Lecture n°1 Balance of Paiements Reminder - Addendum

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Lecture n°1

Balance of Paiements Reminder

-Addendum

International Finance

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The international financial system

Introduction Different forms of exchange rates organisation :

fixed floatingmanaged monetary unions

Questions ofadjustment of balance of paiements liquidity provision in the systeminternational money deficition and usage

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Impossible Trinity :Exchange rate stability Full financial integration (free capital flows)Monetary independence

Is there a best system?What design of institutions?

Impossible Trinity

Pure float Monetary Union

Full Capital Controls

Exchange rate stability

Full Financial Integration

MonetaryIndependence

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International money Caracteristics : International money should be :

definedconvertibleinspire confidencestore 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

currencies, IMF position)

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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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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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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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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 - reminder The deficit is not dependant of the exchange rate (in

theory) In practice, however :

prices and wages are stickysome regional shocks can create asymmetric disequilibriumlarge players like government and financial insitutions

influence equilibriumsurplus and deficit countries experience asymetric

pressures for adjustments Problem of adjustments : central concern of government -> need for design of institutions

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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 logarithmmeaning 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

Peq

s

P

Seq

p= 0

45°Q

Q

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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 asset markets equilibrium to hold continuously.

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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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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 inflows were still coming.

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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 hard-currency 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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Lecture n°1 Balance of Paiements Reminder - Addendum