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POL 4410: Week 7

POL 4410: Week 7. International Finance. Structure. TUESDAY: 1) Test 2) Capital Flows and Exchange Rates THURSDAY 1) Currency Crises 2) Currency Unions 3) Multinational Corporations. International Capital. Capital flows are like any other factor ‘Returns’ to capital should equalize: Bonds

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POL 4410: Week 7

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  1. POL 4410: Week 7 • International Finance

  2. Structure • TUESDAY:1) Test2) Capital Flows and Exchange Rates • THURSDAY1) Currency Crises2) Currency Unions3) Multinational Corporations

  3. International Capital • Capital flows are like any other factor • ‘Returns’ to capital should equalize: • Bonds • Equities and Equity • Real Estate • Currency

  4. Bonds • Investment in foreign governments • Issued by a central bank • Price of bonds can vary after their issuing • Price is inversely related to ‘yield’ or interest rates • Arbitrage in bonds implies equalization of interest rates

  5. Private Equity • Invest directly in a foreign private company or investment scheme • Invest in foreign equities = public companies abroad • Portfolio finance • MNC internal investment?

  6. Real Estate • Owning foreign real estate means purchasing assets excluded from GDP • Might do this for a holiday home • Or as a rental property (income stream) • Or... for speculative reasons

  7. Currency: FOREX • Unlike other assets, currencies do not promise stream of returns. • Like equities and real estate there may be a speculative reason to purchase them. • Common practice to ‘long’ or ‘short’ currencies - which can undermine or overvalue them.

  8. Who does this? • International Banks • International Governments • Hedge Funds • Equity Funds • Private Investors

  9. Balance of Payments • Current Account is the gap between exports and imports. • Capital Account is the gap between purchases of foreign assets and foreign purchases of domestic assets. • US 1980s led to Japanese inward investment

  10. The Exchange Rate • If interest rates differ substantially from comparator states - lose capital inflows, lose value in your currency. • Balance of payments problems because of over-valued currency lead to currency attacks by speculators. • You lose currency strength because of weak capital inflows, or a run on the currency, or both.

  11. History of International Finance • International finances were originally just denominated in gold. Think of origins of balance of payments - gold specie model. • Now most currencies are floating and capital can move into a broad array of asset classes. Different types of BOP problems.

  12. International Monetary System • Footloose capital means exchange rate stability is tough to maintain - hence desire for currency unions. • International Monetary Fund supposed to act as a banker of last resort. • But hedge funds and currency speculators can trade rapidly in enormous volume.

  13. Mundell-Fleming Conditions • Only two of the following three:1) Fixed exchange rate2) Open capital markets3) Autonomous monetary policy • Why? Think through each

  14. Graph of M-F Dollars per Euro Undervalued $ Equilibrium Ex Rate Overvalued $ US $ return from holding Euros US Interest Rate Rate of Return

  15. Graph of MF (2) Dollars per Euro Old Ex Rate New Ex Rate US $ return from holding Euros Old US IR New US IR Rate of Return

  16. Graph of MF (3) Dollars per Euro New Ex Rate Old Ex Rate New US $ return from holding Euros Old US $ return from holding Euros US IR Rate of Return

  17. Currency Crises • If investors believe your currency is massively overvalued they start to move money abroad. • Eichengreen estimates loss of 0.7% of GDP per annum. • Problems: debt denominated in foreign currency. Move from spending more money than you earn to less.

  18. Banking Crises • Foreign investors panic that banking system is unsustainable (or that currency will collapse and take down banks). • Run on the banks leads to banks calling in loans. • Businesses cannot pay back loans - bankruptcies. • Lose 0.3% GDP per anunum

  19. Eichengreen: Causes • Unsustainable Macroeconomic Policies. Currency = too expansionary to maintain peg. Banking = bank takes bad public debt • Fragile Financial Systems: dependence on short term debt • Corporate and public sector governance • Flaws in international markets

  20. Benefits of Open Capital (Wolf) • Individual freedom to send money abroad • Import outside capital and expertise • Crises are not inevitable and rare in OECD • People circumvent controls • Forces transparent governance of finance

  21. Asian Financial Crisis • 1997 speculators short the Thai baht • Collapse of baht leads to ‘currency contagion’ • Banking sectors collapsed in Thailand, Malaysia, Korea, Philippines, Indonesia • IMF recommended raising interest rates to prevent currency collapse - hurt economies

  22. Causes of AFC • Attempt to peg currencies was not credible • IMF failed to bailout states properly plus poor advice • Banking sectors were cronyistic - lots of bad debts • Reliance on short-term debt led banks to make risky loans • Fear of FDI and long-run investment made systems volatile

  23. Solutions to Crises • Eichengreen:(1) Re-regulate financial markets(2) Re-impose capital controls(3) Create world currency(4) Create Emerging Markets index • Scrap IMF / Rebuild IMF • Tobin Tax • Democracy, transparency, growth

  24. Multinational Corporations • Big users of foreign currency. If they need to pay for 5,000,000 Euros they must swap dollars through bank or have own currency traders (Kodak). • Within own firm may trade in dollars but will need to pay local suppliers • Foreign Direct Investment: politically advantageous or not?

  25. The Product Cycle • Raymond Vernon • New labor-saving technology started in the USA because early innovation must be close to market. • Standardization of technology permits labor cost reduction by sending to cheaper OECD states. Also adapt for market. • Eventually LDCs take over

  26. Exchange Policies • Three main types of x-rate1) Fixed exchange rate2) Managed peg3) Full flexibility

  27. Fixed X-rate • Gold standard • Explicit fixed x-rate to dollar • Dollarization

  28. Flexible Peg • Bretton Woods system • European Monetary System • East Asian Tigers • China?

  29. Total Flexibility • Canada to United States • Dollar to Euro to Yen • How much flexibility can governments stand?

  30. Frieden on Mundell-Fleming • Capital mobility means that monetary and fiscal policy are synonymous with exchange rate policy. • Monetary expansion = currency devaluation • Fiscal expansion = currency appreciation • Think about US in 1980s

  31. Frieden (2) • Specific vs. mobile capital • Open capital markets favor mobile capital and harm specific capital in developed world. Thus sectors matter. • Open capital markets favor specific capital and harm mobile capital in developing world.

  32. Individual Preferences on Finance

  33. Frieden and USA • Frieden predicts that mobile capital in USA will be chief beneficiary and specific capital loses out in ACM world. • Decline of old ‘specific’ sectors like autos. Rise of finance. Finance now larger than manufacturing (27% vs. 25%) • Meanwhile, dollar is overvalued. Who benefits? Finance and real estate? Who loses? Exporters and manufacturers / farmers -> outsourcing. • Monetary policy is flexible. Beneficiaries: real estate and manufacturers / farmers. But how can it be so flexible and dollar remain overvalued?

  34. More on the USA • Current dollar is weaker than two years ago but still overvalued in terms of BOP. • How is this sustained? Huge capital account inflows. but why is capital flowing to a capital-rich state like USA? • Asian banks hold 1/2 US T-bills. Massive capital inflows keep interest rates down: boom in housing / rise in DJIA.

  35. Debt and the USA • Debt

  36. Broz • How do countries signal low inflation to international investotr? • Developed states increasingly use independent central banks. • But who would believe that such a bank is independent in an autocracy? • Autocracies must peg currency instead.

  37. Broz (2) • Pegging and central banks are substitute methods of ensuring transparency to international investors. • But central banks only work in transparent political system. • This means democracies should have more macroeconomic flexibility in an ACM world than autocracies.

  38. Broz (3)

  39. Broz (4)

  40. Broz (5)

  41. Broz (6)

  42. Eichengreen and EMU • EMU emerged from Werner report 1970, which had advocated fully fixed x-rates and coordinated fiscal policies. Led to Snake then ERM. • 1986 Single European Act: Delors report. Remove capital controls, single central bank, no fiscal harmonization. • 1990 Maastricht treaty signed. Capital mobility then coordinated monetary policy, then fixed x-rates, then single currency.

  43. EMU • 1998 currencies fixed to one another. • Euro existed non-physically from Jan 1 1999. • Currencies changed over to Euro Jan 1. 2002 • European Central Bank, based in Frankfurt, is sole setter of monetary policy. 6 seats. • Stability and Growth Pact • Real exchange rates still exist. how?

  44. Who is a member?

  45. Concerns with EMU • Rationale was transactions costs (0.4% of GDP) and exchange rate risk (but already high stability). Maybe SEA undermined ERM. This leads to political economy explanation. • Why can all countries not just fix x-rates? Escape clause problem. • Concern about asymmetric shocks. Is US economy better integrated than Europe? Interest rate adjustment vs. mobility adjustment. • Fiscal autonomy and specificity. Fiscal coinsurance. Fiscal coordination: spillover effects?

  46. EMU Expansion • Eichengreen and Ghironi examine impact of Central and East European entrants on EMU • Concern is about convergence of growth rates. Likely a function of institutional reform. • Concern about banking crises in CEEs • Should loosen Stability and Growth Pact • Migration could help adjustment but will be low • Voting rights in ECB.

  47. Next Week • Development. • Begin at the international level - World Bank and IMF • International Inequality • Week after: development strategies at the domestic level

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