiveness effect.
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Monetary approach
Overshooting model - Hypothesis
Goods market adjust only slowly toward equilibrium, whereas
asset market are assumed to clear continuously (always on
QQ)
Money is neutral in the long-run : changes in the supply of
money have no long-run effect on the real economy : an %
increase (decrease) in money supply will lead to the same %
increase (decrease) in p and s. There is no money illusion or
price stickiness in the long run.
Short-run adjustments : the fall in interest rates disturbs the
interest parity. There is a capital outflows causing s to rise
(depreciate), but it has to rise beyond its equilibrium level to
generate expectations of appreciation = “overshooting”.
Overshooting reaction of money markets are necessary for the
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asset markets equilibrium to hold continuously.
Monetary approach
Overshooting model - Input
Dornbush’s model can provide an explanation for the large
fluctuations in exchange rates.
The model has served as a basis for other models of the
overshooting type : no full employment, imperfect currencies
and assets substitutability, imperfect capital mobility, rational
expectations, dynamic (not analysed here).
Overshooting model - Empirical evidence
Methods : multivariate lagged regressions
Mixed evidence : some support of PPP in the long-run, some
evidence of overshooting in the short-run.
Some support from recent tests.
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International Finance
Lecture n°6
FMI and the provision of finance
Financial Crises
Addendum
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Financial crises
Recent financial crises
The Asian crisis of July 1997
The Russian rouble’s collapse in August 1998
The fall of the Brazilian real in January 1999
These crises provide a spectrum of emerging markets
economic failures, each with its own complex causes
and unknown outlooks.
They also illustrate the growing problem of capital
flights and short-run international speculation in
currency and securities markets.
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Financial crises
The Asian crisis
 Roots : fundamental change in the economies of the region of
many Asian countries, expanding their economies from net
exporters to net importers
 Starting in 1990 in Thailand, this rapid expansion required major
net capital inflows to support their currencies
 As long as capital kept flowing in, the currencies were stable, but
if this inflow stopped then the governments would not be able to
support their fixed currencies
 Most visible part : the excesses of capital inflows into Thailand in
1996 and 1997.
 Easy access to capital for firms and Thai banks to US dollar
denominated debt at cheap rates.
 Banks continued to extend credits and as long as the capital
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inflows were still coming.
Financial crises
The Asian crisis
 After some time, the Thai Baht came under attack due to the
country’s rising debt.
 The Thai government tries to support the exchange rate by
direct intervention on the markets by selling foreign reserves
and indirectly by raising interest rates.
 This caused the Thai markets to come to a halt along with
massive currency losses and bank failures
 On July 2, 1997 the Thai central bank allowed the Baht to
float and it fell over 17% against the dollar and 12% against
the Japanese Yen
By November 1997, the baht fell 38% against the US
dollar, form Baht 25/US to Baht 40/$.
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Financial crises
The Asian crisis
 Within days, other Asian countries suffered from the contagion
effect from Thailand’s devaluation.
 Speculators and capital markets turned towards countries with
similar economic traits as Thailand and their currencies fell
under attack : Indonesia, Korea, Malaysia, Philippines, Taiwan...
 The only currencies that were not severely affected were the
Hong Kong dollar and the Chinese renminbi.
 The causal factors of the crisis were complex :
Corporate socialism
Corporate governance
Banking and liquidity management
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Financial crises
The Asian crisis
 Corporate socialism
Great stability in Asia in the post-war period, with active
government intervention in the economy, and life-long employment
in firms. Until the crises, the government was reluctant to allow
firms and banks to close, workers to lose their jobs.
 Corporate governance
Most firms were controlled by families or groups related to the
governing parties. Theses practices could favor exploitation of
private benefits of power and conflicts of interest of the
management or controlling shareholders not acting in the firm’s
best interests.
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Financial crises
The Asian crisis
 Banking and liquidity management
The government used up its reserves in tentative of direct
intervention and could not support banks when large speculative
attacks and huge capital outflows cause the failure of many of
them.
The liquidity disruption of the banking and financial system
profoundly affected the real economy, causing a chain effect of
failures among Asian companies, leading to a region-wide
recession.
There are interpretation disputes over the role of the IMF in the
provision of finance in distressed Asian countries during the crisis.
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Financial crises
The Russian crisis of 1998
The Russian crises was the culmination of a continuing
deterioration in general economic conditions in Russia.
From 1995 to 1998 Russia extensively borrowed on international
capital markets and the servicing of the debt became soon a
preoccupying problem. Although the country run a surplus of $15$20 billion per year, capital flight was accelerating as hardcurrency earnings were leaving the country.
The Ruble operated within a managed float from Rub 5.75/$ to
Rub 6.35/$. The government maintained this band by announcing
what rate it was willing to buy/sell rubles to the markets.
Even after a $4.3 billion IMF facility, the ruble fell under attack in
August of 1998.
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Financial crises
The Russian crisis of 1998
On August 7, 1998 the central bank announced that its hard
currency reserves had fallen by $800 million to a level of $18.4
billion as of July 31st
Russia announced that it would issue an additional $3 billion in
foreign bonds but the ruble continued to fall
On Monday August 10th, the Russian stocks fell by more than 5%
as investors feared a Chinese renminbi devaluation that would aid
Chinese exports but would deteriorate Russia’s ability to generate
foreign exchange reserves. Russia’s ability to collect taxes was
also waited to be proved.
On August 17th, the central bank announced that the Ruble would
be allowed to fall by 34% to Ru9.50/$. They postponed $43 billion
in short-term debt as well as a 90-day moratorium on all
repayment of foreign debt in order to avoid a banking collapse.
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Financial crises
The Russian crisis of 1998
On August 28th, trading of the Ruble was halted after ten minutes
as the Ruble traded around Ru19.0/$. By January, the Ruble had
settled at Ru25.0/$
 Russia had defaulted on its foreign denominated debt,
mostly dollar debt marking the first time a sovereign
issuer defaulted on Eurobonds.
 The crisis of the Ruble and the loss of Russia’s access to
international capital markets has brought into question
the benefits of a free market economy among the Russian
society.
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Financial crises
The Brazilian crisis of 1999
In 1997 and 1998, most analysts did not question the perspective of
a devaluation of the Real, but wondered when and how much.
Since 1994, its value had been artificially maintained by the
government in the hopes of stabilization of economic condition and
financial growth.
But the government’s inability to resolve the persistent current
account deficit and the inflationary pressures drove expectations of a
devaluation.
Increased volatility on the markets in the second half of 1998, in the
context of the Russian crises, pave the way for speculative attacks on
the Real.
From January 11th, till 15th, 3.44 billion USD flew out of the country
and the Real lost 16% of its value, devalued twice at R$1.43/$
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Financial crises
The Brazilian crisis of 1999
During the following week, the floating rate was temporarily
adopted and the Real continued to fall.
The finance minister rose interest rates from 36% to 41% “to
limit inflationary pressures from the devaluation”.
By April of 1999, the real had appreciated against the dollar and
was now hovering around R$1.70/$
After a sharp drop, equity markets steadily recovered in the
following weeks and month, based on positive expectations due to
the improved competitive position of Brazil compared to its major
competitors, and following the renewed confidence brought by
the return of foreign investors to the Brazilian markets, signaling
the end of the crisis.
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