Transcript Chapter 8.

Chapter 8
The International Financial
System
1
Unsterilized Foreign Exchange
Intervention
Central Bank
Assets
International
Reserves
Central Bank
Liabilities
+TL1B Currency in
circulation
Assets
+TL1B
International
Reserves
Liabilities
+TL1B Reserves
+TL1B
 When Central Bank (CB) sells domestic
currency to purchase foreign currency, its
international reserves increase and the
monetary base also increases.
 When CB purchases domestic currency and
sells foreign currency, its international reserves
and the monetary base decreases.
2
Unsterilized Intervention
When CB sells (or buys) domestic
currency and buys (or sells) foreign
currency, we call this an “unsterilized
intervention” An unsterilized purchase
(sale) of foreign currency leads to a gain
(loss) in international reserves, an
increase (decrease) in the money supply,
and a depreciation (appreciation) of the
domestic currency.
3
Sterilized
Foreign Exchange Intervention
Central Bank
Assets
International Reserves
Liabilities
+YTL1m Monetary Base
(reserves)
Government Bonds
0
-YTL1m
 Sterilization: To neutralize the effect of the
foreign exchange intervention on the money
supply.
 Example: If CB buys dollars and increases the
supply of liras, then CB also sells govt. bonds
at the same amount. This leaves the monetary
base, the money supply and exchange rates 4
unchanged.
Balance of Payments
 Balance of Payments = Current Account +
Capital Account
(Net Capital
Inflows)
 Sum of current account and capital
accounts shows the net change in the
official (dollar) reserves of Turkey.
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Balance of Payments
1. Current Account :Assets (+) Liabilities (-)
1. Trade Balance = +Exports – İmports
2. Services Balance
1.
2.
3.
4.
+Net Foreign Tourism Revenues
+Banking & Insurance Net Revenue
+Construction & Transportation Net Revenue
+Workers’ Remittances + Paid Military Service
3. Unilateral transfers (Aid to TRNC)
6
Balance of Payments
“Current Account (CA) Deficit” means that
CA is a negative number. This is usually
because the largest item “Trade Balance”
is negative. For example, Turkey’s 2008
(2007) January-March exports are $33
($24.4) billion, imports are $49 ($33)
billion, trade balance is -$16 (-$8.6)
milyardır. See: odemelerdengesi.xls
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Balance of Payments
2. Capital Account = Net Capital İnflows =
1. +Purchases of Domestic (Turkish) assets by
Foreigners
2. – Purchases of Foreign Assets by Domestic
(Turkish) Residents
3. + Net Borrowing of Turkish Residents from
Foreign residents
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Balance of Payments
 Capital Inflows: Two types:
1.Foreign Direct Investments (FDI): Takes
control of the firm, bank, etc. Ex: Migros sale
to British, Finansbank sale to NBG, ToyotaSA,
are FDI inflows. Ülker purchase of Godiva is
FDI outflow.
2.Foreign Portfolio Investment (FPI) (stocks,
bonds, credits). Foreign investors buying
stocks at ISE, Turkish banks & firms borrowing
from foreign banks are FPI inflows. Turkish
banks lending to Azeri firms is FPI outflow.
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Balance of Payments
Except year 2001, TR’s current account
has been negative. However, TR’s capital
account surplus is by far greater than its
current account deficit. This means that
there was a net dollar inflow into TR. This
is why dollar has depreciated against TL in
the last few years.
Current Account/GNP(%)
2000
2001
2002
2003
2004
2005
2006
2007
-4.90
2.37
-0.99
-2.86
-5.17
-6.39
-6.62
-5.7
10
Exchange Rate Regimes
Fixed exchange rate regime
 Value of a currency is pegged relative to the
value of one other currency (usually dollar).
CB intervenes by buying and selling dollars
to keep ER fixed.
 Turkey followed fixed ER regime before
2001. ER was kept within a band.
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Exchange Rate Regimes
Floating exchange rate regime
 Value of a currency is allowed to freely
fluctuate against all other currencies: no
interventions in the forex market.
Managed float regime (dirty float)
 Attempt to influence exchange rates by buying
and selling currencies. Turkey has followed
dirty float after 2001.
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Past Exchange Rate Regimes
Gold standard: 19th century and until
World War I
 Fixed exchange rates
 No control over monetary policy
 Money supply influenced heavily by
production of gold and gold discoveries.
When gold production is low (high), money
supply increases slowly (fast), deflation
(inflation) happens.
13
Past Exchange Rate Regimes
(cont’d)
 Bretton Woods System: 1944-1971
 Fixed exchange rates using U.S. dollar as the
reserve currency: $ 35 convertible per 1 ounce of gold
(only for governments and CBs, not public).
 International Monetary Fund (IMF)
 World Bank
 General Agreement on Tariffs and Trade (GATT)
 Became World Trade Organization
14
Past Exchange Rate Regimes (cont’d)
European Monetary System: 1979-1990
 Exchange rate mechanism is a fixed ER regime
within Europe. Before the euro in 1999, as a
preparation.
Euro’s challenge to the dollar as the
reserve currency in international financial
transactions:
 Not yet because Europe is not a united political
entity.
15
How a Fixed Exchange Rate
Regime Works
 Suppose that the official fixed parity is 1,31
TL/USD. Suppose that for some reason demand
for TL assets increases. This increases value of TL
in the free forex market above the official parity:
1,20 TL/USD (TL is undervalued). In this case, CB
buys dollars and sells TL and increases the
money (TL) supply. This decreases the interest
paid by TL assets, which reduces demand for TL
assets. CB can buy dollars until the free market
ER is equal to the fixed 1,31 TL/USD. CB’s
inetrnational reserves increase.
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How a Fixed Exchange Rate
Regime Works
1/E
($/TL)
S
1/1,20
1/1,31
1/1,60
D
D’
Qty of TL
assets
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How a Fixed Exchange Rate
Regime Works
 Now let us suppose that for some reason demand
for TL assets decrease (maybe because FED
increases rates). TL loses value in the free forex
market below the fixed parity (overvalued). In
this case CB buys TL and sells dollars. This
reduces money supply and increases the interest
rate on TL assets, which increases demand for TL
assets, which increases value of TL back to 1,31
TL/USD. But notice that CB’s dollar reserves are
spent in this process. If CB does not have enough
reserves to defend the peg, then it must devalue
value of TL to a lower level.
18
How a Fixed Exchange Rate
Regime Works
1/E
($/TL)
S
1/1,20
1/1,31
1/1,60
D’
D
Qty of TL
assets
19
What Happens during a Currency
Crisis?
 Speculators force the CB to devalue by quickly
selling TL assets they have bought before and
buying dollars: speculative attack. Their
objective is to make profit from a devaluation.
 When the CB runs out of dollars, then the CB
cannot defend the value of lira anymore. So need
to devalue the lira to a lower level: Devaluation.
 When the CB does not want to hold additional
international reserves anymore, then revaluation
occurs.
20
How Bretton Woods (1944-71)
Worked
 Exchange rates adjusted only when experiencing a
‘fundamental disequilibrium’ (large persistent deficits in
balance of payments)
 Loans from IMF to cover loss in international reserves
 IMF encourages contractionary monetary policies
 Devaluation only if IMF loans are not sufficient
 IMF cannot force surplus countries to revalue.
 U.S. could not devalue the dollar during 1960s. The other
surplus countries did not want to revalue. System
collapsed in 1971.
21
Managed (Dirty) Float (1971now)
 Bretton-Woods collapsed: US and others allowed
exchange rates to float.
 Hybrid of fixed and flexible
 Small daily changes in response to market
 Interventions to prevent large fluctuations
 Appreciation of domestic currency hurts exporters
and employment
 Depreciation of domestic currency hurts imports
and stimulates inflation
22
European Monetary System
 1979: 8 members of European Economic
Community fixed exchange rates with one
another and floated against the U.S. dollar
 ECU value was tied to a basket of specified
amounts of European currencies: Exchange
Rate Mechanism (ERM).
 Fluctuated within limits. If goes beyond limits,
Central Banks intervene in the market by
buying the weak currency and selling the
strong currency.
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European Monetary System
Fixed ER policies may lead to foreign
exchange crises involving speculative
attack: massive sales of the weak
currency and purchases of the strong
currency.
Profitable if they can cause a sharp
devaluation of the weak currency.
Turkey: 1994, 2001. Europe: 1992, Brazil
1998, East Asia 1997-98, Mexico 1994.
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European Forex Crisis of September
1992
 German unification (1990) and inflationary
pressures led Bundesbank to increase interest
rates.
 This led British pound to be overvalued at the
ERM parity 2.778. To correct this, either British
had to increase rates or Germans had to
decrease rates. Neither wanted to do these b/c
Britain was in recession.
 Speculators knew pound devaluation is coming
and sold massive amounts of pound assets and
bought mark assets.
25
26
European Forex Crisis of
September 1992
 Sept. 16: British floated the pound: 10%
devaluation against the DM. They also quit ERM
and did not join the euro.
 George Soros made $1 bn, Citibank made $200
m.
 Same story in Turkey 1994, 2001, Argentina
2001, East Asia 1997, Mexico 1994, Brazil 1998.
 Causes may be a little different. But all were
following fixed ER policies.
 Argentina’s 2001 and Turkey’s 2001 crises are
both due to government budget imbalances.
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Capital Controls
Controls on Outflows
 Outflows of capital promote financial instability
by forcing a devaluation
 Controls are seldom effective because it is
easy to find ways around them.
 Controls may block funds for productive uses
such as roads, infrastructure
 Chilean experience: capital cannot leave the
country before one year (Tobin Tax) .
 Controls on outflows reduces the inflows too.
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Capital Controls (cont’d)
 Controls on İnflows: Capital İnflows lead to a
lending boom and excessive risk taking by
financial intermediaries (1997 Asian Crisis)
 Strong case for improving bank regulation
and supervision. Turkey has been successful in
reforming the banking system after the 2001
crisis.
29
IMF
 Was established after World War II. Its purpose
was to maintain the fixed exchange rate system
called “Bretton Woods” (1944-71) by lending to
the countries that had balance of payments
deficits.
 However, the Bretton Woods system collapsed in
1971 and IMF became an institution that provides
financial and technical assistance to member
countries.
30
IMF
 IMF has lent to less developed countries in repaying their
foreign debt during:
 1980s’ Third World Debt Crisis, 1994-95 Mexican Crisis,
1997-98 East Asian Crisis, and 2001 Turkish Crisis
(~20billion).
 Of course, during credit arrangement, IMF asks the
borrowing country to write a commitment letter in which
the country’s government commits to the policies
prescribed by IMF. Because if these policies are not
followed, the same imbalances in the economy will cause
another crisis in the future. If the borrowing country
believes that IMF will bail them out even if they do not
follow prescribed policies, then the country will never solve
its problems and there will be moral hazard problem.
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IMF Critics
 IMF critics say that:To the governments that
cannot sell its debt and cannot preserve the
value of their currency, IMF lends if the
following conditions are promised by the
borrower:
1. Reduce government expenditures or
increase taxes so that you need to borrow
less. Joseph Stiglitz and other critics: such
measures during a crisis can only deepen the
crisis and recession. They argue that
government should increase expenditures and
aggregate demand so that the economy is
brought out of recession.
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IMF Critics
2. Increase interest rates. This helps
increase the value of domestic currency.
However, according to Stiglitz, this causes
otherwise sound firms to go bankrupt
because they cannot repay their debt with
higher interest rates.
3. Trade and Financial Liberalization:
Critics: The industrialized countries of
today did not have liberal trade and
financial systems when they were
industrializing 200 years ago. Foreign
banks take over the weak banking systems
in less developed countries.
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IMF Critics
4. Privatization: Critics argue foreign
companies take over sectors and increase
dependency.
5. Fear of default. Critics argue that one
of the objectives of the IMF is to ensure
that high-risk, high-return loans from
international banks to less-developed
countries are repaid.
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IMF Critics
6. Instead of financial reform, IMF
prescribes contractionary
macroeconomic policies. This causes
the IMF to be a profitable scapegoat for
domestic politicians as anti-growth,
anti-employment. IMF is seen as a
foreign entity interfering with domestic
policy.
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IMF as a Lender of Last Resort
IMF can prevent contagion of crises.
Crisis in one country can easily spread to
other countries in the same region or
category due to herding behavior in
financial markets.
IMF bailouts may cause excessive risktaking and moral hazard for domestic
banks and their international creditors.
This will increase risk of crisis in the
future.
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IMF Stand-By Arrangements with TR
Figure 1. Stand-By Arrangements Cases in Turkey (1960-2004)
Karagöl, Erdal, Metin Özcan, Kıvılcım, “The Economic Determinants of IMF Standy Aggreements in Turkey”
Actual
1
0.5
0
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
Actual
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Factors that Increase the Likelihood of
an IMF Standby Agreement
According to Erdal Karagöl and Kıvılcım
Metin Özkan (2008):
Standby Prob.
 Total investments / GNP 
 Foreign debt service / F.D. stock 
 Foreign debt service / Exports 
 Govt. expenditures / GNP 
decrease
decrease
increase
decrease
38
World Bank
 Mission: Established after WWII to provide funds
to reduce poverty and promote development in
the world. Provides loans for infrastructural
projects in health, education, agriculture, energy.
 Critics: Stiglitz, Caufield: Hasty and unregulated
free market reforms prevent economic
development.
39
Balance-of-Payments Considerations
Current account deficits in Turkey suggest
that Turkish businesses may be losing the
ability to compete because the YTL is too
strong.
Current A. deficits increase the risk of a
BOP crisis. CB may reduce interest rates
for this purpose: expansionary policy.
Expansionary (contractionary) policy
reduces (increases) interest rates and
decreases (increases) value of TL.
40
Balance-of-Payments Considerations
But expansionary policy increases risk of
inflation for two reasons:
 Prices of imported goods (tradables) increase
(energy)
 Since money supply increases, real value of
money (in terms of goods and services)
decreases.
41
Advantages of
Exchange-Rate Targeting
Crawling Peg Policy applied in Turkey
1999-2001 as a method to bring
inflation under control. Internationally
tradable goods’ prices are anchored to
the world prices, rate of inflation fell.
We floated after the 2001 crisis.
Crawling Peg Policy keeps the ER in a
pre-specified band. Ex: (1,50 YTL/$ ±
0,20 YTL/$) for a specific period. Allows
lira to move within the band.
42
Advantages of
Exchange-Rate Targeting
Automatic rule for conduct of monetary
policy. Prevents temptation of short-run
benefits of expansionary policy. (Ex:
election economics). Reduces political
pressure on the CB to expand money
supply.
43
Exchange-Rate Targeting
for Emerging Market Countries
Political and monetary institutions
are weak. Not much to gain from
independent mon. policy. But much to lose
from irresponsible CBs and politicians
(high inflation 1977-2003).
Helps tie the hands of the govt. from
conducting expansionary policies.
BUT!!! Costs of a currency crisis much
more than these benefits.
44
Disadvantages of
Exchange-Rate Targeting
 Moral Hazard: Banks take on too much
exchange rate risk expecting the govt. to
defend the peg. İncreases financial fragility.
 Then economy becomes vulnerable to
speculative attacks on currency. İnt. creditors
suddenly sell lira assets, capital flight. Force
the CB to devalue.
 Loss of independent control of money supply.
Cannot fix both ER and money supply. Cannot
respond to domestic shocks.
 Shocks to anchor country are transmitted to
domestic country
45
Currency Boards
 Extreme case of fixed ER policy.
 Domestic currency is backed 100% by a foreign
currency
 Note issuing authority establishes a fixed
exchange rate and stands ready to exchange
currency at this rate. (Ex: 1 YTL/$)
 Money supply can expand only when CB’s dollar
reserves increase. Decreases the possibility of
a speculative attack-currency crisis.
46
Currency Boards (cont’d)
 Stronger commitment by central bank
 Loss of independent monetary policy
and increased exposure to shock from
anchor country
 Loss of ability to create money and act as lender
of last resort
 Applied in Argentina (1991-2002), Bulgaria
(1997), Bosnia (1998), Hong Kong (1983),
Estonia (1992), Lithuania (1994)
47
Dollarization
 Totally giving up domestic currency and adoption
of another currency (dollar)
 Ecuador dollarized in 2000.
 Even stronger commitment mechanism
 Completely avoids possibility of speculative
attacks on domestic currency
 Loss of independent monetary policy
and increased exposure to shocks from
anchor country (US)
48
Dollarization (cont’d)
 Inability to create money and act as lender
of last resort
 Loss of seignorage revenue earned from
purchasing bonds with printed currency. $30bn
per year for US.
 Ex: “President Carlos Menem of Argentina has
advocated replacing the Argentine peso with
the dollar. Dollarization would benefit Argentina
because it would eliminate the peso-dollar
exchange-rate risk, lower interest rates, and
stimulate economic growth” March 12, 1999 by Steve H. Hanke
and Kurt Schuler, ”A Dollarization Blueprint for Argentina”, CATO Foreign Policy Briefing No. 52
49