Download Currency, Economics and Financial Markets

Currency, Economics and
Financial Markets
Trevor Hunter
King’s University College
Foreign Exchange
• Foreign Exchange Market:
– The market for converting the currency of one
country into that of another
• Exchange Rate:
– The rate at which one currency is exchanged into
that of another country
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Foreign Exchange
• Functions of the Foreign Exchange Market:
– Convert currency of one country into another
– Provide insurance against foreign exchange risk
• Foreign Exchange Risk:
– Adverse consequences of unpredictable changes
in exchange rates.
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Foreign Exchange
• What would happen if your business buys its
raw materials in US dollars but earns sales in
Canadian dollars and the Canadian dollar
drops against the US?
• How can you guard against this?
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Foreign Exchange
• Main uses of foreign exchange markets for
international businesses:
– Convert export payments, foreign investment
income or licensing income from host to home
currency
– Payment of to suppliers of products or services to
host country companies
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Foreign Exchange
• Main uses of foreign exchange markets for
international businesses:
– Short term investments of spare cash in host
countries
– Currency speculation (arbitrage) – short-term
movement of funds from one currency to another
in the hopes of profiting from shifts in exchange
rates
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Foreign Exchange
• Insurance against exchange risk:
– Spot Exchange Rate: the rate at which a foreign
exchange dealer converts one currency into
another
– Forward Exchange Rate: occurs when two parties
agree to exchange currency and execute a deal at
a future time
– Forward Exchange: rates for currency are typically
quoted for 30, 90 or 180 days in the future
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Economic Theories of Exchange Rate
Determination
• Economic perspective:
– Basically determined by supply and demand for
different currencies
• The Law of One Price:
– In a competitive market free of non-production
related costs or trade barriers, identical products
sold in different countries must sell for the same
price when expressed in the same currency
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Prices and Exchange Rates
• Purchasing Power Parity (PPP):
– Used to examine what exchange rates “should” be
– Given relatively efficient markets (markets with
few impediments to international trade and
investment) the price of a “basket of goods”
should be roughly equivalent in each country
– If a basket of goods costs $200 in the US and Y20
000 in Japan, the exchange rate should be $US 1 =
Y100
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Prices and Exchange Rates
• The Economist’s Big Mac Index:
– Examines the cost of Big Macs in about 120
countries to examine what the exchange rate
between those countries’ currencies and the US
dollar “should” be.
– For numerous reasons, currencies can be over or
under valued. The difference between the PPP
and the actual exchange rates suggests by how
much a currency is valued incorrectly.
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The Big Mac Index Example
•
•
•
•
•
Price in US: $5.06*
Equivalent Price in China: Yuan 19.60
Implied PPP exchange rate: $US1 = Yuan 3.87
Actual exchange rate: $US1 = Yuan 6.93
Yuan is undervalued by 44.1% and should
appreciate against the dollar in the future
*Source:
June 2017 http://www.economist.com/content/big-mac-index,
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Prices and Exchange Rates
• If prices increase in one country but not in the other,
the currency in the country where prices increase
devalues by the same amount as the price increase,
against the first country.
• PPP is a powerful tool for predicting exchange rate
fluctuations for businesses if they study the market
in which they are operating well.
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Convertibility and Government Policy
• Governments often restrict the convertibility
of their currencies.
– Government policies
– Inflation control
– Economic stabilization
– Restrict external FDI
– Restrict MNE profit repatriation
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Convertibility and Government Policy
• Freely Convertible Currency:
– Government allows residents and non-residents to
purchase unlimited amounts of foreign currency with
its domestic currency
• Externally Convertible Currency:
– Government allows non-residents to convert their
domestic currency into foreign currency, but residents
can’t
• Non-convertible Currency:
– Both residents and non-residents are prohibited from
converting their domestic currency into foreign
currency
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Convertibility and Government Policy
• Capital Flight:
– Residents convert domestic currency into foreign
currency
– Most likely to happen during periods of
hyperinflation or shaky economic prospects
– Governments want to stop the loss of foreign
reserves to maintain or boost the domestic
currency
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Convertibility and Government Policy
• What happens if your business cannot convert the
money it makes in a foreign country into your home
country’s currency or transfer it out of the country?
(profit repatriation)
• Countertrade:
– Trade of goods and services for other goods and services
• Transfer pricing:
– Charges to subsidiaries for services or products supplied by
the parent MNE or other subsidiaries
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Foreign Exchange
• Dealing in multiple currencies is a requirement of
doing business internationally, but it also creates
risks and significantly alters the attractiveness of
different investment locations (i.e. FDI) over time
• Firms can use foreign exchange markets to minimize
the risks, but can also prevent them from benefiting
from favourable changes
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The Role of the IMF
• Frequent national and international financial
crises have required the IMF to step in to save
struggling economies burdened with debt.
• By 2012 IMF had 184 members, 117 of which
had some kind of surveillance program:
– “To maintain stability and prevent crises in the
international monetary system, the IMF reviews
country policies, as well as national, regional, and
global economic and financial developments
through a formal system known as surveillance”
http://www.imf.org/external/np/exr/facts/glance.htm
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International Monetary System
• The institutional arrangements countries
adopt to govern exchange rates:
– Gold standard
– Fixed exchange rate
– Pegged exchange rate
– Floating exchange rate
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The Gold Standard
• The practice of “pegging” currencies to gold and
guaranteeing convertibility to gold. One US dollar
was at one time worth 23.22 grains of gold. Exchange
rate was determined by how much gold each
currency could buy.
• One ounce of gold = 480 grains, so one ounce of gold
= $20.67. (today 1 ounce is worth about US $1281!)*
*Source: http://www.nasdaq.com/markets/gold.aspx, June 5, 2017
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The Gold Standard
• Strengths:
– Powerful way to ensure balance of trade equilibrium by all
countries – (income earned by exports = money spent on
imports) and controls inflation and money supply.
– If country 1 has a trade surplus vs. country 2, country 2 has
to pay out gold, buying it with its currency thereby
reducing its money supply and lowering costs. With its
costs lowered, 2’s products are more attractive to the
country 1 and will then buy more from 1 reversing the
situation resulting (eventually) in equilibrium.
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The Gold Standard
• Weaknesses:
– If countries purposely devalue their currency vs.
gold (i.e. making their currencies worth a lower
amount of gold meaning more money was
required to buy the same amount of gold), other
countries start to actually demand gold for
currency, depleting countries’ reserves and
creating massive inflation.
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The Gold Standard
• Weaknesses:
– High demand for gold leads countries to suspend
convertibility thereby destroying investor
confidence and credibility of the system
– Impracticality of physically transferring gold
between countries as trade grows
– Gold is somewhat finite and unequally dispersed
among countries
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The Bretton Woods System
• Creation of International Monetary Fund (IMF)
and International Bank for Reconstruction and
Development (IBRD or World Bank) to
supervise and police exchange rates (to avoid
purposeful devaluation of gold standard) and
to loan money to developing countries who
could not afford gold
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The Bretton Woods System
• Only the US dollar would be convertible to
gold and at a “pegged” rate.
• All other currencies set their exchange rate
relative to the US dollar
• Countries could not devalue their currency by
more than 10% without IMF approval
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The Bretton Woods System
• IMF would provide loans to buy currencies to
control for inflation and balance of payments
deficits but would impose stringent economic
policy requirements
• Led to concerns about national sovereignty
infringements
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The Bretton Woods System
• Strengths:
– Countries cannot use currency devaluation as a
trade weapon and thus not adversely affect
other countries’ economies
– Requires countries to have tight fiscal policies
to control money supply and inflation
– Allowed some flexibility to countries to control
their economy through internal economic
stimulus
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The Bretton Woods System
• Weakness:
– Totally dependent upon the belief that the US
would follow prudent fiscal policy and the US
dollar would therefore never devalue
– That is a pretty big leap of faith!
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The Bretton Woods System
• The Breakdown:
– US finances welfare and Viet Nam war by printing
more money – leads to inflation, economic
stimulus puts more money in peoples’ pockets
(good) but they spend it on cheaper imports (bad)
leading to balance of trade deficit (bad) and the
need to devalue the dollar (really bad)
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The Bretton Woods System
• The Breakdown:
– Currency traders buy a lot of other currencies
requiring other countries to buy more US to
maintain their currency value costing them a
lot of money and adversely effecting their
economies
– Other countries say “forget this” since it is too
expensive and just let the value of their
currencies fluctuate and do nothing to support
them
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Floating Exchange Rates
• The 1976 Jamaica Agreement
– Floating rates declared acceptable
– Gold abandoned as a reserve asset
– IMF member contributions increased to $41
billion!
– Results: greater volatility in exchange rates and
less predictability
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Floating Exchange Rates
• Events that had a large impact on exchange
rates:
– 1973 oil crisis
– Loss of confidence in dollar after high inflation in
1977-78
– 1979 oil crisis
– Unexpected rise in dollar between 1980-85
– Rapid fall of dollar against yen and deutche mark
between 1985-1995
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Floating Exchange Rates
• Strengths:
– Monetary policy autonomy – country’s ability to
expand and contract money supply is allowed
since countries’ do not have to maintain currency
parity
– Trade balance adjustments (from currency
devaluations) are much smoother with floating
rates
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Floating Exchange Rates
• Weaknesses:
– Allows countries to expand their money supply
and devalue currency which could lead to
contagion
– Opens up speculator market and could lead to
unsubstantiated devaluations
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Pegged Exchange Rates
• A country “pegs” or sets the value of its currency to
that of another major currency (usually the dollar)
• Countries have to maintain reserves of the foreign
currency equal to amount of the domestic currency
issued
• Popular among small countries and effective (if
reserves can be maintained) in moderating inflation
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Crises Facing the IMF
• Currency Crisis:
– Occurs when a speculative attack on the exchange
value of a currency results in a sharp depreciation
in the value of the currency or forces authorities
to expend large amounts of international currency
reserves and increase interest rates in order to
defend the exchange rates.
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Crises Facing the IMF
• Currency Crisis:
– If the domestic currency devalues:
• Imported goods increase in price – hyperinflation
• Loss of reserves – no secure source of funding vital
operations
• Citizens rush to exchange their currency for others –
further decreasing reserves
• Lowers the revenues exporting companies earn
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Crises Facing the IMF
• Banking Crisis:
– A situation in which a loss of confidence in the
banking system leads to a run on the banks as
individuals and companies withdraw their
deposits
– If banks do not have cash on hand to meet their
short term obligations (such as customer savings –
that’s why they are considered liabilities to banks)
they go out of business
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Crises Facing the IMF
• Banking Crisis:
– If banks go out of business there is:
• Increased unemployment
• No source of financing for businesses or individuals
meaning businesses close, people don’t buy things and
the economy halts – fast.
• No place to save money - no injection of investment
into economy
• No way to exchange foreign currency
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Crises Facing the IMF
• Foreign Debt Crisis:
– A situation in which a country cannot service its
foreign debt obligations, whether private sector or
government debt
– Essentially, a government owes more than it earns
and risks defaulting
– What happens when a government goes
bankrupt?
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Crises Facing the IMF
• Foreign Debt Crisis:
– If a country owes more than it earns:
• Huge amounts of its GDP is earmarked for interest and
principle payments on loans rather than the education
and health of its citizens
• Government is not free to use its income to stimulate
its economy
• National assets owned by foreigners
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Crises Facing the IMF
• Since the collapse of Bretton-Woods there have been
six main crises:
–
–
–
–
–
–
–
Third World Debt – 1980s
The Russian economic crisis after 1991
1995 Mexican currency crisis
the 1997 Asian financial crisis
Argentina foreign debt default in 2001
“Great Recession” of 2008
Generally all caused by excessive foreign borrowing, a
weak or poorly regulated banking system and high
inflation rates
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Third World Debt
• Banks lend developing countries massive
amounts of money to stimulate their economy
(mainly in Africa and Mexico) based on high
growth forecasts
• Forecasts inaccurate, thus incomes did not
materialize and developing countries choked
by interest charges (which were rising)
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Third World Debt
• Worsened by high inflation rates (caused by negative
growth leading to currency devaluation), recession in
developed countries (the destination of developing
countries’ exports) reduces inflows of hard currency
• USD $1 trillion in commercial debt among developing
countries that had to be written off – that’s 1 000
000 000 000!!!
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Third World Debt
• Countries announce they cannot service debts:
– Mexico - $80 billion
– Brazil - $ 85 billion
– Argentina, etc. etc.
• IMF steps in to:
– Provide new loans
– Reschedule existing loans
• Countries have to follow tight IMF economic
policies
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Third World Debt
• IMF plan dependent upon economic growth in
debtor countries – meaning income growth would
outpace payment growth didn’t happen
• Brady plan – debt reduction not rescheduling
– World Bank, IMF, and Japanese government (where most
of the creditors were located) each contribute $10 billion
to pay off some of the debt poorer countries owe
– Mexico gets relief of $15 billion on $107 billion
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Mexican Currency Crisis
• High Mexican debt
• Pegged currency that did not allow for natural
price adjustments – Mexico abruptly ends the
pegging and inflation skyrockets
• Mexican government runs out of reserves
trying to stabilize the peso
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Mexican Currency Crisis
• Mexico announces that it cannot pay its debts
due to depleted reserves, devalued currency
and hyperinflation
• IMF steps in with $50 billion ($20 billion
directly from the US)
• Tight monetary policies implemented and so
far, Mexico is recovering and paying its debt
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Russian Rouble Crisis
• From 1992 to 1995 the rouble fell from
US$1:R125 to US$1:5130. By 1997 it was
about US$1:R6300!
• Inflation in 1992 was 3000%!
• In 1997 federal spending was 18.3% of GDP
but revenues were only 10.8% - no taxes were
being collected
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Russian Rouble Crisis
• Russia asks IMF for money and promises to
reform tax system and implement strict
economic policies – IMF and US doesn’t
believe Russia and only gives part of the
request
• IMF is right but the rest of the money is given
and wasted
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Russian Rouble Crisis
• 1998 – Russia announces a 90-day
moratorium on foreign debt and unilaterally
reschedules all its short-term debt to longterm (of about $18 billion) – what could
foreign banks do?
• Introduce revalued Novy Roubles (they
chopped three decimals off the old ones but
they still devalue against the dollar
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Asian Financial Crisis
• The “BIG ONE” in 1997
• Seeds sewn in the previous decade when the
affected countries underwent unprecedented
growth
• Investments made in the 1990s, usually at the
urging of governments, based on questionable
projections declined in value as excess
capacity was created
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Asian Financial Crisis
• Huge increases in exports led to increase in
incoming funds fuelling a boom in commercial
and residential property, industrial assets and
infrastructure
• But investment came at demand peak,
demand fell, excess capacity resulted in
bankruptcies, recession and devalued assets
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Asian Financial Crisis
• Investment often supported by dollar-based
debt but earned local currency
• As demand decreased and inflation and
imports increased, currency devaluation
occurred meaning the value and amount of
income was not enough to pay debts
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Asian Financial Crisis
• The meltdown
• As several Thai financial institutions were on
verge of default, FX dealers and speculators
went against the currency.
• Thai government tries to maintain the peg,
but run out of foreign reserves
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Asian Financial Crisis
• Thai government abandons the peg and the
currency devalues by 50%
• Unable to defend the currency or pay its debt
in foreign currency, the government
approaches the IMF – result, $17.2 billion loan
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Asian Financial Crisis
• Analysts start eyeing other similarly structured
Asian economies and see the same problems
and start attacking their currencies
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Asian Financial Crisis
• Malaysia:
– Before, $1 = 2.525 ringgit, After, = 4.15
– Spends billions trying to support currency
– Avoids IMF loans
• Singapore:
– Before, $1 = S$1.495, After, = $2.68
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Asian Financial Crisis
• Indonesia:
– Before, $1 = 2400 rupiah, After, = 10000
– Gets $37 billion in IMF loans to help pay off debts
of over $80 billion
• South Korea:
– Before, $1 = 1000 won, After, = 1500
– Gets $55 billion in IMF loans to help pay off debts
of $100 billion with reserves of only $6 billion
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Asian Financial Crisis
• Results:
– $110 billion to support poorly run economies and
industries
– Thousands of unemployed people around the
world – for the first time, Hong Kong sees a big
spike in unemployment
– Billions of dollars in wealth (from that of large
firms to individual savings) wiped out
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Argentina’s Default
• “Argentina will not devalue, will not default in its
debt” Domingo Cavallo, Argentina’s Economy
Minister, Aug. 7, 2001
• December 2001, Argentina defaults on bonds
worth $81 billion of $188 billion worth of foreign
debt - $15 billion of that is owed to IMF from
three previous defaults
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Argentina’s Default
• Swaps old debt for new longer term debt (42
years) – now “only” has $120 billion or 75% of
GDP
• Forced banks to freeze withdrawls and convert
US accounts to pesos – citizens couldn’t get
their money because the government needed
it
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The 2008 Global Financial Crisis
• Caused by a collapse of the sub-prime mortgage system in the
US
• Led to losses of about 50% of the value of global equity
markets in 2-3 months – roughly $30 trillion
• Worst economic crisis since Great Depression
• High unemployment
• Decreased consumer spending and economic output
• Not really the realm of IMF – more domestic issue than global
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Critiques of IMF
• “One size fits all” mentality – doesn’t
adequately deal with national differences
• Creates “moral hazard” since people and
governments believe that the IMF will bail
them out, they don’t learn a lesson and
continue to undertake risky investments
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IMF Successes
• After initial periods of hardship, South Korea
and Mexico have seen their economies grow,
the standard of living of their citizens improve
and a big reduction in their foreign debt
• Mexico paid off the $20 billion from the US
ahead of schedule
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Implications for Business
• In reality the currency markets don’t often work as
they are planned or intended. Government
intervention occurs often and can have disastrous
results
• Speculative currency trading (which is a way that a
lot of companies – including Canada’s banks – make
a lot of money) can create currency volatility when
such movement may not be economically warranted
– Soros vs. Bank of England
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Implications for Business
• Flexibility and hedging with respect to
exchange rate is the best way to protect
yourself from exchange rate volatility
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Thoughts
• Think about where the IMF, the World Bank,
and the governments of the “rich” countries
get the money they use to bail out “poor”
countries – taxes on their citizens, and what
that money could be used for rather than
bailing out others
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Thoughts
• Is it right that my money, which by rights could
(and according to the initial purpose of taxation)
should be used for my benefit goes to help others
at literally my expense?
• Whose fault is it that these governments go
bankrupt? Didn’t they make the loans? Shouldn’t
they be held responsible?
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Thoughts
• What about the companies that made the
loans. Why do I pay for their poor credit
judgement (remember the 4 C’s of credit)?
• Why is my money used to bail out the fat-cat
banks and currency speculators who started
this all?
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Thoughts
• What benefit could be gained from the billions
of dollars government contribute to the IMF
and World Bank if it was spent on education,
health care, domestic poverty reduction, antidiscrimination, violence reduction, drug
problems, etc. etc. . . .
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Thoughts
• Remember who suffers because of these
financial crises. It is not the few rich people in
these poor countries, it is the many, many
really poor people.
• Don’t we as citizens of the planet have a
responsibility to help those of us who are
extremely disadvantaged?
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Thoughts
• The actions of a relative few: bankers, traders,
speculators, analysts, arbitragers; have
incredible effects on the global economy and
ultimately the lives of billions of people.
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