Download P t US

International Finance
FINA 5331
Lecture 3:
Exchange rate regimes
Read: Chapters 2
Aaron Smallwood Ph.D.
Classifications
• There are various classifications as it can
be difficult to determine what countries are
actually doing (de-facto) as compared to
what the claim they do (de-jure).
• The IMF provides an annual classification
of different exchange rate systems. The
most recent classification can be found at:
https://www.imf.org/external/pubs/nft/2013/areaers/ar2013.pdf
IMF Classification of Exchange Rate Regimes
Categories were recently changed:
• No separate legal tender
• Currency board
• Conventional pegs
• Stabilized arrangement
• Crawling peg
• Crawl-like arrangements
• Horizontal band
• Other managed arrangements
• Floating
• Free floating
Free Floating
• Intervention occurs only “exceptionally”
with the aim being to calm markets.
According to the IMF, intervention must be
limited to 3 times in the previous 6 months,
with each intervention lasting fewer than 3
days.
• Example: United States
Floating
• Exchange rates are largely market
determined without obvious policy
interference. Intervention can be direct or
indirect, but only serves to “moderate the
rate of change and prevent undue
fluctuations in the exchange rate.”
• Examples: Brazil, India, Thailand
Managed arrangements
• A residual category, which captures
countries that cannot be placed into
others. Countries in this category are
typically characterized by frequent
changes in policy.
• Examples: Iran, Myanmar, Syria,
Switzerland
Exchange rates within horizontal bands
• The domestic currency is pegged to
another currency or group of currencies.
The exchange rate is maintained within
bands that are wider than +/-1% of the
established target:
• Example: While ERMII countries could fall
into this category, they choose not to. The
only country that falls into this category is
Tonga.
Crawl-like arrangements
• The exchange rate must remain in a
narrow band of 2% relative to a
“statistically identified trend” for at least 6
months. The annualized rate of change in
the exchange must be at least 1%.
• Most prominent example: China.
Yuan-Dollar
Currency issues
• In June 2010, the RMB price of the dollar was 6.8322.
On March 12, 2013, the price had dropped to 6.1258.
• Represents a 11.53% appreciation of the yuan.
• In a recent interview, Huo Jianguo, President of the
Chinese Academy of International Trade and Economic
Cooperation stated:
• “Hot money is flowing into China, and that
will push up the yuan exchange rate.”
Effects???
• Exporters that accept payment in currencies like
the dollar are seeing profits eroded.
• – In competitive industries, like apparel, it can be
very difficult to pass costs on to customers.
• – Says, Donald Lee of Esquel Group:
•
“The appreciation in the value of the yuan will have a big impact on our
business. Most of our customers are invoiced in dollars, yet a very large
percentage of our cost structure is in renminbi. In our industry, we are
facing a situation of excess global capacity and, as a result, a very high
level of competition. Therefore, we cannot simply pass on the increase
in our costs caused by the revaluation to our customers. Instead, we
will need to address this cost increase in other ways.”
Recent developments
• In April, 2012, the PBOC announced that it
would widen the trading bands within
which the RMB was allowed to fluctuate
each day from +/-0.50% to +/-1.00%.
• It is very widely expected that China will
announce another widening this year with
the ultimate aim of making the yuan more
market determined and ultimately an
international reserve currency.
How do we avoid risk?
• According to an article in China Daily, “In order to
minimize currency exchange losses, suppliers are also
trying out financial instruments, such as Chinese yuanNDF contracts. By fixing the desired exchange rate, a
NDF contract allows you to hedge against risk of
exchange rate fluctuations.”
The article goes on to say:
“ ‘Using financial instruments requires significant capital’,
said Chen Cunman, a power equipment salesman in
Suzhou…`The most effective method to minimize
currency loses is yuan settlement.’ ”
Crawling pegs
• The domestic currency is pegged to
another currency or basket of currencies
at an established target rate, that is either
publicly announced or made available to
the IMF. The target rate is periodically
adjusted, perhaps in response to changing
economic indicators.
Example: Nicaragua
Stabilized arrangement
• An arrangement where the spot rate
remains within a margin of 2% for 6
months or more.
• There can be a small number of specified
outliers.
• There is no actual policy commitment.
– Example: Vietnam
Conventional pegs
• The country pegs its currency at a fixed
rate to another currency (or group of
currencies). The currency cannot fluctuate
by more than 1% relative to the
established target:
• Example: Saudi Arabia, formerly China
Saudi’s currency
Currency boards
• Currency board countries are sometimes called
“hard peggers”. Example: Hong Kong….
• The currency board is a separate government
institution whose only responsibility is to buy and
sell foreign currency at an established price. The
country will typically maintain foreign currency
reserves equivalent to 100% of the total amount
of outstanding domestic money and credit.
No separate legal tender
• The country uses another country’s (or
group of countries’) currency as its own:
• Example: Ecuador (US dollar)
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
• 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
• 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 begins with the ECSC in 1951. With the
Treaty of Rome, the ECSC, EUROTOM, and the EEC are
formed, which eventually are absorbed into 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 fixed is known as the exchange
rate mechanism. The EMS leads to European Monetary
Union. The 18 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.
• Today, there are 28 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
EU countries that are not part of the
ERMII
• EU countries that will eventually adopt (or
plan to):
–
–
–
–
–
–
Bulgaria
Croatia
Czech Republic
Hungary
Poland
Romania
• EU countries (not part of ERMII) with no
stated intention of adopting the euro
– Sweden
– UK
ERM II Countries
• That will adopt:
• Lithuania
• The have no stated intentions of adopting
• Denmark
EMU countries
Austria (1999)
Belgium (1999)
Cyprus (2008)
Estonia (2011)
Finland (1999)
France (1999)
Germany (1999)
Greece (2000)
Ireland (1999)
Italy (1999)
Latvia (2014)
Luxembourg (1999)
Malta (2008)
Netherlands (1999)
Portugal (1999)
Slovak Republic (2009)
Slovenia (2007)
Spain (1999)
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
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 Facility 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.
Debt crisis continued (2011)
• July 2: A compromise is reached so that an installment of the €110
billion to Greece can be made. European leaders call on private
bondholders to contribute to the bailout.
• July 21: A new bailout is approved for Greece. Originally valued at
€109 billion, the total has recently increased to €130 billion.
• August 7: The ECB begins to actively intervene to aid bond markets
in PIIGS countries.
• October 26: In a summit of EU leaders, a grand plan is put together,
where bondholders indeed agree to take up to 50% losses on
holdings of Greek debt.
• As a result of severe political pressure, prime ministers George
Papandreou (Greece) and Silvio Berlusconi (Italy) resign in
November.
Debt crisis continued
• December 9: In a summit in Brussels, an
intergovernmental treaty is agreed to, which among
other things, cements more rigid rules for broaching
thresholds on deficit and debt to GDP levels.
• December 21: The ECB announces that it will
provide€489 billion in three-year loans to more than 500
banks in the EMU.
• As of January 4, 2012, with Italian sovereign debt
hovering around 7%, the dollar price of the euro is
$1.2923.
Debt crisis: 2012
• In late January, the “fiscal pact” agreed to in December is
signed by all EU members except the UK and the Czech
Republic.
• On February 12, Greece’s parliament passes an austerity bill
in anticipation of receiving additional bailout funds.
• On March 13, the eurozone agrees to an additional bailout of
Greece totaling €130 billion.
• In April, French voters elected Socialist Party candidate
François Hollande, an opponent of austerity, as their new
president. In Greece, voters rejected austerity policies backed
by the two incumbent parties.
Debt crisis continued
• June 2012: Spain requests a bailout for private banks only.
• June 25: Cyprus requests a bailout
• September 6, 2012: Outright Monetary Transactions program
is agreed to by the European Central Bank. The ECB agrees
to the sterilized purchase of sovereign bonds from countries
that have requested bailouts
• September 25, 2012: The European Stability Mechanism is
formally established. The ESM will replace the EFSF with a
maximum lending capacity of 500 billion euros for sovereign
entities in the EMU that are in need of financial support.
Calm?
• March 25, 2013: Cyprus reaches a deal with the troika to receive
the bailout of 10 billion euros. Cyrpus’ largest bank (Bank of
Cyprus) will be restructured, while its second largest bank will be
eliminated.
• As the size of the austerity program increases, eurozone
unemployment reaches an all time high of 12% in March 2013.
– Significant difference across the eurozone. Unemployment rates broach 24.3%
and 21.7% in Spain and Greece, but are only 5.4% in Germany as of March.
• July 2, 2013: A second Portuguese cabinet member resigns in
protest over continued austerity programs imposed by the “troika”
(European Central Bank, the EU, and the IMF).
• June’s unemployment rate in Portugal broaches 17%.
• Given the ECB backstop, the euro had stabilized in spite of turmoil.
It closed at 1.2973 on July 2, 2013.
Today
• In January of this year, Latvia becomes
the 18th EMU country.
• At least for now, markets appear to have
stabilized.
• On March, 12, 2014, the euro price of the
dollar hit it’s highest level in almost 3
years, reaching $1.3948.
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?
• 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:
Pt
( FC )
 St
( FC / $)
St
( FC / $)
$

Pt
FC
Pt
Pt
$
1
Real Exchange Rate
• The real exchange rate is defined as:
Rt =
St
(FC / DC )
Pt
Pt
DC
FC
• Take Mexico as an example: Suppose St is
relatively stable but, PtMex increases much
more rapidly than PtUS. The result, Rt
increases. The Mexican peso appreciates in
real terms.
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
• 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
• 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.