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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 King's College 2 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. King's College 3 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? King's College 4 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 King's College 5 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 King's College 6 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 King's College 7 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 King's College 8 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 King's College 9 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. King's College 10 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, King's University College 11 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. King's College 12 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 King's College 13 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 King's College 14 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 King's College 15 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 King's College 16 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 King's College 17 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 King's College 18 International Monetary System • The institutional arrangements countries adopt to govern exchange rates: – Gold standard – Fixed exchange rate – Pegged exchange rate – Floating exchange rate King's College 19 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 King's College 20 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. King's College 21 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. King's College 22 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 King's College 23 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 King's College 24 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 King's College 25 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 King's College 26 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 King's College 27 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! King's College 28 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) King's College 29 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 King's College 30 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 King's College 31 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 King's College 32 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 King's College 33 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 King's College 34 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 King's College 35 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. King's College 36 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 King's College 37 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 King's College 38 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 King's College 39 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? King's College 40 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 King's College 41 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 King's College 42 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) King's College 43 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!!! King's College 44 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 King's College 45 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 King's College 46 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 King's College 47 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 King's College 48 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 King's College 49 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 King's College 50 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 King's College 51 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 King's College 52 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 King's College 53 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 King's College 54 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 King's College 55 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 King's College 56 Asian Financial Crisis • Analysts start eyeing other similarly structured Asian economies and see the same problems and start attacking their currencies King's College 57 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 King's College 58 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 King's College 59 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 King's College 60 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 King's College 61 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 King's College 62 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 King's College 63 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 King's College 64 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 King's College 65 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 King's College 66 Implications for Business • Flexibility and hedging with respect to exchange rate is the best way to protect yourself from exchange rate volatility King's College 67 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 King's College 68 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? King's College 69 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? King's College 70 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. . . . King's College 71 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? King's College 72 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. King's College 73