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Chapter 8. The International Financial System. Unsterilized Foreign Exchange Intervention. When C entral B ank (CB) se lls domestic currency to purchase foreign currency, its international reserves increase and the monetary base also increases.

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Chapter 8 l.jpg

Chapter 8

The International Financial System


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Unsterilized Foreign Exchange Intervention

  • When Central Bank (CB) sells domestic currency to purchase foreign currency, its international reserves increase and the monetary base also increases.

  • When CB purchases domestic currency and sells foreign currency, its international reserves and the monetary base decreases.


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Unsterilized Intervention

  • When CB sells (or buys) domestic currency and buys (or sells) foreign currency, we call this an “unsterilized intervention”An unsterilized purchase (sale) of foreign currency leads to a gain (loss) in international reserves, an increase (decrease) inthe money supply, and a depreciation (appreciation) of the domestic currency.


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Sterilized Foreign Exchange Intervention

  • Sterilization: To neutralize the effect of the foreign exchange intervention on the money supply.

  • Example: If CB buys dollars and increases the supply of liras, then CB also sells govt. bonds at the same amount. This leaves the monetary base, the money supply and exchange rates unchanged.


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Balance of Payments

  • Balance of Payments = Current Account + Capital Account (Net Capital Inflows)

  • Sum of current account and capital accountsshows the net change in the official (dollar) reserves of Turkey.


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Balance of Payments

  • Current Account :Assets (+) Liabilities (-)

    • Trade Balance = +Exports – İmports

    • Services Balance

      • +Net Foreign Tourism Revenues

      • +Banking & Insurance Net Revenue

      • +Construction & Transportation Net Revenue

      • +Workers’ Remittances + Paid Military Service

    • Unilateral transfers (Aid to TRNC)


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Balance of Payments

  • “Current Account (CA) Deficit” means that CA is a negative number. This is usually because the largest item “Trade Balance” is negative. For example, Turkey’s 2008 (2007) January-March exports are $33 ($24.4) billion, imports are $49 ($33) billion, trade balance is -$16 (-$8.6) milyardır. See: odemelerdengesi.xls


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Balance of Payments

  • Capital Account = Net Capital İnflows =

    • +Purchases of Domestic (Turkish) assets by Foreigners

    • – Purchases of Foreign Assets by Domestic (Turkish) Residents

    • + Net Borrowing of Turkish Residents from Foreign residents


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Balance of Payments

  • Capital Inflows: Two types:

    • Foreign Direct Investments (FDI): Takes control of the firm, bank, etc. Ex: Migros sale to British, Finansbank sale to NBG, ToyotaSA, are FDI inflows. Ülker purchase of Godiva is FDI outflow.

    • Foreign Portfolio Investment (FPI) (stocks, bonds, credits). Foreign investors buying stocks at ISE, Turkish banks & firms borrowing from foreign banks are FPI inflows. Turkish banks lending to Azeri firms is FPI outflow.


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Balance of Payments

  • Except year 2001, TR’s current account has been negative. However, TR’s capital account surplus is by far greater than its current account deficit. This means that there was a net dollar inflow into TR. This is why dollar has depreciated against TL in the last few years.


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Exchange Rate Regimes

  • Fixed exchange rate regime

    • Value of a currency is pegged relative to the value of one other currency (usually dollar). CB intervenes by buying and selling dollars to keep ER fixed.

    • Turkey followed fixed ER regime before 2001. ER was kept within a band.


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Exchange Rate Regimes

  • Floating exchange rate regime

    • Value of a currency is allowed to freely fluctuate against all other currencies: no interventions in the forex market.

  • Managed float regime (dirty float)

    • Attempt to influence exchange rates by buying and selling currencies. Turkey has followed dirty float after 2001.


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Past Exchange Rate Regimes

  • Gold standard: 19th century and until World War I

    • Fixed exchange rates

    • No control over monetary policy

    • Money supply influenced heavily by production of gold andgold discoveries. When gold production is low (high), money supply increases slowly (fast), deflation (inflation) happens.


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Past Exchange Rate Regimes (cont’d)

  • Bretton Woods System: 1944-1971

    • Fixed exchange rates using U.S. dollar as thereserve currency: $ 35 convertible per 1 ounce of gold (only for governments and CBs, not public).

    • International Monetary Fund (IMF)

    • World Bank

    • General Agreement on Tariffs and Trade (GATT)

      • Became World Trade Organization


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Past Exchange Rate Regimes (cont’d)

  • European Monetary System: 1979-1990

    • Exchange rate mechanism is a fixed ER regime within Europe. Before the euro in 1999, as a preparation.

  • Euro’s challenge to the dollar as the reserve currency in international financial transactions:

    • Not yet because Europe is not a united political entity.


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How a Fixed Exchange Rate Regime Works

  • Suppose that the official fixed parity is 1,31 TL/USD. Suppose that for some reason demand for TL assets increases. This increases value of TL in the free forex market above the official parity: 1,20 TL/USD (TL is undervalued). In this case, CB buys dollars and sells TL and increases the money (TL) supply. This decreases the interest paid by TL assets, which reduces demand for TL assets. CB can buy dollars until the free market ER is equal to the fixed 1,31 TL/USD. CB’s inetrnational reserves increase.


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How a Fixed Exchange Rate Regime Works

S

1/E

($/TL)

1/1,20

1/1,31

D

1/1,60

D’

Qty of TL assets


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How a Fixed Exchange Rate Regime Works

  • Now let us suppose that for some reason demand for TL assets decrease (maybe because FED increases rates). TL loses value in the free forex market below the fixed parity (overvalued). In this case CB buys TL and sells dollars. This reduces money supply and increases the interest rate on TL assets, which increases demand for TL assets, which increases value of TL back to 1,31 TL/USD. But notice that CB’s dollar reserves are spent in this process. If CB does not have enough reserves to defend the peg, then it must devalue value of TL to a lower level.


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How a Fixed Exchange Rate Regime Works

S

1/E

($/TL)

1/1,20

1/1,31

1/1,60

D’

D

Qty of TL assets


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What Happens during a Currency Crisis?

  • Speculators force the CB to devalue by quickly selling TL assets they have bought before and buying dollars: speculative attack. Their objective is to make profit from a devaluation.

  • When the CB runs out of dollars, then the CB cannot defend the value of lira anymore. So need to devaluethe lira to a lower level: Devaluation.

  • When the CB does not want to hold additional international reserves anymore, then revaluation occurs.


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How Bretton Woods (1944-71) Worked

  • Exchange rates adjusted only when experiencing a ‘fundamental disequilibrium’ (large persistent deficits in balance of payments)

  • Loans from IMF to cover loss in international reserves

  • IMF encourages contractionary monetary policies

  • Devaluation only if IMF loans are not sufficient

  • IMF cannot force surplus countries to revalue.

  • U.S. could not devalue the dollar during 1960s. The other surplus countries did not want to revalue. System collapsed in 1971.


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Managed (Dirty) Float (1971-now)

  • Bretton-Woods collapsed: US and others allowed exchange rates to float.

  • Hybrid of fixed and flexible

    • Small daily changes in response to market

    • Interventions to prevent large fluctuations

  • Appreciation of domestic currency hurts exporters and employment

  • Depreciation of domestic currency hurts imports and stimulates inflation


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European Monetary System

  • 1979: 8 members of European Economic Community fixed exchange rates with one another and floated against the U.S. dollar

  • ECU value was tied to a basket of specified amounts of European currencies: Exchange Rate Mechanism (ERM).

  • Fluctuated within limits. If goes beyond limits, Central Banks intervene in the market by buying the weak currency and selling the strong currency.


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European Monetary System

  • Fixed ER policies may lead to foreign exchange crises involving speculative attack: massive sales of the weak currency and purchases of the strong currency.

  • Profitable if they can cause a sharp devaluation of the weak currency.

  • Turkey: 1994, 2001. Europe: 1992, Brazil 1998, East Asia 1997-98, Mexico 1994.


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European Forex Crisis of September 1992

  • German unification (1990) and inflationary pressures led Bundesbank to increase interest rates.

  • This led British pound to be overvalued at the ERM parity 2.778. To correct this, either British had to increase rates or Germans had to decrease rates. Neither wanted to do these b/c Britain was in recession.

  • Speculators knew pound devaluation is coming and sold massive amounts of pound assets and bought mark assets.


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European Forex Crisis of September 1992

  • Sept. 16: British floated the pound: 10% devaluation against the DM. They also quit ERM and did not join the euro.

  • George Soros made $1 bn, Citibank made $200 m.

  • Same story in Turkey 1994, 2001, Argentina 2001, East Asia 1997, Mexico 1994, Brazil 1998.

  • Causes may be a little different. But all were following fixed ER policies.

  • Argentina’s 2001 and Turkey’s 2001 crises are both due to government budget imbalances.


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Capital Controls

  • Controls on Outflows

    • Outflows of capital promote financial instability by forcing a devaluation

    • Controls are seldom effective because it is easy to find ways around them.

    • Controls may block funds for productive uses such as roads, infrastructure

    • Chilean experience: capital cannot leave the country before one year (Tobin Tax) .

    • Controls on outflows reduces the inflows too.


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Capital Controls (cont’d)

  • Controls on İnflows: Capital İnflows lead to a lending boom and excessive risk taking by financial intermediaries (1997 Asian Crisis)

  • Strong case for improving bank regulation and supervision. Turkey has been successful in reforming the banking system after the 2001 crisis.


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IMF

  • Was established after World War II. Its purpose was to maintain the fixed exchange rate system called “Bretton Woods” (1944-71) by lending to the countries that had balance of payments deficits.

  • However, the Bretton Woods system collapsed in 1971 and IMF became an institution that provides financial and technical assistance to member countries.


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IMF

  • IMF has lent to less developed countries in repaying their foreign debt during:

    • 1980s’ Third World Debt Crisis, 1994-95 Mexican Crisis, 1997-98 East Asian Crisis, and 2001 Turkish Crisis (~20billion).

  • Of course, during credit arrangement, IMF asks the borrowing country to write a commitment letter in which the country’s government commits to the policies prescribed by IMF. Because if these policies are not followed, the same imbalances in the economy will cause another crisis in the future. If the borrowing country believes that IMF will bail them out even if they do not follow prescribed policies, then the country will never solve its problems and there will be moral hazard problem.


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IMF Critics

  • IMF critics say that:To the governments that cannot sell its debt and cannot preserve the value of their currency, IMF lends if the following conditions are promised by the borrower:

    • Reduce government expenditures or increase taxes so that you need to borrow less. Joseph Stiglitz and other critics: such measures during a crisis can only deepen the crisis and recession. They argue that government should increase expenditures and aggregate demand so that the economy is brought out of recession.


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IMF Critics

  • Increase interest rates.This helps increase the value of domestic currency. However, according to Stiglitz,this causes otherwise sound firms to go bankrupt because they cannot repay their debt with higher interest rates.

  • Trade and Financial Liberalization: Critics: The industrialized countries of today did not have liberal trade and financial systems when they were industrializing 200 years ago. Foreign banks take over the weak banking systems in less developed countries.


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IMF Critics

  • Privatization: Critics argue foreign companies take over sectors and increase dependency.

  • Fear of default. Critics argue that one of the objectives of the IMF is to ensure that high-risk, high-return loans from international banks to less-developed countries are repaid.


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IMF Critics

  • Instead of financial reform, IMF prescribes contractionary macroeconomic policies. This causes the IMF to be a profitable scapegoat for domestic politicians as anti-growth, anti-employment. IMF is seen as a foreign entity interfering with domestic policy.


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IMF as a Lender of Last Resort

  • IMF can prevent contagion of crises. Crisis in one country can easily spread to other countries in the same region or category due to herding behavior in financial markets.

  • IMF bailouts may cause excessive risk-taking and moral hazard for domestic banks and their international creditors. This will increase risk of crisis in the future.


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IMF Stand-By Arrangements with TR

Figure 1. Stand-By Arrangements Cases in Turkey (1960-2004)

Karagöl, Erdal, Metin Özcan, Kıvılcım, “The Economic Determinants of IMF Standy Aggreements in Turkey”


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Factors that Increase the Likelihood of an IMF Standby Agreement

  • According to Erdal Karagöl and Kıvılcım Metin Özkan (2008):

    Standby Prob.

    • Total investments / GNP  decrease

    • Foreign debt service / F.D. stock  decrease

    • Foreign debt service / Exports  increase

    • Govt. expenditures / GNP  decrease


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World Bank Agreement

  • Mission: Established after WWII to provide funds to reduce poverty and promote development in the world. Provides loans for infrastructural projects in health, education, agriculture, energy.

  • Critics: Stiglitz, Caufield: Hasty and unregulated free market reforms prevent economic development.


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Balance-of-Payments Considerations Agreement

  • Current account deficits in Turkey suggest that Turkish businesses may be losing the ability to compete because the YTL is too strong.

  • Current A. deficits increase the risk of a BOP crisis. CB may reduce interest rates for this purpose: expansionary policy.

  • Expansionary (contractionary) policy reduces (increases) interest rates and decreases (increases) value of TL.


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Balance-of-Payments Considerations Agreement

  • But expansionary policy increases risk of inflation for two reasons:

    • Prices of imported goods (tradables) increase (energy)

    • Since money supply increases, real value of money (in terms of goods and services) decreases.


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Advantages of AgreementExchange-Rate Targeting

  • Crawling Peg Policy applied in Turkey 1999-2001 as a method to bring inflationunder control. Internationally tradable goods’ prices are anchored to the world prices, rate of inflation fell.

  • We floated after the 2001 crisis.

  • Crawling Peg Policy keeps the ER in a pre-specified band. Ex: (1,50 YTL/$ ± 0,20 YTL/$) for a specific period. Allows lira to move within the band.


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Advantages of AgreementExchange-Rate Targeting

  • Automatic rule for conduct of monetary policy. Prevents temptation of short-run benefits of expansionary policy. (Ex: election economics). Reduces political pressure on the CB to expand money supply.


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Exchange-Rate Targeting Agreementfor Emerging Market Countries

  • Political and monetary institutions are weak. Not much to gain from independent mon. policy. But much to lose from irresponsible CBs and politicians (high inflation 1977-2003).

  • Helps tie the hands of the govt. from conducting expansionary policies.

  • BUT!!! Costs of a currency crisis much more than these benefits.


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Disadvantages of AgreementExchange-Rate Targeting

  • Moral Hazard: Banks take on too much exchange rate risk expecting the govt. to defend the peg. İncreases financial fragility.

  • Then economy becomes vulnerable to speculative attacks on currency. İnt. creditors suddenly sell lira assets, capital flight. Force the CB to devalue.

  • Loss of independent control of money supply. Cannot fix both ER and money supply. Cannot respond to domestic shocks.

  • Shocks to anchor country are transmitted to domestic country


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Currency Boards Agreement

  • Extreme case of fixed ER policy.

  • Domestic currency is backed 100% by a foreign currency

  • Note issuing authority establishes a fixed exchange rate and stands ready to exchange currency at this rate. (Ex: 1 YTL/$)

  • Money supply can expand only when CB’s dollar reserves increase. Decreases the possibility of a speculative attack-currency crisis.


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Currency Boards (cont’d) Agreement

  • Stronger commitment by central bank

  • Loss of independent monetary policy and increased exposure to shock from anchor country

  • Loss of ability to create money and act as lender of last resort

  • Applied in Argentina (1991-2002), Bulgaria (1997), Bosnia (1998), Hong Kong (1983), Estonia (1992), Lithuania (1994)


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Dollarization Agreement

  • Totally giving up domestic currency and adoption of another currency (dollar)

  • Ecuador dollarized in 2000.

  • Even stronger commitment mechanism

  • Completely avoids possibility of speculative attacks on domestic currency

  • Loss of independent monetary policy and increased exposure to shocks from anchor country (US)


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Dollarization (cont’d) Agreement

  • Inability to create money and act as lender of last resort

  • Loss of seignorage revenue earned from purchasing bonds with printed currency. $30bn per year for US.

  • Ex: “President Carlos Menem of Argentina has advocated replacing the Argentine peso with the dollar. Dollarization would benefit Argentina because it would eliminate the peso-dollar exchange-rate risk, lower interest rates, and stimulate economic growth” March 12, 1999by Steve H. Hanke and Kurt Schuler, ”A Dollarization Blueprint for Argentina”, CATO Foreign Policy Briefing No. 52


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