International Monetary System

1. International Monetary System Chapter 2 International Financial Mgmt Eun, et.al. 3460.03 notes: A.P. Palasvirta, PhD

2. Off the Gold standard • When CBs execute a monetary policy • discipline of the gold standard is gone • after WWII governments ran inflationary policies • interest rate policies • employment policies • inflation sometimes running at 200% or more • Exchange rates fluctuate • creating uncertainty for trade 3460.03 int'l money notes a.p. palasvirta, ph.d.

3. Existing Currency Regimes • Dollarization • Currency boards • http://users.erols.com/kurrency/ • Managed exchange rate • Pegged • Banded peg • Crawling peg • Floating exchange rate • Currency unification 3460.03 int'l money notes a.p. palasvirta, ph.d.

4. Markets and/or individuals in a country use a foreign currency without formal government approval Individuals wealth denominated in foreign currency Notes, bonds, bank deposits in domestic or foreign banks Protect against domestic inflation Markets accept or prefer the use of a foreign currency Grey and black markets Foreigners hold from 55 to 70% of the U.S. Dollars currently in circulation U.S. Dollar, Euro, and Yen are the primary currencies held Unofficial dollarization 3460.03 int'l money notes a.p. palasvirta, ph.d.

5. Government adopts a foreign currency as a predominant or exclusive legal tender Panama, Ecuador No currency board, no central bank Benefits Dollar inflation Low interest rates No exchange rate risk (transaction, translation, & operating exposure) Loss of sovereignty No independent monetary policy Loses the power of seignorage http://users.erols.com/kurrency/basicsup.htm Official dollarization 3460.03 int'l money notes a.p. palasvirta, ph.d.

6. Currency board issues notes & coin convertible into foreign currency at a fixed exchange rate on demand 100% to 110% in foreign reserves General t-bills denominated in the foreign currency Has no discretionary power Inflation and interest rates are approximately in line with the foreign currency Cannot be a lender of last resort http://users.erols.com/kurrency/intro.htm Currency Boards 3460.03 int'l money notes a.p. palasvirta, ph.d.

7. Currency Board • Gold, silver • Foreign exchange • U.S. dollar assets (T-bills) • Domestic coinage and cash • Commercial Bank deposits Liabilities Assets 3460.03 int'l money notes a.p. palasvirta, ph.d.

8. Central Banks • Create money • Mandate reserve ratios • Mandate capital ratios • Control bank rate • Operate in t-bill market • Operate in exchange markets • Bank of Canada Report 3460.03 int'l money notes a.p. palasvirta, ph.d.

9. Managed exchange rates (fixed) • Advantages • No exchange rate risk (transaction, operating and translation exposure is zero) • Maintain artificially low prices for one’s products • Disadvantages • Lack of monetary policy independence • Imbalances in international financial markets continue and grow • Eventually sudden large adjustments in exchange rates 3460.03 int'l money notes a.p. palasvirta, ph.d.

10. Types of managed exchange rates regimes • Pegged • A fixed peg maintained by the central bank • Banded peg • Central bank intervenes if the exchange rate increases or decreases by more than a given percentage • Crawling peg • Central bank fixes to an exchange rate, but changes the fixed value it defends periodically • China 3460.03 int'l money notes a.p. palasvirta, ph.d.

11. Crawling peg example • China (Yuan) • CB of China will supply enough Yuan to satisfy the demand for the Yuan due to Balance of Payments surplus • Causes money supply to increase (inflationary pressure) • CB of China is moving to a managed float • Will allow the Yuan to appreciate but is not announcing how or when it is allowing the Yuan to appreciate 3460.03 int'l money notes a.p. palasvirta, ph.d.

12. The impact of a devaluation • Brazilian Stock market take a hit • Government borrowing in dollars • have to pay back in higher valued currency • often leading to re-negotiation of terms • operating exposure • (change in real exchange rate) • on exporters • on importers 3460.03 int'l money notes a.p. palasvirta, ph.d.

13. Central bank targets? • Inflation targets • Bank tries to increase supply of money just enough to accommodate demand • Assume demand increases by 5% per year • If bank is targeting 2 – 3 % inflation rate, supply will be increased by about 8% • Interest rate targets • Low interest rates tend to increase capital investment • Keep growth in the economy positive • Exchange rate targets • Fixing exchange rates reduces transaction risk and keeps international prices in one’s favor 3460.03 int'l money notes a.p. palasvirta, ph.d.

14. Bank of Canada • Floating exchange rate regime • Does not try to affect trend • To affect trend it would have to either buy or sell foreign exchange in large quantities • Bank’s policy is directed at an inflation target • 2 – 3% inflation per year • Will jump into the market to affect volatility • Over the year this means that the net sales and purchase of foreign exchange is approximately zero • http://www.bankofcanada.ca/en/annual/2007/ar2007.html 3460.03 int'l money notes a.p. palasvirta, ph.d.

15. Central Bank policy objectives • Control money • Open market operations • Bank rate • Manage banking system • Reduce liquidity risk • Reserve ratios • Deposit insurance • Reduce default risk • Capital ratios • Lender of last resort • Bank of Canada balance sheet 3460.03 int'l money notes a.p. palasvirta, ph.d.

16. Create money • Central banks order coin and currency which is stored in the vault • Money is created when the central bank buys something with that coin and currency • Gold and silver • Foreign exchange • Foreign denominated cash and currency • Foreign denominated t-bills • Domestically denominated t-bills • Keeps purchases sufficiently high to meet inflation targets 3460.03 int'l money notes a.p. palasvirta, ph.d.

17. Market operations • Central bank has large influence in two markets • Domestic t-bill market (largest single entity) • Exchange market (largest single entity in domestic currency in exchange markets) • As a large entity it, unlike other operators in the market, can affect price 3460.03 int'l money notes a.p. palasvirta, ph.d.

18. Determines the bank rate • Bank rate • Interest rate charged member banks for borrowing to increase reserves • Increase the bank rate decreases system reserves thereby leading to a decrease in the money supply • Decrease the bank rate increases system reserves thereby leading to an increase in the money supply 3460.03 int'l money notes a.p. palasvirta, ph.d.

19. Mandate reserve ratios • Commercial banks required to maintain liquid reserves to meet demand of deposit holders demanding redemption • Inverse of reserve ratio is called the money multiplier • How much bank money, base money will support 3460.03 int'l money notes a.p. palasvirta, ph.d.

20. Chartered Bank T-account Reserves Cash Currency Deposits with CB cd t-bills Checking Accounts Savings Accounts Loan Portfolio Lines of Credit Car loans Business Loans Home and Business Mortgages GICs Bank Capital 3460.03 int'l money notes a.p. palasvirta, ph.d.

21. Commercial bank T-account • Reserve Ratio = 10% • Money multiplier = 10 Reserves = $1 billion Loan Portfolio = $9 billion Checking deposits Savings Deposits $9.6 billion GICs Bank capital = 400 million 3460.03 int'l money notes a.p. palasvirta, ph.d.

22. Commercial bank T-account • Reserve Ratio = 20%, • Money multiplier = 5 Checking deposits Savings Deposits $4.8 billion GICs Bank capital = 200 million Reserves = $1 billion Loan Portfolio = $4 billion 3460.03 int'l money notes a.p. palasvirta, ph.d.

23. Mandates Bank Capital Ratios • Leverage • Measured by the debt/equity ratio or debt ratio • Measure of risk • Manufacturing firms usually D/E = 1 or D/TA = 0.5 • Banks D/E = .96/.04 = 24 or D/TA = 0.96 • The liabilities (deposits) in a bank are guaranteed (insured) by the government • Banks can lever quite a bit because of this • CIBC balance sheet 3460.03 int'l money notes a.p. palasvirta, ph.d.

24. Floating exchange rates • Advantages • Purchasing power parity allowed to hold • Trend line reflects relative inflation • International prices adjust automatically • Prices more transparent • Allows an independent monetary policy • Disadvantages • Exchange rate volatility increases • Higher costs due to need to hedge volatility 3460.03 int'l money notes a.p. palasvirta, ph.d.

25. Bank of Canada (floating exchange rate) Gold, foreign exchange T-bills 70 – 80% Cash, currency Commercial bank reserves held at BOC Liabilities Assets 3460.03 int'l money notes a.p. palasvirta, ph.d.

26. Euro-Zone (Currency Unification) • Independent European Central Bank • convergence criteria • nominal inflation < 1.5% above • avg of 3 with lowest in previous year • long-term interest < 2.0 % above • avg of 3 with lowest in previous year • fiscal deficit no more than 3 % of GDP • debt no more than 60% of GDP 3460.03 int'l money notes a.p. palasvirta, ph.d.

27. Currency unification • Advantages • One monetary policy • No exchange rate risk • Costs of trade much lower • Financial market integration (money & capital) • Disadvantages • Loss of sovereignty on monetary/fiscal policy • Loss of national currency 3460.03 int'l money notes a.p. palasvirta, ph.d.

28. Countries in the Euro • Belgium (franc) • Germany (deutschemark) • Spain (peseta) • France (franc) • Ireland (punt) • Luxembourg (franc) • Italy (lira) • Netherlands (guilder) • Austrian (shilling) • Portugal (escudo) • Finland (markka) • Vatican City (lira) • Greece (drachma) • Slovenia (tolar) 3460.03 int'l money notes a.p. palasvirta, ph.d.

29. EU Countries not in Euro zone • Bulgaria (Lev) • Czech Republic (Koruna) • Denmark (krone) • Estonia (Kroon) • Hungary (Forint) • Latvia (Lats) • Lithuania (Litas) • Poland (Zloty) • Romania (Leu) • Slovakia (Koruna) • Sweden (krona) • United Kingdom (pound) 3460.03 int'l money notes a.p. palasvirta, ph.d.

30. The Spot Exchange rate • Price for current delivery • Price of one currency in terms of another • Delivery no later than four business days • Price market determined • fluctuates to reflect new information 3460.03 int'l money notes a.p. palasvirta, ph.d.

31. Equilibrium Spot Rate • Current demand for CD by holders of foreign currency • foreigners want to buy something Canadian • Current supply from Canadians holding CD demanding foreign exchange • Canadians want to buy something foreign 3460.03 int'l money notes a.p. palasvirta, ph.d.

32. Spot rate • e0 , Can terms = CD/USD = 1.0004 • CD cost of the USD • e0 , us terms = USD/CD = 0.9996 • USD cost of the CD • exchange rates 3460.03 int'l money notes a.p. palasvirta, ph.d.

33. Candidate countries for the EU • Croatia • Macedonia • Turkey 3460.03 int'l money notes a.p. palasvirta, ph.d.

34. Eurocurrencies • Deposits held in other than the domestic currency • A usd account at a Chartered Bank is a eurocurrency deposit • Off-balance-sheet account • Chartered bank would hold a liability to the depositor which is matched equally by an asset which is a deposit to an U.S. bank for the same amount 3460.03 int'l money notes a.p. palasvirta, ph.d.

35. LIBOR London Interbank Order Rate • Eurocurrency interest rates • PIBOR (Paris), MIBOR (Madrid), SIBOR (Singapore) • Off-balance-sheet lending in currencies other than home currency • Wholesale market • Between multinationals • Large banks • Central banks • Narrow spread • Low risk • Large amounts ($500,000) or more 3460.03 int'l money notes a.p. palasvirta, ph.d.