BSP2005 – Asia Pacific Business EnvironmentSemester I, AY 2011/2012

Week 6 Lecture(by Jo Seung-gyu)

Foreign Exchange and International Monetary System

(Hill - Ch 9, Ch 10 and others)

Part I: Foreign Exchange

Part II: Current Exchange Rate Regimes

Part III: Evolution of International Monetary System(to be skipped!)

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Part I: Foreign Exchange

A. IntroductionB. Economic Theories of Foreign Exchange Rate

Determination

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Some realities

US-China row over the value of Yuan Currency war in 2010

(US midterm election , G20 Summit – coincidence?) Toyota’s first loss in 70 years; (6 Sept, 2011) Swiss central bank announced unlimited

intervention to commit to minimum target of 1.20 franc/euro

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Straits Times, Jun 16, 2010

‘IMF: China Yuan undervalued’

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Is Yuan really undervalued?

• Those who argue that the Yuan is too cheap point to three factors:

1. China’s huge trade surplus2. China’s huge and rising foreign-exchange reserves3. Lower Chinese prices relative to prices in America4. On-going capital inflow into China

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The Economist, 2 November, 2010

Real vs Nominal Rates?

Real exchange rates increased shaper than nominal rates: nominal rates could be misleading.

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A. Introduction

The foreign exchange market is a market for converting the currency of one country into that of another country

The exchange rate is the rate at which one currency is converted into another (=price of one currency in terms of another)

Definition: dollar/yen exchange rate is denoted by E$/¥ and defined as value of ¥ in terms of $

Significant features of the market are:

The market never sleeps Arbitrage through high-speed computer linkages created a single market Like any other asset types, they are subject to bubbles

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● Traded currencies Most transactions involve U.S. dollars on one side

The U.S. dollar is still a vehicle currency (85%)

Can you guess about Chinese Yuan’s Share? ( ) %

• But, China is the 2nd largest economy?− Far from free convertibility, strictly controlled− Yuan-denominated assets are rarely traded

• Gradually changing− McDonald issued Yuan-bonds in HK− Yuan-deposits allowed in Singapore, HK etc 8

Demand/Supply Rules:

An increase in the desire to hold local (foreign) currency will lead to an appreciation (depreciation) of the local currency vis-à-vis the foreign currency. (depreciation/appreciation vs devaluation/revaluation)

Determinants of exchange rate:

1. a country’s balance of payments (trade/capital flows)2. a country’s price level (inflation)3. a country’s capital flows (interest)4. market psychology and expectations (bandwagon effect)

Examples:

Effect on RMB of a rise in US demand for Chinese exports (2010 currency war) Effect on US$ if US Fed increases monetary supply (like recent QEII)? Effect of China’s interest rate or RRR increase? Effect on Thai Baht when the public expect Baht to depreciate following the

domestic political turmoil (or during Asian crisis)

B. Economic Theories of Exchange Rate Determination

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Definition of Balance of Payments (BOP)

Principle divisions of BOP accounts (by IMF) :Balance of payments = current account + financial account + capital

account ± statistical discrepancy = zero

1. Current account: - net trade balance: exports and imports of goods and services- net international income: factor earnings and factor payments

2. Financial account- net investments (i.e. net ownership of international assets)- central bank reserve account

3. Capital account: - special categories of assets (non-market, non-produced,

or intangible assets such as debt forgiveness, copyrights and trademarks)

(Note: standard definition defines 2+3 as capital account)

1. Balance of Payments and Exchange Rates

Inbound flow (surplus)=borrowing/asset sales/

inbound FDI

Outbound flow (deficit) = lending/asset purchases/

outbound FDI

Inbound flow (surplus)= net export

Outbound flow (deficit) = net import

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Trade Flows and Exchange Rates

BOP model of exchange rate holds that exchange rate stabilizes current account balance: external value of a currency depends on D for and S of it.

Define Exchange rate E$/¥ as value of ¥ in terms of $:

Japan’s trade surplus vs US (export>import)

ES of $ED of ¥

E$/¥ increases: $ depreciates and ¥ is appreciated

Trade balance restored and equilibrium E$/¥ is determined

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Trade Flows and Exchange Rates - cont

Drawbacks:

1) Chicken-egg problem: Exchange rate trade balance: which direction is correct?

1) Global money chases not only goods/services but financial assets. The latter gets big.Thus, capital flow becomes more important in determining exchange rates. (See the next slide for US-China trade deficit and exchange rate)

Real Life Examples: • US QEII in Oct. 2010 + interest rate increase in AP countries capital inflow to AP countries

Asian currencies appreciated− Explains ‘capital controls’ by Emerging countries (Brazil, Korea, Thailand etc)

• Japanese Yen appreciation since July 2007( high D for Japanese currency/bonds)

?

July 2007

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Yen/dollar

Case: US-China Trade Deficit and Exchange Rates

Yuan/Dollar Exchange Rate(July 2010 – Jan 2011)US Trade Deficit with China (US$mil)

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2. Price Level and Exchange Rates: PPP theory

‘Law of One Price’

argues that given relatively efficient markets (markets in which few impediments to international trade and investment exist) the price of a “basket of goods” in terms of the same currency should be roughly the same t in each country

PiU= (E$/¥ ) x (Pi

J)

where:

PiU is the dollar price of good i when sold in US

PiJ is the corresponding yen price in Japan

E$/¥ is the USdollar/Japan exchange rate

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Absolute Purchasing Power Parity

The exchange rate between two counties’ currencies equals the ratio of the counties’ price levels. It predicts a US dollar/euro exchange rate of:

E$/¥ = PU/PJ

The Economist:

“Big Mac Index Says The Yuan Is Actually Valued Just Right”

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From the absolute PPP: E$/¥ = PU/PJ

% change in E (depreciation of $, appreciation of ¥)= inflation rate in US (πU) – inflation rate in Japan (πJ)

i.e.

(E$/¥,t - E$/¥, t –1)/E$/¥, t –1 = U,t - J,t

Relative Purchasing Power Parity

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How well does PPP theory work?

Empirical testing of the PPP theory indicates that it is not completely accurate in estimating exchange rate changes in the short run, but is relatively accurate in the long run.

PPP theory – cont.

Exchange rates deviation from PPP?

• Trade barriers• Non-tradeables• Market power and

price discriminations

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3. Interest Rates and Exchange Rates (‘International Fisher Effect’ or ‘Uncovered Interest Rate Parity))

Notations: i : nominal interest rate, r: real interest rate, π: inflation rate , E: spot exchange rate

Question: If iU > iJ, how would it affect exchange rates (E$/¥) ?

‘Fisher Effect’: i = r + πe , thus

Recall PPP theory:

Thus, the following ‘International Fisher Effect (or Uncovered Interest Rate Parity’) holds:

Why?

% change in E$/¥ [=Ee$/¥ - E$/¥)/E$/¥]= πe(US) – πe(Jap)

πe i

Assume: by arbitrage, r are the same over countries

iU > iJ

πe(US) > πe(Jap)

E$/¥ , i.e. $ depreciates and ¥ appreciates And exchange rate change is equivalent to interest rates gap.

% change in E$/¥ [=Ee$/¥ - E$/¥)/E$/¥] = iU – iJ

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Aside: Real interest rates and exchange rates

● International Fisher Effect or Uncovered Interest Rate Parity is rather a hypothesis (or an assumption) than a theory.

● International Fisher Effect or Uncovered Interest Rate Parity assumes ‘no arbitrage’ condition holds in equilibrium, i.e. real interest rate should be equal. If real interest rates differ across countries, capital flow towards a higher (real) interest rate will cause exchange rate adjustment as well:

rU > rJ investors want to invest in US

Note: It is only a theoretical prediction, but empirical results does not necessarily follow theory: the reality contains noise factors

D for yen increases in Japan

D for $ increases in forexmarket

and

r increases in Japan and

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E$/¥ decreases, i.e. $ appreciates and ¥ depreciates

An Empirical Test on International Fisher Effect

‘International fisher effect’ roughly supports long run exchange rates. (Of course, short run fluctuations occur)

Real Life Example: Before 2008 Financial Crisis, S$ Investors usually bet on appreciation of S$ (b/c ising < ius) 20

trade balance, relative monetary growth and inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates, but poor predictors of short term changes

Summary of Exchange Rate Determinants

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4. Market Psychology and Expectations: Bandwagon Effects

“In short run, investors’ psychology and bandwagon effect concern more than PPP and FE” (Ito, ‘Foreign Exchange Rate Expectations: Micro Survey Data’, American Economic Review, vol 80)

The bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies, and traders join the bandwagon and move exchange rates based on group expectations

Example 1: in 1990s, G. Soros bet against £: - borrowed £ and exchanged for DM- £ depreciates- buy £ and pay back £ loan- traders join (bandwagon effect), making their expectations a reality.- as a result, £ depreciates and DM appreciates (without serious

macro fundamental background)

Example2: Depreciation of Thai Baht and Korean Won during Asian Crisis

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Part II: Exchange Rate Regimes in Practice

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Classifying Forex Schemes is tricky Convertibility Monetary Policy Framework (Monetary Supply, Inflation, Interest Rate etc) Degree of intervention by central authority

etc.

Case for Floating Forex Scheme Monetary policy autonomy (free of forex burden) Help adjust trade imbalances

Case for Fixed Forex Scheme Monetary discipline (discretionary monetary policy is controlled) Speculation prevented Uncertainty hedged Trade imbalance can be maintained

Foreign Exchange Regimes

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De Facto Classification of Exchange Rate Regimes by IMF, 2009 No Separate Tender

No forex policy or currency union members: Dollarization(Equardor), Euro members

Fixed Exchange Rate (or Currency Board) Fixed forex rate to US$, with full commitment by monetary authority (HK, Brunei

etc. e.g.1US$=7.8HK$, with margin allowed within 7.75-7.85) Pegged System

Fixed Peg: fixed forex rate, pegged to a currency or a basket of currencies, allowed to fluctuate 1% ± central rate within 3 months (Vietnam, Sri Lanka, Danish Krone pegged to euro)

Pegged Rates with Horizontal Margins: fixed peg without 3 month limit (Syria) Crawling Peg: fixed peg but central rates are periodically adjustable (China

2008- June 2010) Crawling Bands: fixed peg but forex rates fluctuate within margin of ±1% band

and periodical adjustment of central rates (Costa Rica) Floating Exchange Rate System

Managed Float with no predetermined path for forex rate (=Dirty Float): float system but interventions without specific path (intervention is discretionary) (Singapore, China, Thailand, Malaysia, Myanmar, Indonesia, India etc)

Independent Float: forex rates are market-determined, but interventions to moderate undue fluctuations exist (US, Korea, Japan, Philippines etc)

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Classification based on ‘IMF Classification 2009’

Regime Number Share (%)

Dollarisation / currency union 10 5.3

Currency board 13 6.9

Pegged 81 43.1

Managed floating 44 23.4

Independent floating 40 21.2

Source: International Monetary Fund (http://www.imf.org/external/np/mfd/er/index.asp) 26

Case: China’s Exchange Rate Regime and Yuan/Dollar Rates(11 Sept, 2000 – 2 Sept, 2011)

2005, managed float introduced by pressure from ROW: RMB 2.1% appreciated

2008 amidst Financial Crisis,  return to pegged scheme: for BOP purpose$1 = RMB6.88

June 2010,  back to managed float:Pressure from US, and also to stabilize macro econ

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• We will revisit the yuan issue during ‘the global economy outlook lecture’ (Week 12 or 13)

Use of foreign reserve for forex market intervention?

● You buy foreign reserves and sell local currency to make local currency weak

• China

● You sell foreign reserves and buy local currency to make local currency strong Thailand, Indonesia, Taiwan and Korea during the 1997 Asian Crisis Below, we revisit the Asian Crisis case.

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The Asian Crisis - cont

Investment boomExport boom in the 80s led to investment boom in the 1990s, most of which was paid by borrowing…local banks were borrowing from the US banks

Excess capacityOverinvestment, much of which was based on borrowed funds, led to excess capacity, which led to falling prices and lower profits

The debt bombTo make things worse, debt was in US$ which had to be paid back regardless of profits. If currency were to depreciate, it would be even harder to pay back the loans

Trade deficitRising current account deficit meant that the US$ peg would be increasingly difficult to defend

Short-selling by currency tradersWhat started as a drip now became a flood when it was clear that Bank of Thailand did not have the sufficient funds to defend falling Baht (lack of transparency and communication….nobody knew how much reserve the Thais had)

Case of Korea? – Bank of Korea was holding $30bln reserve (just good for IMF suggestion) but used up in two weeks

The band-wagon effectThailand, Malaysia, Indonesia, South Korea, Singapore. Herd mentality.

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Exchange rates during the Asian Crisis

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CurrencyExchange rate

(per US$1)[ ChangeJune 1997 July 1998

Thai baht 24.5 41 – 40.2%

Indonesian rupiah 2,380 14,150 – 83.2%

Philippine peso 26.3 42 – 37.4%

Malaysian ringgit 2.5 4.1 – 39.0%

South Korean won 850 1,290 – 34.1%

Part III:Evolution of International Monetary System

Part III is to be skipped and has been attached only for your reading. (Our final exam only covers the materials were covered during the lectures/tutorials/guest speaker series)

Wish you a sweet break!!

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Evolution of International Monetary System

Contents

1. The Gold Standard

2. The Bretton Woods system• The International Monetary Fund• The World Bank

3. Post-Bretton Woods System • Collapse of Bretton Woods System• Floating Exchange Rate Regimes• Asian Crisis in Post-Bretton Woods Era and IMF’s role revisited

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1. The Gold Standard

What is the Gold Standard? The origin of the gold standard dates back to ancient times when gold coins were

a medium of exchange, unit of account, and store of value To facilitate trade, a system was developed so that payment could be made in

paper currency that could then be converted to gold at a fixed rate of exchange

Mechanics of Gold Standard The gold standard refers to the practice of pegging currencies to gold and

guaranteeing convertibility• Under the gold standard one U.S. dollar was defined as equivalent to 23.22

grains of "fine (pure) gold The exchange rate between currencies was based on the gold par value (the

amount of a currency needed to purchase one ounce of gold)

Strengths of Gold Standard The key strength of the gold standard was its powerful mechanism for

simultaneously achieving balance-of-trade equilibrium (when the income a country’s residents earn from its exports is equal to the money its residents pay for imports) by all countries

Many people today believe the world should return to the gold standard 33

The Period Between the Wars: 1918 - 1939

The gold standard worked fairly well from the 1870s until the start of World War I

After the war, in an effort to encourage exports and domestic employment, countries started regularly devaluing their currencies

Confidence in the system fell, and people began to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility

The Gold Standard ended in 1939

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2. The Bretton Woods System

A new international monetary system was designed in 1944 in Bretton Woods, New Hampshire

The goal was to build an enduring economic order that would facilitate postwar economic growth

The Bretton Woods Agreement established two multinational institutions

1. The International Monetary Fund (IMF) to maintain order in the international monetary system

2. The World Bank to promote general economic development

Under the Bretton Woods Agreement

the US dollar was the only currency to be convertible to gold, and other currencies would set their exchange rates relative to the dollar

devaluations were not to be used for competitive purposes a country could not devalue its currency by more than 10% without IMF

approval

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The Role of the IMF

The IMF was responsible for avoiding a repetition of the chaos that occurred between the wars through a combination of

1. Discipline a fixed exchange rate puts a brake on competitive devaluations and

brings stability to the world trade environment a fixed exchange rate regime imposes monetary discipline on

countries, thereby curtailing price inflation

2. Flexibility A rigid policy of fixed exchange rates would be too inflexible So, the IMF was ready to lend foreign currencies to members to tide

them over during short periods of balance-of-payments deficits A country could devalue its currency by more than 10 percent with

IMF approval

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The Role of the World Bank

The official name of the World Bank is the International Bank for Reconstruction and Development (IBRD)

The World Bank lends money in two ways under the IBRD scheme, money is raised through bond sales in the

international capital market and borrowers pay what the bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses.

under the International Development Agency scheme, loans go only to the poorest countries

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3. The Collapse of the Fixed Exchange Rate System

What caused the collapse of the Bretton Woods system?

The collapse of the Bretton Woods system can be traced to U.S. macroeconomic policy decisions (1965 to 1968)

During this time, the U.S. financed huge increases in welfare programs and the Vietnam War by increasing its money supply which then caused significant inflation

Speculation that the dollar would have to be devalued relative to most other currencies forced other countries to increase the value of their currencies relative to the dollar

The Bretton Woods system relied on an economically well managed U.S. So, when the U.S. began to print money, run high trade deficits, and

experience high inflation, the system was strained to the breaking point The Bretton Woods Agreement collapsed in 1973

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The Floating Exchange Rate Regime

What followed the collapse of the Bretton Woods exchange rate system?

Following the collapse of the Bretton Woods agreement, a floating exchange rate regime was formalized in 1976 in Jamaica

The rules for the international monetary system that were agreed upon at the meeting are still in place today

The Jamaica Agreement

At the Jamaica meeting, the IMF's Articles of Agreement were revised to reflect the new reality of floating exchange rates

Under the Jamaican agreement floating rates were declared acceptable gold was abandoned as a reserve asset total annual IMF quotas - the amount member countries contribute to

the IMF - were increased to $41 billion (today, this number is $311 billion)

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Exchange Rates Since 1973

Since 1973, exchange rates have become more volatile and less predictable because of

the oil crisis in 1971 the loss of confidence in the dollar after U.S. inflation jumped between

1977 and 1978 the oil crisis of 1979 the rise in the dollar between 1980 and 1985 the partial collapse of the European Monetary System in 1992 the 1997 Asian currency crisis the decline in the dollar in the mid to late 2000s

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1997 Asian Crisis RevisitedCauses of the Crisis

1. The Investment Boom fueled by export-led growth large investments were often based on projections about future demand

conditions that were unrealistic

2. Excess Capacity investments made on the basis of unrealistic projections about future

demand conditions created significant excess capacity

3. The Debt Bomb investments were often supported by dollar-based debts when inflation and increasing imports put pressure on the currencies,

the resulting devaluations led to default on dollar denominated debts

4. Expanding Imports by the mid 1990s, imports were expanding across the region causing

balance of payments deficits The balance of payments deficits made it difficult for countries to

maintain their currencies against the U.S. dollar41

The Asian Crisis – cont.

By mid-1997, it became clear that several key Thai financial institutions were on the verge of default

Foreign exchange dealers and hedge funds started to speculate against the Thai baht, selling it short

After struggling to defend the peg, the Thai government abandoned its defense and announced that the baht would float freely against the dollar

Thailand turned to the IMF for help

Speculation continued to affect other Asian countries including Malaysia, Indonesia, Singapore which all saw their currencies drop

These devaluations were mainly a result of excess investment, high borrowings, much of it in dollar denominated debt, and a deteriorating balance of payments position

South Korea was the final country in the region to fall

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Evaluating the IMF’s Policy Prescriptions

How successful is the IMF at getting countries back on track?

In 2006, 59 countries were working IMF programs All IMF loan packages come with conditions attached, generally a

combination of tight macroeconomic policy and tight monetary policy

Many experts have criticized these policy prescriptions for three reasons

1. Inappropriate Policies The IMF has been criticized for having a “one-size-fits-all” approach to

macroeconomic policy that is inappropriate for many countries2. Moral Hazard The IMF has also been criticized for exacerbating moral hazard (when

people behave recklessly because they know they will be saved if things go wrong)

3. Lack of Accountability The final criticism of the IMF is that it has become too powerful for an

institution that lacks any real mechanism for accountability43