AND THE GLOBAL BUSINESS ENVIRONMENT

2nd edition

MACROECONOMICS

Currency Crisis and Exchange Rate Systems

PowerPoint by Beth Ingram University of Iowa

Copyright 2005 John Wiley & Sons, Inc. All rights reserved.

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Key Concepts
Covered Interest Parity

Uncovered Interest Parity

Spot and Forward Exchange Rates Global Capital Markets

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Currency Crisis
Sudden and dramatic currency depreciation,

accompanied by decline in the real exchange rate

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Exchange Rates during Crisis

250 225 200 175 150 125 100 75 A pr Jul Oct 98 A pr Jul Oct 99 A pr Jul Oct

Malaysia E xchange rate against U S dollar (1996=100) Thailand E xchange rate against U S dollar (1996=100) S outh K orea E xchange rate against U S D ollar (1996=100)
Source: EcoWin

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GDP during Currency Crisis

125 120 115 110 105 100 95 90 85 80 75 94 95 96 97 98 99 00

Malaysia GD P (1996=100) Thailand GD P (1996=100) S outh K orea GD P (1996=100) Indonesia GD P (1996=100)

Source: EcoWin

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First Generation Model

US policy

Fiscal deficit Nominal exchange rate constant Short term interest rate must fall Expected inflation must rise

Finance deficit through inflation tax

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Nominal Exchange Rate

Current exchange rate (/$)

iJ

Short term interest rate falls Expected future exchange rate falls (inflation)

S*(0)

iUS + [Se(1)-S(0)]/S(0)

Rate of Return

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Nominal Exchange Rate

Current exchange rate (/$)

iJ

To maintain S(0), interest rates must increase (consistent with inflation story)

S*(0)
iUS + [Se(1)-S(0)]/S(0)

Rate of Return

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First Generation Model

US policy

Fiscal deficit Nominal exchange rate constant Short term interest rate must fall Expected inflation must rise Offer higher interest rates Buy domestic currency

Finance deficit through inflation tax

To keep exchange rate constant

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Vicious circle
Fiscal Deficit and Monetization

Inflation and downward pressure on exchange rate

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End game
Government eventually runs out of reserves

Currency traders anticipate a currency

depreciation Speculative attack

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Second generation model

ERM

Exchange rate mechanism Fixed exchange rates among European economies Implied same inflation and interest rate among member countries If rate is stable, no attack If currency is vulnerable, sell off

Self-fulfilling equilibria

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Tradeoff
Low and Stable Inflation

Fixed Rate

No Fixed Rate

Lower interest rates, more growth

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Snowball effect
Slow Growt h Incentive to abandon fixed rate Investors sell currency Interest rate must rise

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Asian Currency Crisis

Liberalization of capital markets

Capital inflows to Asian countries Countries become net borrowers (capital account surplus)
Capital account deficit Downward pressure on exchange rate

Capital outflow

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Currency Crisis (cont.)

Purchase domestic currency, sell foreign

currency Raise interest rates

Stop capital outflow Put upward pressure on exchange rate Deflationrecession

Decline in money supply, rise in interest rate

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Debt Dependence
Emerging economies rely on foreign-

denominated debt Original sin Debt intolerance

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International Monetary Fund

Established in 1946

Bretton Woods, 1944

Lender of last resort 184 member countries

http://www.imf.org/

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Elements of IMF lending

Special Drawing Rights (SDR)

Member quota
Emergency lending service
Wednesday August 4, 2004 1 SDR = 1.456 USD 1 USD = 0.686811 SDR SDR Interest Rate = 1.91%

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IMF outstanding credit

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IMF Intervention and GDP growth

Figure 21.6a

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IMF Intervention and Fiscal Deficits

Figure 21.6b

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Capital Account Liberalization

Financing investment and stimulating growth

Risk diversification
Improving government policy Increasing efficiency of financial sector

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Pre-crisis IMF Statements

In October 1998 the IMF argued that Capital

controls may also turn out to be an important setback not only to that countrys [Malaysia] recovery and potentially to its future development, but also to other emerging market economies

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Michael Mussa -- IMFs former chief economist

High openness to international capital flows,

especially short-term credit flows, can be dangerous for countries with weak or inconsistent macro-economic policies or inadequately capitalized and regulated financial systems

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The Impossible Trilogy

Independent monetary policy

Fixed exchange rate

Absence of capital controls

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Exchange Rate Regimes (70 Small countries)

80%

60% 1991 1999

40%

20%

0% Hard Peg Intermediate Float

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Fixed Rate
Exchange rate fixed at constant level

Advantages

Provides a nominal anchor Encourages trade and investment Avoids speculative bubbles Reduces risk premium

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Floating Rate
Let nominal exchange rate adjust to market

conditions Like US, Canada, Australia Advantages

Independent monetary policy Automatic adjustment to trade shocks Seignorage Avoid speculative attacks

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Intermediate Regime
Float, but within boundaries

Exchange Rate

Time

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Hard Peg
Fix one bilateral nominal exchange rate Dollarize (Ecuador)

Abandon own currency and use another nations currency No more seignorage! Central bank holds interest-bearing foreign assets Will exchange domestic currency for foreign currency at a fixed exchange rate, backed by assets

Currency Board (Argentina)

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Currency Board
Role of Central Bank

Exchange domestic currency for foreign reserves at fixed rate of exchange Can never produce fiat money Cannot issue liquidity of domestic banks

Goals? If FX reserves fall, domestic money supply

falls

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Argentina
Public sector financing requirements (Billions of US$) 2001 2002 Uses 20.1 18.8 Fiscal Deficit 6.9 0.0 Primary Surplus 4.1 10.4 (T G) Interest 11.0 10.4 Amortizations 12.2 17.8 (existing bonds/loans) Other 1.0 1.0 Sources Initial Cash IFIs
Voluntary Market

End Cash

24.4 0.2 17. 2 7.0 4.3

18.8 4.3 7. 0 (International Financial Institutions, IMF) 7.5 (Financial markets) 0.0

Source: Lehman Brothers

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Argentina
$150 billion in external debt

Currency board pegged to US$

$8 billion in IMF loans

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Argentine deposits and FX reserves

82 80 78 76 74 72 70 68 66 8-M ar-99 6-Oct-99 9-M ay-00 13-Dec-00 18 25-Jul-01 28 reserves deposits 23 33 38

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10%

15%

20%

0%

5%

3-month interest rate differential between Argentina and US

3Ja n01 31 -J an -0 1 28 -F eb -0 1 28 -M ar -0 1 25 -A pr -0 1 23 -M ay -0 1 20 -J un -0 1 18 -J ul -0 1 15 -A ug -0 1

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Argentina what happened?

Real exchange rate appreciation

Labor market rigidities

Inappropriate monetary policy Recession Fiscal deficit Foreign currency denominated debt

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Why go Euro?

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The euro
Optimal Currency Area

Degree of trade between countries Similarity of economic shocks Labor market mobility Nature and amount of fiscal transfers

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The road to Euro

1979 European Monetary System Establishes the Ecu Blueprint for monetary union 1986 European Single Act Free movement of people, goods, capital 1992 Maastricht Treaty (Treaty on European Union) Provides legal basis for EMU Provides for single currency 2002 Euro replaces domestic currencies

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Convergence Criteria
Inflation

Rate cannot be more than 1.5% above average inflation rate of three lowest Member states
Cant exceed 3% of GDP Cant exceed 60% of GDP Rate cannot be more than 2% higher than the average of the three states with the lowest inflation rates No currency fluctuations outside the normal EMS margins for two years

Public Budget Deficit

Public Debt

Interest Rate

Currency

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Euro Exchange Rates

1.95583 German marks 6.55957 French francs 1936.27 Italian lira 166.386 Spanish pesetas 200.482 Portuguese escudos 5.94573 Finnish markka 0.787564 Irish punts 40.3399 Belgian/Luxembourg francs 2.20371 Dutch guilders 13.7603 Austrian schillings 340.750 Greek drachmas

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Benefits
Reduce business costs for intra-EU trading

Ease purchases for tourists and people in

bordering areas Decrease prices Increase stability in EU

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Central Bank Intervention

Unsterilized intervention. Central bank purchases its own currency using foreign exchange reserves Reduces money supply, increases interest rate Sterilized intervention Purchase domestic currency using FX reserves Follow by purchase of domestic bonds so money supply doesnt change Concerted Intervention Bilateral intervention in same direction

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Yen/Dollar intervention (Yen/$)

160 150 140 130 120 110 100 90 80 88 89 90 91 92 93 94 95 96 97 98 99 00 01

Source: EcoWin

Light area buy dollars; dark area sell dollars.

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DM/Dollar Intervention
2.4 2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 88 89 90 91 92 93 94 95 96 97 98 99 00 01

Source: EcoWin

Foreign Exchange Reserves: Selected Countries 1999

Country Australia Brazil Canada China France Germany Japan Taiwan Mexico Mozambique Russia
United Kingdom
Gross Reserves US$ billion Import Cover (months)*

21.2 34.8 28.1 157.7 39.7 61.0 286.9 106.2 31.8 0.6 8.5 29.8 60.5 0.3

3.2 5.6 1.4 11.4 1.4 1.2 9.4 10.2 2.7 6.5 1.4 0.9 0.7 1.2

United States Zimbabwe

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Summary
Currency crises

Models 1st generation, 2nd generation

Asian crisis IMF Exchange rate regimes Euro Central bank intervention
Copyright 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein.