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International Finance FINA 5331 Lecture 7: Crises Read: Chapters 2 Aaron Smallwood Ph.D. Benefits of pegging your currency. Exchange rates are stable Could possibly benefit trade If pegged to a country with stable inflation, we may be able to import stable inflation.
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Read: Chapters 2
Aaron Smallwood Ph.D.
Integration in Europe begins with the ECSC in 1951. With the Treaty of Rome, the ECSC becomes the EEC, which eventually becomes the EC and then the EU in 1994.
Monetary integration is formalized with the establishment of the EMS where exchange rates are fixed. The mechanism by which exchange rates are fixes is known as the exchange rate mechanism. The EMS leads to European Monetary Union. The 17 countries that use the euro are part of a currency union known as the EMU. Monetary policy for the entire EMU is overseen by the European Central Bank in Frankfurt.
Today, there are 27 EU countries. The European Union is a political and economic union based on free trade. NOT ALL countries use the euro.
There are several distinct groups
Ireland Czech Republic
EU countries that will eventually adopt (or plan to):
EU countries (not part of ERMII) with no stated intention of adopting the euro
That will adopt:
The have no stated intentions of adopting
- Portugal (in 1999)
OCA optimum currency area: The best geographic region where one currency is used within the region, and where outside the region, different currency(ies) are used.
It is generally accepted that within an OCA:
Many were skeptical about EMU.
The European Union is not an ideal candidate for a currency union because within the union, labor is immobile, business cycles are weakly correlated, and fiscal transfers are limited.
Others focused on the advantages and dynamic gains likely under EMU:
lower transaction costs and exchange rate risk, and greater capital mobility and depth of financial markets across Europe
Some Specific Concerns about the EMU
The lack of national exchange rate policy under EMU can be a source of tension if national growth rates are not sufficiently correlated.
Ireland found it helpful to make a small adjustment to the Irish punt’s central rate in 1998.
The euro can challenge the dominant role played by the U.S. dollar over the last 50 years.
Liquidity in the US$ market may be affected.
The euro changes some basic aspects of international financial management.
To obtain diversification benefits, the investor must turn to other markets.
The government’s choice of monetary system affects the decisions that firms face.
There is greater exchange rate variability under floating.
Nominal exchange rate variability
raises the importance of the choice of currency of denomination for cash flows and financial assets
increases the demand for financial instruments that can be used to hedge or offset currency risks.
EMS crises of 1992-93.
Following German re-unification contractionary monetary policy caused the currencies of German trading partners to become overvalued.
Mexican peso crisis 1994-95.
An overvalued exchange rate, policy mistakes, and political turmoil led to collapse of the peso, a severe recession and inflation before an IMF and US led bailout.
Asian currency crisis (1997-98)
Failure to use fiscal restraint and inflexibility in labor markets led to the collapse in this board system.
How would we know if a currency was overvalued or undervalued?
Most economists use “real exchange rates”.
According to the law of the one price:
The real exchange rate is defined as:
Take Mexico as an example: Suppose St is relatively stable but, PtMexincreases much more rapidly than PtUS. The result, Rt increases. The Mexican peso appreciates in real terms.
If a country’s real exchange rate rises, some combination of the following three are occurring:
The nominal exchange rate is appreciating
Domestic prices are rising rapidly
Foreign prices are falling.
ALL THREE LIKELY LEAD TO A DECLINE IN THE DEMAND FOR EXPORTS
On July 2, 1997, Thai Baht is devalued.
July 11 Philippines devalues the peso
July 14: Malaysia floats the ringgit
July 17: Singapore devalues
August 14: Thailand moves to a float
October 14: Taiwan devalues
November 14: Korea floats
August 17, 1998: Russia abandons its peg
Hong Kong: At one point, Hong Kong monetary authority raises rates to 500%.
Liberalization of capital markets in a weak domestic financial environment.
Surge in risky real estate investment
Secondary cause: Over-valued real exchange rates.