Global Finance: National Finances and currency

1. Global Finance: National Finances and currency March 20, 2013

2. Money and global trade • Given that global trade is organized along market lines, transactions are often (though not exclusively) carried out by means of monetary transactions. • Money is a medium of exchange and store of value that is accepted for the payment of any goods and services or the settling of debts. • Currency refers to a system of money used by a nation (or a group of nations).

3. Nations and money • As implied above, while there are currencies that are shared by different countries (most notably the Euro, shared by European countries in the Euro zone), there is no single world currency, even though there are world financial institutions and a type of world currency . • National currencies are generally good only within the country that issues it, and conversely, it is usually the case that only a nation’s currency is accepted within its borders.

4. Money • Currently a nation creates a currency that is backed not by the intrinsic value of the currency, but by the economic strength and political will of a national government. Money is generally in the form of paper or base metals • Traditionally, currencies were created by minting precious metals into coins (though other items, such as shells in ancient China, were used). While coins would have a relatively fixed political value within a country (enforced by government institutions), in fact their true value was that of the amount of precious metals they contained • These metals were gold and silver for larger denominations, and copper and bronze for smaller, domestic use. In China, copper cash, and taels(liǎng) of silver were used. • Gold and silver were also used in trade in the form of bullion, i.e., refined and smelted but uncoined metals.

5. Money and international trade • This means that international trade often entails currency exchanges in which one form of currency is converted into another by buying and selling. Such exchanges also take place outside the contexts of other trades, in that currencies can be traded like commodities and, on the world commodity market, have floating values determined by supply and demand. Supply and demand itself affected by a complex environment that includes the strength of the issuing nation’s economy its stability, and the relative desirability and overall strength of other currencies. • A currency that is low in value makes imports expensive and exports cheaper. So it might be advantageous for a country to make its currency cheaper (devalue it) by, for example, selling lots of it on the international market in exchange for other currencies. Conversely, a country may need to strengthen its currency because of the activities of speculators and buy lots of it on the world market in exchange for other currencies.

6. Convertibility • Nations may have currencies that are not convertible to other currencies because they are not seen as good, stable holders of value. This is true for countries that have unsustainable debts or trade deficits, or are experiencing hyperinflation– extremely high, uncontrolled inflation. This makes international trade difficult, as they must attempt to trade commodities for foreign currency or engage in other types bartering arrangements. • Convertible currencies are currencies that can be exchanged for other currencies. • Hard currencies are those that are most readily convertible into other currencies because they have the reputation for being good and stable holders of value, such that nations or corporations would want their assets denominated in such currencies.

7. Currency markets • Just as there are commodity in various cities throughout the world, there are also several major currency markets located in New York, London, Zurich, Tokyo and Hong Kong. It is the buying and selling on these markets that generally sets the international values of currencies. • Both governments and private investors operate on these markets. Governments do so to try to control the value of their currency, intervening when it becomes too cheap or too costly. Such interventions often require multi-lateral cooperation, as one nation alone generally does not have enough of its own denomination or sufficient foreign currency to make an impact on the market. • Private investors speculate in currencies, buying and selling them in the hopes of making a profit as the values of currencies relative to one another fluctuate in both the short and long term.

8. Foreign reserves • In order to have the means for dealing with emergencies or to intervene on the world currency markets, nations often have reserves that are not denominated in their own currencies. • These reserves most often take the form of hard currencies (generally dollars and Euros), but can also take the form of gold reserves.

9. Fixed exchange rates • Apart from the market for currencies, nations also sometimes attempt to set a fixed exchange rate for their currency. These are official rates of exchanges enforced by governments in territories they control. A nation can also refuse to make exchanges for its currency at rates other than that which they officially set, but buyers do not have to take the bargain. • The result may be difficulties in convertibility, leading to problems of managing international trade and the rise of black markets in that currency.

10. Fixed exchange rates • Another way in which nations may attempt to fix exchange rates is to tie the value of their currency to the value of another (usually stronger) currency. This is often the result of an attempt to combat inflation internally and to strengthen a weakened currency. • The problem is that this move a) removes sovereign control over a currency, as it has to keep step with the foreign currency, b) assumes that the two countries have the same monetary needs growing out of similar economic trends, which is not always the case, and c) if the currency country A ties its currency to is stronger, this can hurt currency A’s exports.

11. Currency stability • Both states and corporations in general have a shared interest in stable currencies. Stability allows both to plan expenditures and for states, to plan trade policies. Thus states, for the most part, cooperate with one another to prevent large swings in the worth of convertible currencies on the world market. • But there are circumstances which work against stability. Adverse economic reactions or political developments may lead to large devaluations of a currency that cannot be overcome. Speculators may predict the movements of states seeking to stabilize a currency and make the intervention costly. • It is also the case that nations can free ride on the stability of other countries, manipulating the value of their currency by keeping it artificially low, or make it rise and fall quickly to gain short term advantages.

12. stability • Generally speaking, stability in the world currency system is enforced by a relatively small group of nations, generally those that possess hard currency and posses the larges shares of global wealth. • In the past, this group was comprised of the G7 (later G8), a formal group consisting of the US, UK, France, Germany, Italy, Canada, and Japan, who negotiated to find a common ground in terms of financial and currency stability. • This group is now part of a larger group, the G20, consisting of representatives from the G7 countries (with France and Germany represented by a EU representative), plus South Africa, Indonesia, South Korea, Mexico, Brazil, Argentina, PRC, India, Russia, Turkey, Saudi Arabia and Australia, plus the other members of the EU, represented by an EU representative.

13. Control of currency • A nation may vest control of its currency in its general political leaders. This allows for the coordination of monetary policy with political and other aspects of economic policy. • However, such control also can lead to short term currency policies that may be harmful to the nation in the long run, as well as policies that are derived from attempts to implement partisan views or to gain partisan advantage (e.g., loose monetary policies before an election). • Thus, many countries vest this responsibility with a central bank, which is run by appointed officials who are experts in economic and monetary policy. • In the US, this bank is the Federal Reserve, which is run by a director jointly with a board comprised of directors of regional branches of the reserve.

14. monetary policy • Monetary policy is generally concerned with the amount of currency that is available and the value of that money. • These are set in several ways: • Intervention on the international market to set exchange rates– buying or selling currency using other hard currencies • The printing of actual currency

15. Monetary policy • The setting of the discount rate: this is the rate of interest the central bank charges commercial banks to borrow money. Commercial banks then lend out this money on the fractional reserve system: banks only have to have on hand a fraction of the money that is deposited with them, thus being able to lend out several times the amount of currency they actually have on hand. • The lower the discount rate, the more money banks will borrow, the lower the rates they can charge their borrowers, and the more money will be in the system (loose monetary policy). This encourages borrowing and spending, but could set inflation in motion. • The higher the discount rate, the less banks will borrow, the higher the rates they will charge and the less money will be in the system (tight economic policy). This policy will combat inflation, but risks depressing economic activity too much and creating a recession.

16. Monetary policy • It is also the case that if interest rates are high in a country, all other things being equal, international capital will tend to flow there, and vice-versa: if rates are low, international capital will tend to go elsewhere. • But it is also the case that other factors are in play. Interest rates may be high because of domestic instability, in which case those who control capital may think the risk is too high. • And it could be that while interests rates in a country are low, international capital may go there anyway because the risks and problems of other locations make alternatives unattractive.

17. World bank and imf • International institutions meant to overcome the problems of creating a stable world monetary system. • As with the UN and its associated organizations, the World Bank and IMF were created in response to the Depression and World War II in the belief that only international cooperation on a permanent basis and an institutional form could solve the problems that arose due to national responses to economic crises and the failure of countries to cooperate consistently. • At an important conference at Bretton Woods in 1944, the World Bank was created to provide reconstruction loans for European countries. It later became the source of economic development loans for newly industrializing countries.

18. IMF • Bretton Woods also created the International Monetary Fund (IMF) as a coordinator of international currency exchange, the balance of international payments and national accounts, including acting as a lender of last resort of hard currency liquidity. • Originally created an international currency exchange system based on gold and the US dollar. The dollar was pegged permanent at a weight of gold, with other currencies exchangeable for the dollar at their own fixed rates that were set periodically by the IMF Board of Governors. Countries were tasked with maintaining these rates on the international markets, intervening to raise or lower the world price if it fell or rose more than 1%. This system lasted until 1971.

19. imf • The system changed in 1971 because Nixon unilaterally took the dollar off the good standard because it was overvalued at the permanent IMF exchange rate. Nixon allowed the dollar to float, which led to its devaluation and thus allowing the US to regain competitiveness on the world export market. But this hurt other highly industrialized countries. • New system: • Creation of a world currency, SDR (Special Drawing Rights), that can be held by central banks alone. • Value of SDR’s governed by the value of a basket of international currencies • US dollar pegged to the SDR at a fixed rate, thus continuing to make it the global reserve currency for entities other than central banks, and alongside SDR’s for central banks.

20. New imf system • Member nations are to deposit hard currency reserves with the bank on the basis of an assigned quota. • Such countries can then borrow against those deposits to help stabilize their currencies in times of crisis. • The IMF itself can also use these reserves to intervene in global crises. But whether it does in any particular instance is a matter for the member nations to decide, with each country receiving a number of votes proportional to its quota of deposits. This means that the IMF is generally controlled by the wealthy, industrialized Western nations, with the US having the largest vote share, controlling 17 percent of the votes.