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International Finance FINA 5331 Lecture 7: Crises Read: Chapters 2 Aaron Smallwood Ph.D. PowerPoint Presentation
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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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International Finance

FINA 5331

Lecture 7:

Crises

Read: Chapters 2

Aaron Smallwood Ph.D.

benefits of pegging your currency
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.
  • Likely provides an anchor for future inflation.
drawbacks
Drawbacks
  • Loss of monetary policy independence
  • Loss of the exchange rate as an automatic adjustment mechanism following economic shocks.
  • Potential for major currency crises, especially if the trillema is violated.
trillema
Trillema
  • The trillema, also known as the “impossible trinity” states that a country can ONLY have TWO of the following three:
    • Fixed exchange rate system
    • Free flow of capital
    • Independent monetary policy.
integration in europe
Integration in Europe

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.

  • ESCS leads to EEC, which leads to EC, which leads to the EU.

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.

the eu and the emu
The EU and the EMU.

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

  • EU Countries
    • EU countries who are not in the ERMII and have no intention of adopting the euro
    • EU Countries that will adopt
    • ERM II countr(y)ies that have no stated intentions of adopting the euro
    • ERM II countries that will adopt
    • EMU Countries
euro area
Euro Area

Austria Denmark

Belgium Latvia

Cyprus Lithuania

Estonia

Finland

France

Germany

Greece Bulgaria

Ireland Czech Republic

Italy Hungary

Luxembourg Poland

Malta Romania

Netherlands

Portugal Sweden

Slovenia UK

Spain

Slovakia

EU

eu countries that are not part of the ermii
EU countries that are not part of the ERMII

EU countries that will eventually adopt (or plan to):

  • Bulgaria
  • Czech Republic
  • Hungary
  • Poland
  • Romania

EU countries (not part of ERMII) with no stated intention of adopting the euro

  • Sweden
  • UK
erm ii countries
ERM II Countries

That will adopt:

  • Latvia
  • Lithuania

The have no stated intentions of adopting

  • Denmark
emu countries
EMU Countries
  • Austria (in 1999) - Netherlands (in 1999)

- Portugal (in 1999)

  • Belgium (in 1999) - Slovenia (in 2007)
  • Cyprus (in 2008) - Slovakia (in 2009)
  • Estonia (in 2011) - Spain (in 1999)
  • Finland (in 1999)
  • France (in 1999)
  • Germany (in 1999)
  • Greece (in 2000)
  • Ireland (in 1999)
  • Italy (in 1999)
  • Luxembourg (in 1999)
  • Malta (in 2008)
is the emu an oca
Is the EMU an OCA?

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:

  • Countries should be relatively buffered from asymmetric shocks
  • Factors of production should be mobile
policy matters public policymakers
Policy Matters - Public Policymakers

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

policy matters public policymakers1
Policy Matters - Public Policymakers

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.

policy matters public policymakers2
Policy Matters - Public Policymakers

The euro changes some basic aspects of international financial management.

To obtain diversification benefits, the investor must turn to other markets.

more generally the choice of an exchange rate system policy matters private enterprises
More generally, the choice of an exchange rate system: Policy Matters - Private Enterprises

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.

debt crisis
Debt crisis
  • On April 27 ,2010, Greece sovereign debt is downgraded to “junk” status by Standard & Poors. Facing a strong probability of default, the EMU and IMF approve a €110 billion rescue package for Greece on May 2, 2010.
  • In May 2010, the European Financial Stability Facilty is formed. In conjunction with the IMF, up to €750 billion is available for countries potentially facing a crisis.
  • In Ireland, the Anglo-Irish Bank is effectively nationalized in December 2008. On November 21, 2010, Ireland reaches an agreement for a bailout. On March 30, 2011, Ireland announces that it will need an additional €24 billion from the IMF and EFSF to aid ailing banks. The total bailout for Ireland has reached €70 billion.
  • The Portuguese government released figures on March 30, 2011, indicating that the deficit had reached 8.6% of GDP.
  • On April 6, 2011, the Portuguese government asks the EMU for a bailout.
major currency crises
Major currency crises

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)

Contagion

Argentina (2001-02)

Failure to use fiscal restraint and inflexibility in labor markets led to the collapse in this board system.

overvalued undervalued
Overvalued/Undervalued?

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:

real exchange rate
Real Exchange Rate

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.

real exchange rate1
Real Exchange rate

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

the asian currency crisis
The Asian currency crisis

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%.

asian currency preview the causes
Asian currency preview: The causes

Liberalization of capital markets in a weak domestic financial environment.

Crony capitalism

Surge in risky real estate investment

Maturity mismatch

Secondary cause: Over-valued real exchange rates.